The Neglected Effect of Fiscal Policy on Stock and Bond Returns
EFA 2003 Annual Conference Paper No. 201; UCLA, Anderson School of Management Working Paper
FEUNL Working Paper No. 413
48 Pages Posted: 6 Aug 2003
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: Suggested Citation
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