Putting the "finance" into "public finance": a theory of capital gains taxation

Standard optimal capital tax theory abstracts from modeling asset prices, making it unsuitable for thinking about capital gains and wealth taxation. We study optimal redistributive taxation in an environment with asset price movements, adopting the modern finance view that asset prices fluctuate not only because of changing cash flows, but also due to other factors (“discount rates”). We show that the optimal tax base (i) generally differs from the case with constant asset prices, and (ii) includes realized trades whenever asset-price changes are not exclusively driven by cash flow changes. A combination of realization-based capital gains and cash flow taxes implements the optimal allocation regardless of the source of asset-price fluctuations. These results stand in contrast to the classic Haig-Simons comprehensive income tax concept as well as recent proposals for wealth or accrual-based capital gains taxes.