Why a tax on bonuses is stupid and dangerous

Ok, I admit it, last Wednesday I was glued to the television watching BBC's broadcast of American International Group CEO Edward Liddy's testimony before the US House Financial Services subcommittee about the $165 million in bonuses paid to executives of his bailed-out company. I held my breath, hoping that the BBC wouldn't cut away to news about Austrian murderer and rapist Josef Fritzl or a fire in central London. I wanted them to stick to the story that mattered to the world. I wanted to watch every twitch on Liddy's face, and I couldn't wait for what I knew would be (and was) a scrumptiously amusing cross-examination from Barney Frank, the ever colourful Massachusetts democrat who is chairman of the Financial Services Committee.

All along, though, I was filled with this nauseating feeling that I was watching a train wreck but still couldn't look away. I'm about to lay into the politicians for feeding this too-easy-to-kindle fire of wrong-sighted passion from the masses. But I was gobbling it up nonetheless.

Liddy, as you know, has become the lightning rod -- even more so than Merrill Lynch's former CEO John Thain -- for an American uproar over bonuses paid to executives of troubled firms. Unlike Thain, who spent lavishly (most famously on redecorating his own office) even as times were getting tough and negotiated $3.6 billion in bonuses for Merrill staff in December, Liddy took over AIG just six months ago, after contracts that included the bonuses were written. It's clear that at least some US lawmakers knew about the bonuses (or should have because they are standard practice in the industry) so the testimony offered the politicians a chance to defend their role and clear their names of guilt by grilling Liddy about the payments and deflecting the focus on what they did or didn't know.

And now the politicians are looking to legislate their way out of any questions of whether they are fit to guide the nation and world out of an economic downturn. They are seeking to penalise the very people who might be able to help us out of the financial mess, i.e. the bulk of investment bankers with any experience at all.

I will admit to being amazed (not quite outraged because I save rage for things that matter to me personally, not for people I don't know) by the handful of mega-bonuses that were delivered to some folks at Merrill Lynch and AIG, and no doubt at other firms too. But the legislators are just pandering to the lowest-common denominator and being incredibly short-sighted.

Consider the legislation proposed to date. Last Thursday (March 19), the US House showed a rare case of bipartisan support when in a vote of 328 to 93 they adopted a bill that will impose a 90% tax on bonuses paid since January 1 by companies that owe the government at least $5 billion in bailout funds. That tax will apply to employees with family income of $250,000 or more. It will apply to firms ranging from Bank of America to Citi. (Note though that it's a 2009 tax, so it would not apply to the $3.6 billion December payout at Merrill Lynch prior to its merger with BoA.)

The next day representative Frank tabled his own proposal. His bill bars bonuses not based on merit for as long as a firm owes bailout money to the government.

Meanwhile, the Senate has proposed its own bill that would apply to all employees at companies owing $100 million in Troubled Asset Relief Programme (Tarp) money. The plan places a 35% tax on the bonus recipient and on the company, and it would apply to any amount above $50,000 for a merit bonus and to the full amount of any bonus paid solely to retain the worker.

That would net a lot of bankers -- including many here in Asia. In short, these are proposals worth worrying about.

Now, here are a few big surprises -- ok, not to our readers but probably to the legislators. Immediately after the politicians started trumpeting their plans, banks started talking about withdrawing from any government bailout plans. Great, so now the banks that may need help are going to avoid it, which is sure to speed up an economic recovery.

Worse, what if healthy borrowers of the Tarp start repaying so as to avoid being stigmatised by any other daft punitive idea the legislators dream up? If they give back their money that could actually hurt the taxpayers because the government is getting 5% a year from its borrowers but it is only paying 2% to lend that money. So the government is profiting from this programme. If the healthy banks that borrowed the $225 billion -- and there are quite a few amongst the 488 banks who were encouraged to take the money "just in case" they need it -- give it back, then the government is just stuck with its lendings to banks that are indeed wobbly, and not sound bets.

And of course, banks which have taken money are now worried about retaining their talent -- and rightly so. In an internal memo to employees at Citi, chief executive Vikram Pandit wrote: "Our industry has recently seen a tide of negative sentiment rising in Washington, D.C. regarding compensation. Of course, some of it is warranted. But I take exception when there is a discussion about spreading the blame to each and every employee in the financial services industry. At our company, we removed the people responsible for Citi's financial distress and acted fast to strengthen and streamline the business, and install new risk processes and new risk personnel. You have been invaluable in our collective efforts to put the company on solid footing."

"The work we have all done to try to stabilise the financial system and to get this economy moving again would be significantly set back if we lose our talented people because Congress imposes a special tax on financial services employees. It would affect countless number of people who will find it difficult, if not impossible, to pay back the bonuses that they earned."

That's nothing short of begging: Please don't go. And you can't blame Pandit. The incentive to stick around is decreasing. Of course, the moral outrage is not limited to the US -- France, the UK, even Sweden is engulfed in similar storms from the masses over bonus payouts. So there is the possibility that employees in the US may have no banks to turn to that can offer outsized bonuses in the future, because everyone will be reined in by their governments thanks to the US's lead. But that's a possibility, and a remote one at that. The more likely scenario is that other countries' governors will not rush to pass silly legislation, and then free market rules will win out, and penalise the American banks for the legislators' simple-minded approach to this.

So what should the US legislators have done? Clearly, in AIG's case the government should have tried to renegotiate these bonuses before giving out any money, as the government has done in the auto industry. But now the damage has been done, and this is a cost of doing business. Capping bonuses in the future for banks that take bailout money has its place. It too can drive talent away, but it is at least seen as a good-faith effort to focus banks on getting their books back in ship-shape so that they can afford to give out good bonuses. I have argued in the past that bankers' wages and bonuses should ultimately come down, but I believe that should be done through market forces, not government intervention.

The White House secretary Robert Gibbs, said on Friday that the administration shared peoples "outrage and frustration" but the president would consider the legislation -- and its impact on the banking system -- when it passes his desk. Hopefully, he is sending a signal to his party: Show off for now, but give me a piece of legislation that is workable, not punitive.

And that brings us back to the Liddy trial, err, testimonial. What amazed me was why it took so long for the White House to simply call upon AIG employees to return the bonuses. And equally, why it took til the testimonial for Liddy to say that at least half of the workers had already done just that. Simply asking people to return the money yielded a 50% result. That's not bad. That's the sort of statistic that should give us hope in the idea that people mostly do the right thing. Whipping up moral outrage, on the other hand is all too reminiscent of the horrors of the past century -- of how easy it is to pander to peoples' biases and engender hate. As I said, I admit to being fascinated by the hearings, but I'm horrified by the grandstanding. The legislators should point out what's wrong, say it's wrong, then avoid making the same mistake again. They should take the blame for not negotiating a better deal before doling out money. They shouldn't penalise the global financial community.