It's Not Just Taxes, It's the Dollar

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.

Sadly, the dollar's fall this decade has not generated any kind of campaign comment from either side. Oddly enough, both Senators McCain and Clinton support a federal gas-tax holiday for the summer. But it should be said that this gimmick perhaps is the primary campaign's ultimate non-sequitur. To endorse an 18-cent-per-gallon tax cut on gasoline is to miss the point. 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 no. 1 for candidates on both sides. Just as high tax rates erode the value of paychecks and investments, so does inflation. And when stock market returns over the last 60 years are considered, it becomes apparent that all three presidential candidates do not have their eyes on the ball. In short, it's the dollar, stupid.

Though tax rates were nominally high in both the 1950s and 1970s, the top marginal tax rate was 91% in the 1950s versus 71% in the 1970s. The major difference between the two decades was not, however, their taxation levels. Instead, the larger factor involved the dollar, whereby the American economy in the 1950s 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 collapsed. Despite the higher rates of growth that were achieved in the 1970s relative to the 1950s, the S&P 500 rose a mere 17% in that decade against a 255% return in the 1950s.

Levels of taxation do matter as well. The reduction of the top rate to 71% from 91% in 1964 ignited impressive economic growth that was partially responsible for stocks reaching all-time highs in 1966.

When we look at the 1980s, 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 the Federal Reserve's policy that joined monetarism with Phillips Curve austerity, the 1980s economic revival occurred in concert with a strong dollar and S&P 500 returns of 121% 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. Protectionist interests in the Clinton administration helped drive the dollar to an all-time low.

At present, many commentators with Republican leanings point to a "Bush Boom" that began with the 2003 income and capital gains reductions. Those with Democratic leanings point to a period of even greater economic growth that occurred amidst higher rates of taxation during the 1990s. Both sides perhaps downplay the greater story.

For Republican partisans to laud the economy's performance under President 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% compare poorly with the 30% return achieved during the charitably abysmal Carter years. And if they're sanguine about 5% unemployment and recent GDP growth of 0.6%, they also would 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 1970s. They also would 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.

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 American 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 want tax cuts, while Democrats want tax increases. Judging by equity returns, both sides ignore the dollar at their peril.

Mr. Tamny, editor of RealClearMarkets, is a senior economist with H.C. Wainwright Economics.