The Neglected Effect of Fiscal Policy on Stock and Bond Returns

48 Pages Posted: 6 Aug 2003

See all articles by José Tavares

José Tavares

Centre for Economic Policy Research (CEPR); Nova School of Business and Economics

Rossen I. Valkanov

University of California, San Diego (UCSD) - Rady School of Management

Date Written: October 2001

Abstract

We analyze the effect of taxes and government spending on quarterly market returns of stocks, government bonds, and corporate bonds. In US data from 1960 to 2000, a one standard deviation increase in the share of tax receipts in GDP has a statistically and economically significant effect on returns, lowering annualized expected returns by 4% and 9% at quarterly and yearly horizons, respectively. Interestingly, the impact of taxes is quantitatively similar for stock and bond returns. These results can partly be explained by the high persistence of the tax series so that increases today imply permanently higher tax levels in the future. An increase in government spending has a positive impact on expected returns, but the effect is statistically significant only for bonds, at short horizons. Our findings represent a novel test of Ricardian Equivalence, using market returns. Fiscal policy shocks account for 3-4% of the variation in unexpected excess stock returns and 8-10% of the variation in unexpected excess bond returns. When fiscal and monetary policy changes are jointly identified, our results remain qualitatively unchanged and the quantitative results are only reinforced. More importantly, we find that fiscal policy is at least as important a source of return variability as is the policy of the Federal Reserve. The findings are surprisingly robust to various system specifications, such as cointegration assumptions and variable choice. Our results strongly suggest that fiscal policy shocks should be given more serious consideration in asset pricing.

Keywords: returns, stocks, bonds, taxes, government spending, Ricardian Equivalence, fiscal policy

JEL Classification: G12, G18, G28, G14, E44, C32

Suggested Citation

Tavares, José and Valkanov, Rossen, The Neglected Effect of Fiscal Policy on Stock and Bond Returns (October 2001). EFA 2003 Annual Conference Paper No. 201; UCLA, Anderson School of Management Working Paper, FEUNL Working Paper No. 413, Available at SSRN: https://ssrn.com/abstract=291670 or http://dx.doi.org/10.2139/ssrn.291670

José Tavares

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Nova School of Business and Economics ( email )

Campus de Carcavelos
Rua da Holanda, 1
Carcavelos, 2775-405
Portugal

Rossen Valkanov (Contact Author)

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858-534-0898 (Phone)