Getting a Tax Clawback Right

Monday night, when I wrote about tax clawbacks, I was afraid that the idea would be written off too quickly based on an oversimplistic view of the law. Two days later, it's like a movement. At least six members of Congress are on record as trying to craft some sort of tax clawback, Conor Clarke has Larry Tribe opining that a well-crafted clawback would be Constitutional, and widely read bloggers like Kevin Drum and Felix Salmon have considered the idea supportively. Tuesday night Bloomberg reports that:

The senior members of the Senate Finance Committee from both parties proposed taxes totaling 70 percent on bonuses at AIG and other companies getting federal money during the U.S. financial meltdown. House Speaker Nancy Pelosi directed committees there to draft several alternatives and said her chamber may consider a bill as early as this week.

If we're going to do this, and it looks like we might, we had better get it right. Regardless of the legal technicalities, a tax clawback does represent a kind of escalation. It sits awkwardly with norms and ideals that are less a matter of law than we think but that are nevertheless an important part of American political culture. In our better moments, we dislike "collective punishment" and try not to change the rules of the game out from under people midstream. On balance, I think the benefits of a well designed tax clawback could exceed its costs. But a poorly designed clawback would set a corrosive precedent for no other purpose than to salve and misdirect public rage.

The main benefit of a tax clawback would not be to punish bankers for the looting they have already done, but to set a precedent. Many commentators (e.g. Surowiecki) have pointed out that during the credit bubble, market discipline failed not so much because shareholders expected to be bailed out, but because the employees who run financial firms could cash out short-term gains regardless of long-term costs to shareholders and taxpayers. The precedent of a tax clawback would put future employees of systemically important financial institutions in jeopardy. They would know that if their mistakes provoke a taxpayer bailout, their personal wealth would be on the line. Eliminating their sense of inviolability, making it impossible for bankers to simply walk away from the losses they impose on investors and taxpayers, would, I think, result in structural changes to financial institutions. Risk-takers would congregate in definitely-small-enough-to-fail boutiques and hedge funds. Managers of systemically important banks would lobby for regulation to prevent competition from forcing them into risky practices that might provoke a clawback of their personal net worth when things go bad.

The dumbest possible tax clawback would be a punitive one-off designed to recoup the AIG bonuses. The brazenness of those bonuses has galvanized public anger, and served usefully as a tipping point, but in the scheme of things recovering less than half a billion dollars of a multitrillion dollar bailout will not matter very much. In order to set a useful precedent, a tax clawback needs to be broadly and rationally targeted. That is, employees of any and all institutions whose weakness necessitates a public bailout must be subject to the clawback. The Paulson Treasury, as a matter of insidious policy, made it difficult to distinguish between failing and healthy banks by forcing solvent banks to suck up TARP money along with the zombies. A good clawback proposal would encourage healthy banks to return any public assistance they've received over a period of several months, and then claw back funds only from employees of banks that are unable to return the funds without violating capital or liquidity requirements. (The law would have to address wrinkles like how to let banks "return" noncash assistance such as asset guarantees.)

A good tax clawback would not have to be very punitive. While getting back the money is an important purpose of a clawback, establishing the principle that the people who run financial institutions will be made responsible for cleaning up their own messes is far more important. Levying a 100% tax on bonuses might be satisfying, but so draconian a law would only pass if it were uselessly addressed to a single scapegoat rather than applied to financial institutions broadly. I'd recommend a 50% tax on compensation above maybe $200,000 in any year during the four years prior to the public assistance. Since this tax would represent an unexpected expense to the people it would affect, I'd allow the liability to be spread out over a period of several years. In general, the law should be structured and justified as a means of having the parties responsible for a financial disaster bear part of the cost of the cleanup, not as punishment.

One might worry that if the tax is too mild, future bankers might not be discouraged from taking foolish risks at critical institutions. If a big bet can get you a $10M bonus this year, but you'd have to return $5M if things go wrong next year, it might still be worth taking the bet. I think there's less to this than meets the eye. Once a firm precedent is established that previous years' compensation is fair game to pay for a taxpayer bail out, bankers would have to keep in mind that tax rates can always change, and that legislators might be less reticent next time around, when the use of clawbacks would not be novel and controversial. The law might even establish a higher tax rate for future failures.

In order for an ex post tax to be Constitutional, it should apply broadly and have some legitimate purpose besides just punishing someone. Kevin Drum gets a bit sardonic about this:

So it looks like the answer here is simple: even though the purpose of this tax would pretty clearly be punitive with extreme prejudice, we need to carefully pretend that it's not. And we need to make sure the legislative history shows that it's not (it should be "manifestly regulatory and fiscal" Tribe says). Then everything is kosher! We can tax their socks off!

