Tax News Shocks, Political Cycles, and Asset Prices

Abstract

Using two instruments of perceived probabilities of income tax changes, I show that the implications of tax news shocks on the economy and asset prices are asymmetric across the political partisan cycle. Tax shocks cause high wealth states during Republican administrations. To compensate for high amount of systematic risk during Republican terms, investors command a premium to hold assets that co-vary positively with tax shocks. In contrast, the wealth effect and premium for tax shocks are trivial during Democratic regimes. An investment strategy that exploits the time-varying premium across the political cycle generates significant returns over commonly used factor models.

Keywords: Tax Shock, Asset Pricing Model, Political Cylce

JEL Classification: G12