A Good Word for Barron's
Jude Wanniski
August 4, 1997


Letters Editor
200 Liberty Street
New York, NY  10281

Dear Editor:

Lauren R. Rublinís piece on why the market is unlikely to fall simply because of passage of a lower capital gains tax (ďNot to Worry,Ē Aug. 4) is the best Iíve seen on the topic in the financial press. It has been amazing to see the myth develop that prices will plunge because people will wish to unload assets that they acquired in anticipation of a lower rate. If the stock market does nothing else, it capitalizes the value of reduced risk to capital formation or increased reward to capital formation as the policy is unfolding.

A large part of the reason for the market rise since the November elections has been the promise that after all these years of waiting, the President and Congress would at last agree to cut the capital gains tax -- a significant increase in the reward for successful capital formation. The market moved two-steps forward, one-step back month by month, as the odds of passage increased or decreased. When the legislation finally was signed into law, the market had fully discounted its value. On January 2, my firm advised our clients of this likelihood and predicted the Dow Jones Industrial Average would climb to 7800 if in fact the tax cut were realized.

In the chart accompanying Ms. Rublinís article, the DJIA is shown falling in 1978 with passage of the capgains cut of that year. Please note that the market advance that preceded enactment of the lower rate began in April of that year, when the late Rep. William Steiger of Wisconsin, a member of the House Ways&Means Committee, reported majority support on the committee for a capital gains tax cut. Throughout that period and the year that followed, the market was dominated by a much more powerful negative effect on capital formation -- the Treasuryís vocal call for a weaker dollar to spur exports. In the following year, the price of gold rose from roughly $200 to as high as $850 on February 1, 1980. A seven-point cut in the nominal capital gains tax is relatively small compared to the risks to creditors of such an inflationary signal.

The chart shows the DJIA beginning a climb in early 1980, from a low of about 780 to 1000 a year later. This coincided with the end of goldís rise and the beginning of its decline, as the Treasury and Volcker Fed, after Ronald Reaganís victory in November 1980, got monetary policy under control. More importantly, the market began to discount the likelihood of a Reagan victory on a mandate to cut tax rates. There were two setbacks to the DJIA in the remainder of 1980. The first slight decline followed the Democratic convention that summer, which seemed to propel President Carter back into the lead. The second came after the Reagan victory, when the new chairman of the Senate Finance Committee, Bob Dole, argued that the promised tax cuts be postponed until the budget was balanced.

The market got back on track, climbing above 1000 until it became clear that the 30% cuts in marginal income-tax rates would in fact be phased in over three years, with almost no increase in 1981. At the same time, the Volcker Fed was mercilessly squeezing inflation out of the dollar, with gold plunging over 15 months to $300 from $625, the deflationary burden on dollar debtors dramatically increasing the risks to capital formation. This is not hindsight. My firm was pointing all this out at the time. In any case, the nominal rate on capital gains is the real rate only when the dollar price of gold is constant. Otherwise, it is not possible to predict equity values after enactment of a capital gains tax cut unless you can also foresee the swings in the dollar/gold exchange rate. By the way, we have been saying since 1987 that the DJIA would have to hit 10000 before it matched its real value of January 1966, when it hit 1000 at a time when the dollar was still defined in terms of gold at $35 per ounce.


Jude Wanniski