War over AIG bonuses dies down

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NEW YORK (CNNMoney.com) -- Legislation to impose a bonus tax -- thrown together in record time last week -- has hit a wall.

Key lawmakers in both the House and Senate on Monday and Tuesday indicated the measure has been pulled from the fast track. The change comes as lawmakers and investors weigh the potential risks of the proposals and as news broke that employees of troubled insurer AIG have begun to give back the bonuses that created a populist firestorm.

In addition, at a congressional hearing on Tuesday, Treasury Secretary Tim Geithner asked lawmakers for legislation that would give the government new regulatory powers to deal with financial institutions like the American International Group (AIG, Fortune 500) whose failure would pose serious risks to the financial system. The ability to renegotiate compensation agreements with employees are among the powers the government is seeking.

AIG has been given access to $182 billion in taxpayer funds in the past six months. Recently it paid out $165 million in retention bonuses to employees in the company's financial products division. Those bonuses were written into employee contracts written in early 2008.

In a breathless run to smite those who took government funds and used them to enrich their own players, the House last week passed legislation that would have taxed the bonuses such that the recipients would in essence get to keep none of them.

Senate Finance Committee Chairman Max Baucus, D-Mont., co-sponsored a similar measure, but its passage in the Senate seems unlikely, at least in its current form. Over the weekend, the White House and some key senators expressed doubts about the bonus-tax measures. And on Monday, Baucus said he's been talking to them about making changes.

"I want to hear what senators have to say. A lot are weighing in now with different ideas," Baucus told CNN. "Some are tax. Some are regulatory. But they're still all addressing bonuses."

And on Tuesday, House Majority Whip Steny Hoyer, D-Md., told CNN, "I think apparently the House bill had its effect. They are giving it back," referring to AIG bonus recipients.

No one disputes that paying out those bonuses given the country's current predicament -- which was exacerbated in great part by AIG's reckless behavior -- was inappropriate and distasteful, contract or no. But the legislative proposals on the table to rectify the situation may end up doing more harm than good in the broader scheme of things.

One objection to the bills: They use the tax code as a punishment for a select group of people and they do so retroactively, meaning they apply to money already paid out. Another concern: Companies in the private sector won't feel comfortable doing business with Uncle Sam if they think he'll change the rules on them after a deal is done.

"I think there are certain constitutional questions about the imposition of a tax on a limited group of people," said Sen. Kent Conrad, D-N.D., a conservative Democrat who chairs the Senate Budget Committee, on ABC's "This Week" on Sunday.

A moderate Republican agreed that Congress' approach needed to be rethought. "We need to look for an alternative means of recouping this money that doesn't cause further harm to our economy as we're trying to get banks lending," said Sen. Susan Collins, R-Maine, who was also a guest on the show.

Not that lawmakers will drop the idea altogether. Indeed, Hoyer told CNN that any future abuses could be subject to quick congressional action.

And Rep. Barney Frank, D-Mass., said he plans to move forward on a proposal he has made that targets executive pay at companies receiving bailout funds.

But it's increasingly likely that any final legislation that lands on the president's desk will look a lot different than the House and Senate proposals to use the tax code to reclaim the bonuses.

"A lot of people on Capitol Hill are nervous about using the tax code for this purpose," said Brian Gardner, the Washington analyst for investment firm KBW, who doesn't see lawmakers having anything ready before mid-April.

On Monday, Geithner called for a measured response.

"We need to balance that basic objective that we not reward failure against the hugely important imperative that we get the financial system doing what it needs to do for recovery," Geithner told reporters. "We're going to look carefully at how this [bonus tax proposal] works through the Congress and try to make sure that we get this balance right."

One option: Legislative aides say lawmakers may try to find a face-saving way out of this -- perhaps by passing something that beefs up rules concerning future bonuses while dropping the language about bonuses already paid.

But the actions of Congress last week may have raised concerns well beyond the bonus question.

"There's a great deal of uncertainty beyond executive pay," said Dan Clifton, the head of policy research at Strategas Research Partners.

For example, Clifton said, investors mulling over Treasury's proposal to form public-private partnerships to get toxic assets off banks' books have some concern that lawmakers could legislate a profit clawback provision if they decide in hindsight that private investors stand to benefit unduly from the toxic asset program.

One possible negative implication of a bonus tax imposed on money already paid is that it could "not just drive private capital away but out of the country," Gardner said.

By that he means, it's easier for investors to size up economic risk than it is to size up political risk. Said Gardner, "We're increasing political risk at a time we need to be increasing stability."

- CNNMoney.com's Jennifer Liberto and CNN's Deirdre Walsh, Ted Barrett and Dana Bash contributed to this report.