research

Abstract

This paper argues that the long run volatility of the price-dividend ratio is decisively driven by capital taxes. First, a new empirical fact is documented: capital taxes alone are able to explain up to 85% of the permanent increase in the long-run volatility observed since the mid 1990s in the United States. Second, the role of stochastic capital taxes is analysed in a consumption-based asset pricing model. In a standard Rational Expectations setup with stochastic taxes, tax volatility capitalizes into price volatility since taxes affect investor’s net cash-flows. However, this fundamental channel only gives rise to a transitory volatility response. Alternatively, a model in which rational investors face uncertainty about how fundamentals map into prices and learn about it brings up a new non-fundamental channel: taxes determine the elasticity of stock prices to investors beliefs. In this case, if a tax rate change is persistent, this second channel produces a persistent rise in volatility as the one observed. Third, different versions of the model are structurally estimated. The learning model quantitatively replicates a list of statistics made of traditional asset pricing facts as well as the new tax-volatility link. Remarkably, a high enough equity premium (along with a low and stable risk-free rate) is obtained with low risk aversion levels. Contrarily, the RE counterpart performs poorly in all the relevant dimensions.