While a lot of us might want to be "punitive with extreme prejudice", this is too cynical a view. The requirements of the Constitution seem perfectly consistent with imposing a clawback that permanently alters the incentives of the people who run systemically important banks. A good law would be both retrospective and prospective, and would firmly establish the principle that the individuals who run critical financial institutions can be decompensated if they let those institutions melt down on their watch. The analogy to Superfund is quite close, I think. If we do this, we oughtn't conceptualize what we're doing as finding a loophole we can use to shaft the f@kers. We should craft a good law that lets us recoup some of the cost of cleaning up existing messes, and that defines a framework for sharing the cost of any future messes with the people most responsible for them.

Comments

[donzelion:]

"A good law would...firmly establish the principle that the individuals who run critical financial institutions can be decompensated if they let those institutions melt down on their watch."
-------
Would you believe it, such a law already exists? It's called tort law (negligence) - which we've been emasculating for a good 15 years or so.

A tax clawback could lead to the same outcome, but changes the legal environment to a greater extent than populists might realize. Folks don't like the IRS much already; just wait when we start giving them any authority whatsoever to make moral judgments about our character, as well as about what we owe and don't owe.

Negligence, on the other hand, means that those who do the wrong will pay (and will pay punitive damages if they were grossly negligent). Instead of broadening the government role, we broaden the duties of the bankers and broaden the penalties for breach of those duties. Treat negligent bankers the same way we treat negligent manufacturers who dump toxic sludge in the river...

(Admission: while negligence law should be the first line of defense, taxes may become necessary as a supplement; it's real hard to define a duty and prove a breach when the products in question are extremely complex and resist objective testing...)

Mar 18 08:33 AM

[oldumbguy:]

Thoughtful and constructive. I hope the congress and administration are thinking in this direction.

Mar 18 10:54 AM

[prudentinve...:]

Back in the late 70's or early 80's congress passed a "windfall profits tax" on oil companies, that was a sort of clawback on corporate profits, and is a precedent. The rationale was that egregious profits were obtained to the detriment of the public.

One can argue that there is a difference between corporations and individuals, but a counter argument is the recent development by which individuals at the tope echelons of Wall Street have been "earning" more than many mid-size (and some full-size) corporations. It has now become clear that this development was much to the detriment of the public and the productive sectors of the Main Street economy.

Mar 18 11:01 AM

[donzelion:]

Prudentinvestor - a "windfall profits tax" is still a variation on an income tax, and in the oil/gas sector, you'd impose it by simply disallowing certain deductions that would otherwise be available for large corporations (in oil and gas, the 'negative taxes' that the companies paid in subsequent decades pretty much made them whole).

A tax clawback like the proposal, is a punitive tax imposed for purposes of correcting an abuse. When it comes to dishing out punishment, do you prefer to have the IRS select the guilty from the innocent, or a judge, before whom you can at least defend yourself?

Now, a tax plan that applies a modest surcharge for certain types of "income" (e.g., "income" based on selling instruments which could be future liabilities) makes sense. But punitive clawbacks are a risky path.


On Mar 18 11:01 AM prudentinvestor wrote:

> Back in the late 70's or early 80's congress passed a "windfall profits tax" on oil companies, that was a sort of clawback on corporate profits, and is a precedent. The rationale was that egregious profits were obtained to the detriment of the public.
> One can argue that there is a difference between corporations and
> individuals, but a counter argument is the recent development by

Mar 18 11:46 AM

[prudentinve...:]

Thank you for your clarification. I was under the impression, perhaps incorrect, that the windfall profits tax was an income tax surcharge on oil companies. I was also under the impression that there was an even earlier precedent, of a windfall profits tax in the form of a surcharge imposed on explosives manufacturers, almost specifically on DuPont, for profiting egregiously from the sale of explosives during WW1.

You are right that targeted, punitive taxes are a dangerous and slippery slope. However, we are facing a highly unusual situation in which the general public, especially its more successful members, are being made to pay more taxes for many years to come, in order to subsidize millionaires (or even billionaires) who have lost on their reckless risks. In this special and unusual circumstance, I would suggest that the millionaires/billionaires who made poor business decisions should cover as much as possible of the losses that they created before the general public is forced to cover the rest.

