Taxes are usually distortionary because they can be avoided, e.g. the $10,000 mansion tax in New York and New Jersey

From Mark Perry.

"Economic theory and empirical evidence suggests that most taxes (and regulations) are distortionary in the sense that buyers, sellers, producers, taxpayers, etc. can change their behavior to avoid (or minimize) the tax (or regulation). For example, if a state (or a country) imposes a “millionaire tax,” the millionaires move to another state (country). If the US government imposes a “luxury tax” on purchases of expensive new yachts and airplanes, the wealthy postpone purchases of those luxury items, or they buy expensive used yachts and airplanes. If one state raises its cigarette taxes, smokers living near the border purchase cigarettes in a nearby state with lower taxes per package of cigarettes, etc.

In a new NBER working paper “Mansion Tax: The Effect of Transfer Taxes on the Residential Real Estate Market,” Columbia University economists Wojciech Kopczuk and David Munroe analyze the distortionary effects of the $10,000 “mansion tax” in New York and New Jersey that only applies to real estate transactions that exceed $1 million in value. The authors analyzed housing market data from both states and find evidence that the “mansion tax” disrupts sales of houses and condos at the $1 million threshold price level. As would be expected, many sellers will reduce their asking prices so that they fall below the $1 million threshold, and others choose not to sell at all. Here are more details about the paper from the NBER Digest:

In New York City, if a property sells for $999,999, no mansion tax is due, but if it sells for $1 million, the tax due is $10,000. This represents a “notch” in the tax schedule: a small change in the value of the transaction can trigger a discrete increase in tax liability. Not surprisingly, sales data show a substantial bunching of transactions right below the $1 million level (see chart above). They also show “missing sales” just above the $1 million level (see chart). Relative to the number of transactions one would predict just above this threshold based on the number of sales in other price ranges, there are too few sales. The authors estimate that there were 2,800 such missing transactions in New York between 2003 and 2011, equivalent to the number of transactions that would have occurred otherwise in the price range of $1 million to $1.04 million. They conjecture that in some cases, if a property would sell for just over $1 million, the sellers may take it off the market or delay the sale, perhaps by renting. The authors conclude that “this one percent tax, applying at a relatively large threshold, managed to eliminate 0.7% of transactions.”

The results suggest that the tax may distort market prices by more than the tax due. For example, it appears that even though the tax on a $1 million property is $10,000, some sellers may offer up to $20,000 in discounts to avoid the tax. The authors also emphasize that the tax has an “unraveling effect.” They write that “the notched design of the tax can destroy a market for housing with values close to the notch.” When potential taxpayers have the option of not participating in a market, as they can in the real estate market by not offering their property for sale, a notched transaction tax can destroy productive matches between potential buyers and potential sellers."