Not Taxing Wall Street

-- Posted by Neil H. Buchanan

In my latest FindLaw column (available here this afternoon), I continue my discussion of the proposed tax on Wall Street bonuses. Going beyond the question of whether such a tax would discourage people from working on Wall Street (which I discussed here earlier this month), I run through the major arguments for and against the tax. While it is obvious that a tax on bonuses is not the first-best way to achieve progressivity in the tax code, I conclude that it is a good idea and that the arguments against it do not add up.

Here, I want to discuss a related question. Suppose that the Bush and Obama administrations had driven a harder bargain with the financial industry, by offering less than 100 cents on the dollar for losses, for example, and requiring changes in financial practices that would have given troubled mortgage holders and other debtors partial relief from their obligations. Would that be better than or worse than taxing them now?

To be simple, let's suppose that the major Wall Street firms are about to pay out $20 billion in bonuses. Let's also suppose for simplicity that there are no exclusions, so that the entire $20 billion would be subject to the tax, which we'll take to be set at a 50% rate. Bonus recipients would then receive $10 billion after taxes. Alternatively, suppose that the bailouts had included contractual obligations that resulted in a total bonus pool of $10 billion, which would not be subject to any special tax.

Which alternative is better? One of the go-to arguments among orthodox economists is that there is an extra bit of economic loss associated with any plan that redistributes resources by non-tax means. If this is true (and I strongly doubt that it is true as a general, real-world matter), then it is better to collect $10 billion in taxes and given it to people than it would be to set up legal rules to attempt to reach the same outcome. Put differently, you can (setting aside administrative costs) take $10 billion from one group and transfer it to another group, or you can take $10 billion indirectly from one group and end up transferring less than $10 billion to another group. This suggests that true believers in economic orthodoxy, if given the choice, should strongly prefer the pure tax to the change in legal rules.

Of course, this completely ignores current political realities. With taxes the dirtiest word in politics, one must do everything possible to make something look like a non-tax. Thus, the Obama administration is now floating a "financial crisis responsibility fee" to have the big financial institutions repay the money that they received in the bailouts.

What we are looking at here, however, is not merely a matter of euphemistically re-labeling a tax. Instead, we are looking at the deeper notion of ownership that people attach to their pre-tax incomes. Among the angry emails that I received after my CNN piece (discussed in my Dorf on Law post two weeks ago), one common theme was that a tax on bonuses would take away people's money. It's their property, the argument goes, and the government shouldn't take it away from them.

If we had instead simply negotiated a contract, in which financial institutions agreed to certain actions in consideration of $xxx billion in bailout money, there would be smaller (or no) bonuses to tax. Yet it would look like this was simply the result of the parties pursuing their self interest under the terms of a contract to which they had agreed.

By now, regular readers of DoL will know that this is just another variation on "the Murphy/Nagel" point, as I have come to call it. Different arrangements of legal rules lead to different outcomes (and thus different incomes for different people), and none of the array of possible legal regimes is the True Baseline. Therefore, people own what they own only because of the legal rules in play. We can change what they own by changing the legal rules, or by taxing them.

Given these political realities, it seems clear that we should reorient our legal and economic rules to redistribute through means other than taxes and transfers. If that is less efficient, let those who decry inefficiency come out clearly in favor of higher taxes.