Bank Bonus Taxes are a Bad Idea
The UK recently instituted a 50% tax on bankers' bonuses and France is reportedly about to follow suit. German chancellor, Angela Merkel, is said to like the idea, but would prefer to institute a tax on financial transactions. Even economist Paul Krugman said that, at first blush, the bonus tax “looks entirely reasonable.” Sure, it might drive the best and the brightest out of the finance business, but that would be a good thing.
If there were an effective way to do it, I'd love to exact revenge on the financial charlatans who wrecked our economy and extorted hundreds of billions in ransom from the feds to keep the financial sector from complete meltdown. The only problem is that the tax ideas being floated would likely do more harm than good.
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I'll discuss the many problems with the financial transaction tax in another post, but let's focus on the bonus tax today.
The UK will impose a 50% tax on bankers' bonuses above about $40,000. Bankers are already looking at ways around the tax and Inland Revenue is busily trying to preempt those stratagems, but the tax is not hard to avoid. The British tax is temporary, so the simplest dodge is to postpone bonuses for a year—an imperfect escape since top income tax rates are scheduled to increase next year and the government might simply decide to make the bonus tax permanent.
However, a permanent bonus tax would surely produce a lot of undesirable and unintended tax avoidance behavior. For example, compensation could be shifted away from bonuses into base pay. Or, to escape the limits altogether, financial service executives could move offshore. In the internet age, financial transaction can be undertaken anywhere.
The United States has painful experience with the unintended consequences of limits on compensation. In 1993, we limited corporate deductions for cash salaries to $1 million, intending to encourage more performance-based pay. The result was much more use of stock options, which produced a huge reward for transactions that pay off in the short-term, as well as a strong incentive to cook the books to boost stock prices. Arguably the salary limit helped fuel the bubbles of the last two decades.
Even if the bonus tax worked, it would set a very bad precedent. Firms in different industries use numerous ways to compensate employees, ranging from fixed salaries to various forms of incentive systems, and what is most suitable varies. Government cannot possibly know how best to compensate workers in any particular firm or industry. Using the tax system to influence how firms compensate employees substitutes a rigid rule for private efforts to figure out what works best. Beyond this, imposing a tax on one form of compensation in one specific sector smacks of industrial policy—the government channeling capital into some activities and away from others. I know, we do that already through tax subsidies for many activities, but imposing a bonus tax on the financial sector seems to be a giant step forward in this very bad practice.
When markets work, it is best for government to get out of the way.
When they don't work, the best approach is to attack the distortions directly. If, as many believe, the financial system became over-leveraged, then do something to reduce excess debt. Overhaul the regulatory structure. Set adequate reserve requirements. Provide enough information so that consumers, investors, and the government can understand risk better and therefore accurately price financial instruments.
If some industries are so concentrated that companies become “too big to fail,” then those companies should be charged a fee commensurate with the risk they are imposing on taxpayers and the public. That is, maybe there should be a tax on bigness, but it certainly should not be limited to the financial sector.
All of this is much harder than imposing a new tax on bankers' bonuses and it may not provide the sweet satisfaction of revenge. But carefully designed structural reforms might help prevent the next financial catastrophe, and that should be the focus of public policy.
Your blog keeps getting better and better! Your older articles are not as good as newer ones you have a lot more creativity and originality now keep it up.
Hi Len!
I see you got the weather my mother sent from Iowa. We did too, but not as badly.
I agree that there must be some backstop to ESOPs, such as a mutual insurance fund which holds substantial shares of all such companies in exchange for bailing out the owners if the company goes belly up. Such a fund could also intervene if a significant minority of the shareholders believe management is off track (depending on the size of the minority who can trigger such an action and the percentage of shares held by the fund). Of course, this would require a change in law and could technically not be an ESOP, but some varient of it.
Mitch, I don't think that poor incentives is the market failure. Companies do dumb things all the time, but it's hard for the government to make better decisions on their behalf. If the market works properly, the ones that make poor decisions will have a great chance of failing. The market failure is when companies get so big that the regular self-correcting mechanism (punishing bad decisions with failure) can't work.
Hi Michael. If the problem is rising inequality, the answer is more progressive taxation (and inheritance tax–as you note), not a tax on a particular form of compensation.
I have real concerns about tax breaks for ESOPs as they encourage employees to put all or most of their retirement savings into their own company stock. Yes, it gives employees a stake in performance of the company, but it also gives many employees undiversified investment risk that they can't afford. Put differently, when their company goes belly up, they lose their savings as well as their job. (And, if it's a company town, they can lose their housing equity too as house prices fall.)
Len
Look at how bonus policy has effected the credit markets. Banks are not making loans so that they can instead repay the government and pay out the bonuses to themselves. Or look at how the tax subsidy for first time buyers led to the unloading of foreclosed properties at bargain basement prices, further exacerbating the problem of underwater mortgages, which keeps others from refinancing away from their bad adjustable rate paper.
If large bank bonuses are part of a systemic problem of inequality that people are just now noticing, no amount of regulation or taxation is going to fix it. The only real way out is employee-ownership of most firms, with such firms becoming the lenders of first and last resort for mortgages and consumer credit. Of course, this will only happen if unions are allowed to invest more in their members employers than the current 10% and if any kind of FICA privatization goes to direct investment in company stock (and a mutual insurance fund to back it) – rather than to an index fund which continue to prop up the financial system. Shifting inheritance taxes from estates to heirs and taxing at normal rates, with a continued (and expanded) exemption for sales to qualified employee-ownership plans, would also speed such a system.
When they don’t work, the best approach is to attack the distortions directly.
If one of the market failures was poor incentives, isn't the government doing exactly this?
Probably true, but it makes for a very bad tax code.
A better option would be to select representative financial titans and put them in stocks so they can face the wrath of the community directly. It worked for the Puritans!
Agree, however, politicians are cut from a different cloth. They must pander for votes and preempt a potential disaster that could be raised by the opposition in the future.