The Impact of Fiscal Policy on Stock Returns
University of Notre Dame - Mendoza College of Business
Claremont Colleges - Robert Day School of Economics and Finance
Michigan State University - Department of Finance
July 3, 2012
We examine whether counter-cyclical government fiscal policies lower equity returns by smoothing consumption. Counter-cyclical fiscal policies are identified by government budget deficits and surpluses in periods of low and high economic growth, respectively. Intuitively, we hypothesize that counter-cyclical fiscal policies stabilize consumption and reduce the need to finance consumption by selling equity positions as a consequence. Our study uses state-level data within the United States since the response of state governments to economic fluctuations varies considerably according to differences in their balanced budget amendments. Our evidence indicates that consumption volatility and stock returns are lowered by counter-cyclical fiscal policies. Differences in fiscal policy induce variation in state-level returns of nearly 2.5% per annum after controlling for risk and industry variation. Our findings are consistent with the sensitivity of consumption to borrowing constraints and local investment biases. The lower returns in counter-cyclical states with local investment biases is confirmed using firm-level headquarter relocations. While differences in consumption volatility attributable to fiscal policy appear to create distinct state-level pricing kernels, empirical support for an alternative cash flow channel is weaker.
Number of Pages in PDF File: 43
Keywords: fiscal policy, consumption smoothing, local investment bias, stock returns
JEL Classification: G12, G28working papers series
Date posted: March 14, 2012 ; Last revised: July 3, 2012
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