Why a bonus tax is a bad idea

(breakingviews.com) -- The pitchfork-wielding anti-bonus mob stirred up by American International Group is making for lousy tax policy.

Outraged U.S. legislators are pushing through punitive taxes on bonuses not just at AIG but at all recipients of government funds. The hot-headed and unfairly retroactive changes could hurt investor confidence, undermine President Barack Obama's credibility and damage the still valuable U.S. finance sector.

AIG (AIG, Fortune 500) has been especially irresponsible, both with its risk-taking during the credit boom and with its handling of its affairs since. Agreeing to extra bonuses and then paying them to employees of its financial products unit after receiving $170 billion-plus in government money - and failing to sufficiently forewarn Congress and others to boot - has rightly riled Americans and their elected representatives.

Plans to tax bonuses at financial institutions that have been bailed out by the U.S. government are the knee-jerk result. The scheme passed on Thursday in the House would result in taxes of 90% on bonuses at institutions that have received funds from the government; in the Senate, which now has to consider the measures, thinking seems to be 35% levied on the employer, and an extra 35% on the employee.

The bonus tax idea is bad for a range of reasons that senators should consider calmly, even if the House didn't do so. One is that it changes the rules - again - for recipients of government assistance. Government initiatives to kick-start clogged financial markets depend on investors and institutions participating. If they think that the rules of the game are going to change continually, they'll be reluctant.

The tax plans are also retroactive to the beginning of this year. Bankers awarded bonuses for 2008 - and some payouts were both relatively modest and legitimately earned - received them earlier this year, net of prevailing taxes. They may in good faith have spent the cash, invested it or even given it away. Changing the rules now, and demanding a giant additional tax check, really isn't fair.

Even more importantly, there's the longer-term impact on the U.S. financial industry. Wall Street's finest, together with AIG - admittedly a different beast - are now in the doghouse together. But the finance business is in fact one of America's global strengths. The planned taxes are just the kind of thing that will give foreign firms and non-U.S. bankers an edge.

In fact, U.S. institutions may be motivated to pay back funds received under the Treasury's Troubled Asset Relief Program so as to escape the new taxes. That sounds like a silver lining - except that administration officials don't want that yet, for fear that firms will lose the capital cushion against further losses that TARP was designed to provide.

That's just one example of the crossed wires inherent in the latest tax plans. And with so many bigger issues at hand, it's surely the kind of risk to credibility that Congress should make sure it avoids.