Long-Run Taxation Risk and the Presidential Equity Premium Puzzle

Abstract

This paper aims to explain the Presidential Equity Premium Puzzle. I estimate a simple model in which a new President serves as an uncertainty shock to the growth rate of dividends. This uncertainty shock is differentially priced across parties because Democrats increase the tax burden of equity holders. The interaction between the dual shocks to expected tax burdens and dividend growth rates gives rise to expected returns that are higher under Democrats. Results from structural estimation show that this channel accounts for approximately a third of the difference in the level of expected returns on the market across parties. This model can match the level of the difference in expected returns for “normal” times, but not in Presidential terms immediately preceding and following financial crises, which accounts for the missing two-thirds of the difference. This model also generates dynamics consistent with the cross-sectional moments of returns and announcement effects noted in the literature. Further, this model is able to generate occasionally high realized returns under Republicans, consistent with the experience of equity markets in the post-2016 sample.