Taxes Matter, but the Dollar Matters More
The proper level of taxation has predictably emerged as a major presidential campaign issue. The irony here is that stock-market returns since the 1950s show that the dollar’s stability and its direction trump taxes as the greatest indicator of our long-term economic prospects. So while tax rates matter a great deal, the discussion has occurred at the expense of any commentary on the dollar.
On the tax front, the major candidates of each party have staked out familiar positions. Thought by many in his party to be wobbly on taxes, presumptive GOP nominee John McCain has seemingly gotten “religion” on the issue and professed a desire to make permanent the 2003 reductions on income and capital gains.
As for the Democrats, both Barack Obama and Hillary Clinton have made plain their desire to sunset the 2003 legislation. In revealing their preference for a 2010 repeal of the 2003 reductions, both make the explicit point that they would like to see rates settle back to levels seen in the 1990s.
Sadly, the dollar's fall this decade has not generated any kind of campaign comment from either side. Oddly enough, both John McCain and Hillary Clinton support a federal gas-tax holiday for the summer, but it should be said that this gimmick is perhaps the primary campaign’s ultimate non-sequitur. To endorse an 18 cent per gallon tax cut on gasoline is to miss the point almost completely. Pump prices aren’t high due to federal taxes, but instead are reaching nosebleed levels thanks to a collapsing dollar.
If it’s agreed that stock-market returns at the very least indicate long-term economic optimism, the dollar’s fall should be issue #1 for candidates on both sides. While rates of taxation should never be ignored, it’s forgotten that inflation is but another form of taxation, albeit a somewhat hidden one. Just as high tax rates erode the value of paychecks and investments, so does inflation. And when stock-market returns over the last sixty years are considered, it becomes apparent that all three presidential candidates have taken their eyes off the ball. In short, it’s the dollar, stupid.
In his 1984 book, Losing Ground, Charles Murray wrote that the “average annual growth rate from 1953 to 1959 was 2.7 percent, noticeably lower than the average annual growth of 3.2 percent from 1970 to 1979.” Allowing for the certainty that government measures of economic activity are frequently misleading, Murray’s numbers would surely surprise economic historians who’ve characterized the ’50s as a period of economic revival in contrast with the stagnant, malaise-ridden ’70s. It should also be recalled that while it was nominally high in both decades, the top marginal tax rate was 91 percent in the ’50s against 71 percent in the ’70s.
The major difference between the two decades was not, however, in levels of taxation. Instead, the larger factor involved the dollar, whereby the U.S. economy in the ’50s benefited from a stable greenback measured as 1/35th of an ounce of gold. Conversely, thanks to President Nixon’s decision to sever the dollar/gold link in 1971, the dollar lacked definition afterward and proceeded to collapse. Despite the higher rates of growth that were achieved in the ’70s relative to the ’50s, the S&P 500 rose a mere 17 percent in that decade against a 255 percent return in the 1950s. High capital-gains rates were surely a factor in the ’70s underperformance, but with inflation a certain tax itself, the falling dollar (as evidenced by market returns in the present decade) to some degree made the tax penalty on investment irrelevant.
To show that levels of taxation surely matter, the reduction of the top rate from 91 percent to 71 percent in 1964 ignited impressive economic growth that was partially responsible for stocks reaching all-time highs in 1966. Still, many a commentator has noted that U.S. shares did not permanently pass those highs again until 1982. Sure enough, while the ’64 reduction in the tax wedge kept the economy buoyant, markets started to price in the likelihood that U.S. monetary authorities were growing increasingly impatient with the Bretton Woods system of fixed exchange rates.
This first showed up in private markets where gold traded far above the Bretton Woods $35/ounce fix, and later in government measures of inflation. By the end of 1968, consumer price inflation rose to 4.7 percent. So despite the pro-growth tax cuts passed after John F. Kennedy’s assassination, stock market returns greatly lagged those achieved in the ’50s. The S&P 500 ultimately rose a mere 54 percent in the ’60s due to inflationary monetary policy that stopped the mid-60s rally in its tracks.
A stronger dollar, 1980-2001. When we look at the ’80s, gold’s free fall from a high of $850 in January of 1980 was doubtless rooted in the approaching election of a president who preferred lower marginal rates and a return to the gold standard. And despite a needless recession caused by Fed policy that joined monetarism with Phillips Curve austerity, the ’80s economic revival occurred in concert with a strong dollar and S&P 500 returns of 121 percent during the Reagan years.
Moving to Bill Clinton’s election in 1992, the dollar sagged early on in the face of marginal rate increases combined with a renewed protectionist sentiment. In her 1995 book American Trade Policy: A Tragedy in the Making, Anne Krueger noted that by 1994, “bilateral trading relations with Japan had deteriorated under the Clinton Administration’s pressure for ‘quantitative targets.’” The latter policy helped drive the dollar to an all-time low versus the yen of 80/1.
Importantly, dollar policy changed not long after. Robert Rubin took over from Lloyd Bentsen at Treasury, and as economists Ronald McKinnon and Kenichi Ohno wrote in their 1997 book, Dollar and Yen, amidst the dollar’s rise from 80 to 113 yen by 1996, not once “did a responsible official in the American government complain that the dollar was too high.” With dollar policy sound, the 1993 tax increases were less biting given the tax “cut” achieved by a rising dollar. And while many credibly argue that the dollar rose into deflationary territory by the late ’90s, stocks soared with Rubin at Treasury; the S&P 500 rising 208 percent during Clinton’s presidency. The 1997 capital gains cuts surely helped the ’90s equity boom, though the rally’s origins predate any market knowledge of a capital gains reduction.
Bush, the dollar and the 2008 campaign. Many commentators with GOP leanings point to a “Bush Boom” that began with the 2003 income and capital gains reductions. Commentators with Democratic Party leanings point to a period of even greater economic growth that occurred amidst higher rates of taxation during the ’90s. Both sides perhaps downplay the greater story.
For GOP partisans to laud the economy’s performance under George W. Bush, they would have to ignore the basic truth that inflation is a taxing enemy of prosperity. S&P 500 returns during the Bush presidency of 3.6 percent compare poorly with the 30 percent return achieved during the charitably abysmal Carter years. And if they’re sanguine about 5 percent unemployment and recent GDP growth of .6 percent, they would also have to acknowledge that in GDP terms the economy grew every year of Carter’s presidency alongside the highest percentage job growth of any post-WWII president.
Democratic partisans would first have to admit that levels of taxation do matter. No credible candidate has suggested bringing tax rates back up to those experienced during the ’70s. They would also have to shed a rising protectionist instinct that has harmed the dollar, and if continued, would quickly discredit any tax plan brought forth under a Democratic administration. And for those who still believe that the Clinton tax increases helped the economy by bringing down interest rates, they should be reminded that the 30-year Treasury was yielding 5.8% when the Clinton tax increases passed in ’93 versus an 8% yield by 1994.
So while the broad policy goal should be one of bringing down tax rates across the board, the simpler reality is that with equities serving as a measure of long-term economic optimism, the U.S. economy has done well under all manner of tax regimes since World War II. What historical equity returns show is that dollar debasement is the one policy the stock market can’t withstand.
Today's Republicans talk up tax cuts, while Democrats talk up tax increases. Judging by equity returns, both sides ignore the dollar at their peril.