Taxes and the Fed: Theory and Evidence from Equities
72 Pages Posted: 13 Oct 2017 Last revised: 16 Oct 2017
Date Written: 2017-10-11
We provide a critical theoretical and empirical analysis that suggests a key driver of fiscal effects on equity markets is the Federal Reserve. For the Post-1980 era, tax cuts lead to higher cash flow news and higher discount rates. The discount rate news tends to dominate such that tax cuts are associated with lower equity returns. This result is flipped for the Pre-1980 era. Our results are confirmed across multiple measures of tax shocks (narrative, SVAR, municipal bonds, etc.) at different frequencies (daily, quarterly, annual). We motivate our empirical findings with a standard New Keynesian model (in addition to the FRB/US model) that exhibits a shift in the aggressiveness of monetary policy. Moreover in our theoretical framework, downward nominal wage rigidities account for observed asymmetries in the response to tax cuts versus tax increases.
Keywords: Federal Reserve, Fiscal policy, News Decomposition, Stock Market
JEL Classification: G0, E0, E63, G12, E5
Suggested Citation: Suggested Citation