Tax Shocks, Political Cycles, and Asset Prices
41 Pages Posted: 24 Aug 2018 Last revised: 19 Jun 2019
Date Written: June 16, 2019
By combining information in equity prices with narratively identified events, I construct a measure of income tax shocks (i.e., expectations about tax cuts). A positive tax shock decreases (increases) future tax revenues (government debt). Wealth effects of tax shocks depend on the political cycle. Tax shocks cause high wealth states during Republican administrations, whereas the effects are trivial during Democratic administrations. During Republican presidencies, tax shocks carry a positive premium since they increase the volatility of consumption growth. An investment strategy that exploits the tax shocks premium across the political cycle generates significant returns over commonly used asset pricing models.
Keywords: Tax Shock, Asset Pricing Model, Political Cylce
JEL Classification: G12
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