I have heard that introducing capital gains taxes would create distortions in investments, and that the optimal tax rate for capital gains is actually 0. My question is what observed evidence is there of the distortions or "side-effects" that have been created do to the introduction of or the increase in capital gains taxes? Is there also empirical evidence of the opposite, i.e. an increase in investments (and any other "desirable" side-effects) due to the decrease or elimination of the capital gains tax?


Correcting Misconceptions in the Question:

Before providing an answer it is worth noting the premise in your question is simply incorrect. You state:

I have heard that introducing capital gains taxes would create distortions in investments, and that the optimal tax rate for capital gains is actually 0.

But this is not rationale for the famous 0 capital income tax Chamley-Judd result. Virtually all taxes create distortions, and any modern government, due the amount that modern governments spend, has to resort to distortionary taxation at some point. However, the famous Chamley-Judd result showed that (Chamley, 1986; Judd, 1985) the burden of capital income tax is in long run shifted to labor, so there is no point to those distortions and one should just levy those taxes on labor incomes instead (although more recent papers showed that the result does not always hold and that only some of the burden of capital income taxes gets shifted not all of it - e.g. see Straub & Werning 2014 or Diamond & Saez 2011).

So the 0 capital income tax result had nothing to do with distortions directly. Indeed taxing labor causes non-trivial amount of distortions as well and in spite of that those economists recommended taxing it directly.


Now to your main question on whether empirically capital taxation causes distortion, the answer is clearly yes. There are numerous studies showing that, and I think it is a fair to say that the question is not if there are distortions but how much and how economically significant they are.

The deadweight loss and distortions caused by capital income taxes will vary from country to country and from time period to time period, and it is beyond scope of a single answer to cover every country on a planet and every time period but here are examples of some studies that found capital taxes create distortions:

Devereux MP (2004) Measuring taxes on income from capital. In: Sørensen PB (ed) Measuring the tax burden on capital and labour. MIT Press, Cambridge

Becker J, Fuest C (2004) A backward-looking measure of the effective marginal tax burden on investment. CESifo Working Paper No. 1342

Goolsbee, A. (1998). Taxes, organizational form, and the deadweight loss of the corporate income tax. Journal of Public Economics, 69(1), 143-152.

Shan, H. (2011). The effect of capital gains taxation on home sales: Evidence from the Taxpayer Relief Act of 1997. Journal of Public Economics, 95(1-2), 177-188.

These are just few examples, but in public economics there is no question that capital taxes create some distortions (generally the only non-distortionary taxes are Pigouvian taxes and lump-sum taxes plus some special cases), so the question is not if but how much and answer to that will differ in time and place. Moreover, this has nothing to do with the zero capital tax result even pro-capital income tax economists would not deny taxing capital is distortionary.

For example, Goolsbee (1998) founds that corporate taxes (which are economically taxes primarily on capital incomes) in the US between years 1900–1939 caused distortions that resulted in deadweight loss of 5–10% of their revenue. Again that number will vary by place and time.

The positive effects of elimination of capital income tax on economy are elimination of the above mentioned distortions. Hence, if capital taxes caused in the US between 1900-1939 deadweight loss of 5-10% of revenue, then eliminating them would mean that this loss would not occur in the first place.

  • $\begingroup$ I'm not sure if I am allowed to ask follow-ups in the comments, but I am still unsure why "the burden of capital income tax is in long run shifted to labor". Is there a theoretical explanation for the phenomenon? $\endgroup$ – MrMineHeads Apr 25 at 3:47
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    $\begingroup$ @MrMineHeads because in a long run they showed that capital supply is perfectly elastic. As a general rule the side of market that is more elastic always gets less of a tax burden. For example, if you have market for apples if supply of apples is perfectly elastic and demand for apples not, then even if you do not tax consumers but producers all the economic burden of a tax is shifted to consumers. On the other hand if demand would be perfectly elastic and supply inelastic then even a consumption tax applied to consumers would be actually fully shifted to producers. So it’s due to elasticity $\endgroup$ – 1muflon1 Apr 25 at 7:54
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    $\begingroup$ However, as mentioned in the answer some newer theoretical research shows that the 0 capital income tax result does not necessarily hold and that is mostly because they show that capital supply won’t necessarily be always completely perfectly elastic (even if it can be still very elastic). If supply is only elastic and not perfectly elastic only part of the tax burden gets shifted to labor not all of it meaning that having non-0 capital income tax could make at least some sense. $\endgroup$ – 1muflon1 Apr 25 at 7:58
  • $\begingroup$ Just to make sure I understand, the consumption side of capital is labour? $\endgroup$ – MrMineHeads Apr 25 at 17:19
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    $\begingroup$ @MrMineHeads no the labor is not consumption side of capital - using producer-consumer was just a simplest example of tax burden shifting this does not hold just between demand and supply in one market but also more generally between multiple markets. In the Ch&J case the tax burden gets actually shifted from capital income through effects of capital income tax on choice between consumption of goods and services and leisure which then later affects both supply and demand for labor on labor markets - this is because capital income tax is economically just tax on future consumption. $\endgroup$ – 1muflon1 Apr 25 at 18:05

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