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Throw Out Baby, Bail Out Bathwater

I’d call this the law of unintended consequences — except that the consequences are explicitly written into the bill. The bonus tax, which passed the House earlier today, applies not only to AIG but also to some 12 other firms that received substantial levels of government assistance. This includes both financial institutions like AIG and nonfinancial ones like General Motors; it includes banks that are preforming poorly, like Citibank, and those that are holding up fairly well, like JPMorgan Chase and PNC. The government has dictated that nobody at anybody of these companies is deserving of incentive-based compensation, unless their household income is less than $250,000 per year.

Just think about some of the implications of this.

A senior engineer at General Motors, who shepherds the production of a new hybrid vehicle that will turn out to be a best-seller, shouldn’t get a bonus for that. Really?

Jamie Dimon at JP Morgan, who has managed his company’s assets adeptly and kept it mostly off the taxpayer’s dole, is no more deserving of a bonus than an AIG crook. Really?

An mid-level investment banker at Morgan Stanley, who works her butt off to persuade her bosses to facilitate a deal for a new wind-power company that turns out to be a big economic and environmental winner, should have her incentive compensation taxed at 90%. Really?

An administrative assistant at PNC, who is volunteering to work 70-hour weeks because of cutbacks in the company’s staff, deserves a Christmas Bonus — unless her husband happens to be a lawyer earning $250,000 per year, in which case it should be taken away. Really?

$500,000 in salary for an employee that performs badly is perfectly fine, but a $500,000 bonus for one who performs exceptionally well isn’t. Really?

I understand that these might be hyperbolic examples. As I argued earlier, compensation in the financial services industry is probably too high in the aggregate. But there are much better ways to design around that. For instance, set a soft cap for aggregate compensation that is adequate to keep a company running healthily — say, 20% of company earnings — and then require companies who allocate more compensation than that to match it one-for-one with paybacks of their TARP funds. This would require companies to either right their ship or control their compensation levels. But it wouldn’t discourage them from paying bonuses to those exceptional individuals who are deserving of it.

As written, I’m not even certain that the bill will reduce compensation for these bailed-out firms at all. It will just shift it from incentive-based compensation, which is subject to the levy, to salary-based compensation, which isn’t. But in so doing, it will make it harder for the companies to align performance and rewards.

I understand why the bill was written this way — it had to be broad enough to fend off a constitutional challenge — but the cure is worse than the disease. Much worse. I can’t imagine a credible defense of it along economic lines, and so far as I’ve seen nobody has even attempted one.

n.b. See also Noam Scheiber, who has been a voice of sanity on this issue; Josh Marshall is also starting to have reservations.

EDIT: To people who say I’m not getting the politics on this one: I’m not talking about the politics of it, I’m talking about the economics. If I were a Senator’s Chief of Staff, I’d probably tell him to vote for it.

But I also think there have been political failures here: the Obama communications team failed to nip the AIG story in the bud to the point where it blew up on them and the political pressures on the Congress became irresistible. The public doesn’t have the most basic understanding, for instance, of what the “bonuses” really are — in AIG’s case, they weren’t really bonuses at all — and so a lot of the debate has evolved from false premises.

I’m also not very sympathetic to the “they’re rich — who cares?” line of argumentation. I’d be happy to pay an employee a million dollars if he made me two million, and since the employees of the bailed-out firms are our employees in a certain sense (since we own various levels of debt/equity in their companies), I feel the same way about them.

If we want to address wealth discrepancies in this country (and I think that we should), we should do so by changing marginal income tax rates. The one good thing that may come out of the AIG mess is that it may actually prove to be fairly paradigm-shifting as far as that stuff goes. But if we’re monkeying around with tax policy, it’s important to do so in an economically coherent way. The idea that an authentically high-performing executive at Morgan Stanley should be subject to the tax but the same employee shouldn’t be if she leaves for Deutsche Bank is asinine — but that’s exactly the outcome that this bill engineers.

Nate Silver is the founder and editor in chief of FiveThirtyEight.

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