6 reasons to kill the bonus tax bill

(breakingviews.com) -- President Barack Obama is clearly uncomfortable with legislation that would retroactively levy huge taxes on bonuses paid by the largest recipients of government bailout money. But he should do more and actually oppose it.

Paying out big bonuses at a time of national sacrifice is distasteful, particularly when it comes to the people who bankrupted American International Group with their unrivalled incompetence. But mutating the tax code is not an effective way to shape good public policy. Here are six reasons to kill the legislation:

1. It may be illegal. The law would almost certainly be challenged as violating Article I, Section 9 of the U.S. Constitution, which states that "No Bill of Attainder or ex post facto Law will be passed." Congress has the right to set tax policy.

But legal experts are divided on whether the Supreme Court would uphold a blatant attempt to punish a subsection of society, retroactively. At least one lawmaker has talked about "retaliation". It would also be a field day for lawyers, incurring huge legal costs on both the government and banks - money much better spent elsewhere.

2. It is unfair. Financial institutions that accepted government funds as part of an effort to shore up confidence - but say they didn't really need them - will be unfairly punished.

The $165 million of guaranteed bonuses paid out to employees of AIG's (AIG, Fortune 500) dunderheaded derivatives group may have sparked the legislation, but it will snag hitherto profitable banks like JPMorgan (JPM, Fortune 500), Wells Fargo (WFC, Fortune 500), Goldman Sachs (GS, Fortune 500) and Morgan Stanley (MS, Fortune 500) along with others, like Citigroup (C, Fortune 500), that are admittedly more deserving of a government crackdown.

3. It is counterproductive. A rush to pay back government funds - a likely consequence of the legislation - would remove capital from the banking system when it needs it most. Many of the banks that received money under the Troubled Asset Relief Program don't technically need it. They could repay enough to exempt them from the strictures of the bills wending their way through Congress.

But unless they replace the Treasury's money by raising equity, that will reduce their Tier 1 capital, and thereby their willingness to lend and investors' confidence in their cushions to handle future bad loans on their balance sheets.

4. It undermines anti-crisis efforts. By rushing bills through the House and Senate, legislators have undermined government efforts, especially the Treasury's. Castigating Timothy Geithner's attempt to persuade AIG to withhold bonuses within the confines of the law has also damaged confidence in the administration's key man in finance and will make it even more difficult to recruit talent to the shockingly understaffed Department of Treasury.

5. It makes the government a dangerous business partner. The government is urging the private sector to participate in programs designed to jumpstart the securitization market (the Term Asset-backed Securities Loan Facility) and remove dodgy assets from the banks (the Public-Private Investment Fund).

Potential participants are now worried that Congress could use the taxpayer financing of these initiatives to impose greater regulation on the programs after the fact, as it has now done for TARP recipients.

6. It is against the national interest. Foreign banks and bankers will benefit at the expense of U.S. banks and bankers. Deutsche Bank (DB), Credit Suisse (CS), UBS (UBS), Barclays (BCS) and Nomura (NMR) have long wanted to grab market share on Wall Street. Because the tax rules will not affect them, they can now dangle huge retention bonuses and guarantees to the best bankers and traders in the business, from New York to San Francisco, Dubai to Shanghai.

Any U.S.-based employees - and any U.S. tax-paying employees elsewhere - of banks caught by the measures will be sorely tempted by such offers. That will leave the U.S. banks in even worse shape to pay back the government, create credit and generate tax revenues. So while Congress claims to be acting for the benefit of taxpayers, its anti-bonus legislation could actually cost them more.

There must be better ways to address the bonus fiasco at AIG. In any event, it's more important to think about how to improve the system for the future. That's what Obama should put firmly at the top of the agenda.