The Impact of Fiscal Policy on Stock Returns

Using state-level data within the United States, we find that consumption volatility and stock returns are lowered by counter-cyclical fiscal policies. These implications are confirmed using state-level balanced budget amendments and budget stabilization funds that determine fiscal policy but are exogenous with respect to economic conditions. Our findings are consistent with the sensitivity of consumption to borrowing constraints and local investment biases. In particular, by smoothing consumption, counter-cyclical fiscal policies lower the returns of firms headquartered in states with local investment biases. This conclusion is confirmed using headquarter relocations that alter the exposure of firms to state-level fiscal policies. Differences in state-level fiscal policy are capable of inducing return variation between 2% and 4% per annum.