On Mar 18 11:46 AM donzelion wrote:

> Prudentinvestor - a "windfall profits tax" is still a variation on
> an income tax, and in the oil/gas sector, you'd impose it by simply
> disallowing certain deductions that would otherwise be available
> for large corporations (in oil and gas, the 'negative taxes' that
> the companies paid in subsequent decades pretty much made them whole).
>
>
> A tax clawback like the proposal, is a punitive tax imposed for purposes
> of correcting an abuse. When it comes to dishing out punishment,
> do you prefer to have the IRS select the guilty from the innocent,
> or a judge, before whom you can at least defend yourself?
>
> Now, a tax plan that applies a modest surcharge for certain types
> of "income" (e.g., "income" based on selling instruments which could
> be future liabilities) makes sense. But punitive clawbacks are a
> risky path.

Mar 18 12:14 PM

[Duude:]

For every action, there is a reaction.
If we were to use a tax clawback to get back bonus money from AIG executives, what case can be made to keep us from using this same mechanism on others? The list is quite long. How about Angelo Muzillo who as CEO of Countrywide mortgage wrote more sub prime and alt a mortgages than you can shake a stick at? What about Herb and Marion Sandler who pushed Sub prime and alt a loans and then cashed out in 2006 with billions? What about Franklin Raines, James Johnson, and Daniel Mudd who all lead Fannie Mae into the toilet but managed to cash out with tens of millions in ill gotten gains by lobbying Congress to block any oversight of their companies? What about taxing all those Congressmen that screwed us all by accepting lobbyist money in exchange of blocking that same supervision, while leaving the American public with the bill? The list goes on and on and on. I'm outraged over the bonuses for AIG too, but how are they so different from these other clowns?

Mar 18 01:42 PM

[mediapro:]

This back and forth about whether clawback carries unintended consequences misses the main point. The situation that exists in our tax code today is the 500 pound gorilla that this clawback is obfuscating.

An article posted by Investment U exposes part of this tax avoidance scheme practiced EVERY YEAR by the Plutocrats. The salient part of that article:

"For many in the financial establishment, bonuses are simply part of their compensation packages. They have no tie to performance at all. Much of the rank and file receives bonuses as a normal part of their “salary.”

It’s because companies use bonuses as a way to minimize expensive payroll obligations.

Think of it this way, if I’m an average corporation and I pay a qualified employee 100k as their salary, I am required to withhold taxes, insurance and a host of other items – in addition to setting aside money for federal programs. However, if I pay that individual 60k, and a bonus 40k, the situation looks much better. The employee has to handle withholding taxes on the 40k and I am only required to deal with the payroll effects of 60k."


So what the light of day is now shining on this tax avoidance scheme is a pay structure that should be patently illegal. How can they avoid paying the payroll taxes (etc.) that they, as Employers, owe the Government? If this is legal, why not simply pay thier entire salary as a "bonus"?

Why are salaried employees and small businesses hit time and time again, while big business always seems to 'bend' the rules and still come out on top?

Add to this simple, common tax avoidance scheme at least four more:

1. Our effective cost per gallon of gas is ~$10.00 when one factors in the roughly $30 billion dollars in tax subsidies ANNUALLY provided to the oil and gas industry. This is the most egregious, downscale tax imaginable. Moreover, the oil and gas companies simply need to bid and secure future leases and INTENT to drill for the largess we reap upon them every year. This ponzi scheme against the American taxpayer is one of our dirtiest tax secrets.

2. Add to that tax subsidy the protectionist import rules on sugar, milk, etc. Removing sugar tariffs alone and replacing this supply with a much more efficient cane sugar ethanol source could end the corn producer/fertilizer manufacturers stranglehold on the taxpayer's neck.

3. For people who don't count the payroll, FICA, SUI, etc. automatic worker payroll contributions while conveniently ignoring the "bonus structure", offshore accounts, shell businesses, and other manipulative uses of the tax code by those who can afford tax attorneys, don't be so quick to condemn the extra pittance through earned income tax credits, adjusted rate schedules for wage earners and such put into the pockets of those who actually contribute a day's labor for a fair wage vs. the incredible sums paid to those who move money through the system. Look where that system of rewards has put us.

4. Finally, would someone please explain to me why there is a ~$100 K cap on wage contributions to Social Security?

While we are all arguing about the validity of the clawback option, we are missing the larger point of just how egregiously the average Joe has been pummeled by a tax system that redistributes wealth from the working middle class up to the 2% Captains of America that continue to rape this country and its resources.

Look where that system of rewards has landed us.

Mar 19 05:37 PM