Fiscal Policy and Asset Returns

José Tavares, Universidade Nova de Lisboa
Rossen Valkanov

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 taxes 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 stock returns and 8-10% of the variation in unexpected bond returns. When fiscal and monetary policy 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.