03/29/2010 05:12 am ET | Updated May 25, 2011

Wall Street Bonuses and Tax Equity: A Modest Proposal for the State of the Union

Much of the country is angry about multimillion dollar bonuses paid out to senior executives at Wall Street firms that accepted bailout funds from the federal government.

This is part of a broader discontentment about the extent to which the federal response to a very real financial crisis has been structured to benefit Wall Street more than Main Street. Many people believed government officials when they said that government support was necessary to save the financial system. But when aided firms turned around and passed out massive "business as usual" bonuses to senior executives of those firms, the public rightly smelled a rat.

There have been cries to tax these bonuses, often at near confiscatory rates. But such proposals are fraught with difficulty: How can one distinguish who deserves to be singled out for such treatment and who does not? Actually acting on these impulses would involve troublesome micromanagement by the federal government in the affairs of private entities.

Most people accept the basic notion that the income tax should be progressive, although there is honest disagreement about how steep this progressivity should be. People with higher incomes typically pay not just more taxes, but also a higher percentage of their incomes in taxes. This notion is embodied in our current tax rates, but only up to a point. The progressivity in our current tax rates ends abruptly with incomes of approximately $375,000 per year. After that, federal income tax rates are flat. And when one considers the regressive payroll tax and favored treatment of capital gains (which are received disproportionately by those with the largest incomes), the real overall incremental tax rate (tax as a percentage of total income) actually is lower for the super-rich than for their upper-middle-class counterparts.

Therein lies the basis of a simple suggestion: Make compensation in excess of $1 million per year nondeductible to the paying corporations. This will not affect the tax rates of those who receive such largess, but it will impact the corporate taxes of companies who choose to reward individuals at these levels. The absence of a deduction would make such compensation moderately more expensive to the corporation. As a result, some companies might choose to adjust compensation rates modestly downward. If they determine that their compensation rates are still appropriate or necessary, they would continue to be free to choose to continue to compensate their most valued employees as they do now. It will just cost them a bit more to do so.

This proposal does not involve any government meddling in the affairs of corporations as would be the case if compensation would be capped by government fiat or if some types of entities were to be singled out for discriminatory treatment.

There is an additional logic to this proposal in terms of overall tax policy.

We currently tax income received by individuals; companies deduct employee compensation and other expenses from their gross incomes. Companies pay corporate taxes on the residual profit.

But profits that are paid to stockholders are taxed twice: first by the corporations, and secondly by those individuals who receive dividends paid from corporate profits.

The premise of my proposal is that multimillion dollar compensation is much more akin to dividends than to normal salaries. Multimillion dollar compensation is often tied, implicitly or explicitly, to corporate profits. Multimillion dollar employees are not just wage earners; they are major stakeholders in the corporations for which they work. Many actually have more power to control the actions of their respective companies than do all but a handful of stockholders. Their fortunes rise or fall largely with the success of their corporate employers. This makes their relationship to their employer more like that of a major stockholder than a run-of-the-mill employee. So tax them like stockholders.

All too often, any proposal to adjust the system of taxation is summarily rejected as a "tax and spend" effort by someone with a hidden agenda to expand government. But we should learn to separate discussions of what and how we should tax from discussions of how much we should tax. This proposal would be revenue-neutral if its implementation were coupled with a dollar-for-dollar reduction in some other taxes. I would propose coupling this change in the tax code with an exemption of the first several thousand dollars of the payroll tax for each employee (the threshold could be set to produce revenue neutrality). In a time of high unemployment, this might even spur employment by making new employees slightly less expensive while also lessening the invidious regressivity of the payroll tax.