The effects of tax policy on financial markets: G3 evidence ☆ K. Peren Arin a , Abdullah Mamun b, ⁎, Nanda Purushothman c a Department of Commerce, Massey University, Private Bag 102 904, NSMC, Auckland, New Zealand b Edwards School of Business, University of Saskatchewan, 25 Campus Drive, Saskatoon SK, Canada S7N 5A7 c Ernst and Young, Australia ABSTRACT ARTICLE INFO Article history: Received 30 June 2007 Received in revised form 12 September 2007 Accepted 2 May 2008 Available online 25 June 2008 JEL classification: E62 E44 G10 G18 H20 Keywords: Fiscal policy Stock returns VAR analysis We investigate the effects of various tax policy innovations on stock market returns. By using a vector autoregressive model that controls for the mutual causality between fiscal policy and financial market performance, we test whether financial markets serve as a transmission mechanism for tax policy innovations. Our findings indicate that indirect taxes have a larger effect on market returns than do labor taxes. Further, corporate tax innovations do not have any statistically significant effect on stock returns. We consider that this finding is a result of a firm's ability to switch between equity financing and bond financing. © 2008 Elsevier Inc. All rights reserved. 1. Introduction During the past 2 decades, several historical developments have led to a revival of interest in fiscal policy. For instance, the Reagan tax cuts in the United States created a discussion about the supply-side effects of tax policy. Similarly, fiscal consolidations in Europe and Canada that were intended to reduce budget deficits led to an increase in private consumption, and thus generated outcomes contrary to the Keynesian framework. In Europe, the formation of a monetary union, the Maastricht Treaty, the evolution of the euro as a single common currency, and the establishment of the European Central Bank made fiscal adjustments crucially important for the member countries. Yet, despite all these developments, our understanding of the transmis- sion of fiscal policy innovations is far from complete. Although previous studies broadly document the relation between fiscal policy and financial markets, they analyze this relation at an aggregate level, and they do not identify which particular fiscal tool(s) and, more specifically, which tax instruments, cause a market response. Therefore, the actual causal effect of specific fiscal policy instruments on stock markets is largely unresolved. In this paper, we fill this gap by investigating the response of stock markets and interest rates to various tax policy innovations in G3 countries. Using data from 1967 to 2005, our results show that different tax policy changes produce different financial responses. Many recent fiscal policy studies based on vector autoregressive (VAR) models document the lack of understanding of how fiscal policy innovations are transmitted. For example, Edelberg, Eichenbaum, and Fisher (1999) find that U.S. government expenditures (particularly defense spending) have a temporary hump-shaped effect on output. In contrast, Fatas and Mihov (2001) use a semi-structural VAR model for the United States and find a more prolonged effect on output. By using a structural VAR (SVAR) approach, Blanchard and Perotti (2002) estimate the effects of exogenous shocks on real government purchases as well as real net taxes. These authors use institutional information about tax and transfer systems and the timing of tax collections to identify the automatic stabilizing aspects of fiscal policy, and then use that information to derive fiscal shocks. Their results show that positive government spending shocks tend to have a transitory effect on output, while positive tax shocks consistently have a negative effect. Perotti (2002) uses an SVAR approach to study the effects of fiscal policy on gross domestic product (GDP), prices, and interest rates in five OECD countries. He argues that the effects of fiscal policy on GDP and its components have become substantially weaker Review of Financial Economics 18 (2009) 33–46 ☆ We would like to thank Henk Berkman, Nuttawat Visaltanachoti, the editor in charge, and two anonymous referees of this journal for their useful comments. The usual disclaimer applies. ⁎ Corresponding author. Tel.: +1 306 966 1862; fax: +1 306 966 2515. E-mail address: mamun@edwards.usask.ca (A. Mamun). 1058-3300/$ – see front matter © 2008 Elsevier Inc. All rights reserved. doi:10.1016/j.rfe.2008.05.001 Contents lists available at ScienceDirect Review of Financial Economics journal homepage: www.elsevier.com/locate/rfe