04/22/2009 05:12 am ET | Updated May 25, 2011

The AIG Bonus Clawback Bill Won't Work -- Here's What Will

2009-03-23-historicaltax_ratechartfrommoveone.gifLast week the House passed a bill designed to claw back any bonuses over 250K from recipients of TARP money. Now I'm a class warfare guy (on the side of regular folks, as opposed to the rich, who are winning the current war and won the last one) but this bill is counterproductive and won't work.

First, the clawback only affects on bonuses, so TARP recipients can just switch bonuses to salaries. Second, if the clawback applied to all income, then employees would be moved to contract or to companies which haven't received TARP money (even if those companies have to be created).

Second, $250K of household income, as Henry Blodget points out, is not that high. Don't get me wrong, no family making that amount is poor (and I've never made anything close to it, so this isn't a personal thing), but they are affluent. Still, they aren't filthy rich, and they shouldn't be taxed as if they are.

But concentrating on bonuses for employees at firms which have been bailed out misses the point. It's not just those firms whose employees need to be taxed heavier, it's everyone. The logic for increasing taxes is simple enough: for the last 20 years, American executives have been able to pay themselves such large bonuses that in 3 to 5 years they were able to amass so much money they would never have to work again. This system created the incentive to do whatever was required in order to get those bonuses -- it led to flagrant risk taking and outright fraud. It also led to a short-term focus on the business. When executives know that it doesn't matter to their personal financial well-being if their firm exists in 5 years, they don't worry about the long term consequences of their decisions. All that matters is booking "profit" now, so you can get money now, and become rich now.

Wall Street and the banks didn't make any money in the last 10 years, for all that they booked record profits. The combined losses of the financial firms is larger than their entire reported profits. What they did was sell synthetic securities based on dubious assumptions about the future -- that the housing bubble would continue forever, there would never be another recession, and defaults wouldn't cluster; and book the entire calculated future profits of these securities as profit in the year they were created. Of course, those future profits were fictional, but the bonuses based on them were in real money.

In order to make sure this never happens again compensation needs to be restricted in every firm, not just in the US, but in the industrialized world. Executives and salespeople and auditors and loan officers (if banks decide to rehire any) need to know that ten years from now if a loan goes bad that they're going to be on the carpet for it, that they might lose their job for it, and that they will still need a job in 10 years.

I recommend 7 measures to restrict compensation:

  1. All income, whether capital gains, wages, bonuses or derivatives, must be taxed at the same rate.
  2. A marginal tax rate of 50% for individual income over $250,000.
  3. A marginal tax rate of 75% for income over $500,000.
  4. A marginal tax rate of 85% for income over $1,000,000.
  5. A marginal tax rate of 90% for income over $5,000,000.
  6. Income from overseas sources must be taxed at US income rates. If the foreign country taxes at less than the US rate, the US will make up the difference.
  7. Index taxation to inflation, so the numbers increase as the dollar becomes worse (or decrease if we get widespread deflation).

Take another look at the top chart on this post, originally from MoveOn. The fact of the matter is that the economy worked much better for most Americans back when marginal tax rates were high. We've had a 40 year experiment in lowering tax rates, and it has led nowhere good.

Time to end the failure of low taxes for the rich. Tax reform is only part of a comprehensive solution, but it's a necessary part of any comprehensive solution. Even if we somehow muddle through this crisis, then if tax rates at the top end are not reformed there will be another crisis, because the executives in charge of corporate America will have every incentive to create one.

Endnote: While the wages chart is for goods producing workers, that is only because it shows the pre-war period more clearly, the data having been collected for longer. Wage earners in other industries show the same pattern.