Fiscal Policy and Stock Returns: A Cointegration Analysis

Abstract

The role of government intervention through fiscal policy is central to the functioning and development of an economy, particularly in influencing financial markets. This study examines the long-run and short-run relationship between fiscal policy instruments and stock market performance in Pakistan using annual time-series data from 1973 to 2008. Stock returns are analyzed in relation to key fiscal and macroeconomic variables, including government taxes, government expenditure, gross domestic product, inflation, and interest rates. Stationarity of the data is assessed using Augmented Dickey–Fuller and Phillips–Perron unit root tests, while the Johansen and Juselius cointegration approach is employed to investigate long-run relationships. The empirical findings reveal a significant negative relationship between government taxes and stock returns, indicating that higher taxation discourages equity market performance. Interest rates and inflation are also found to negatively affect stock returns. Government expenditure shows a positive but statistically insignificant relationship with stock returns, whereas economic growth, measured by GDP, positively influences stock market performance. The results highlight the importance of fiscal policy in shaping stock market dynamics.