How to Tax Tycoons

For as long as we have been following politics, the mantra of the left has been "Soak the rich!"

Of course, they do not generally put it quite that bluntly; usually they use some more appealing construction like calling for the rich to pay their "fair share."  What share is fair is the subject of some debate; considering that 43% of Americans pay no income tax whatsoever, and the richest 5% of Americans pay more than half of all income taxes collected, one could argue that our plutocrats are already pulling their weight and more besides.

No, the issue is not really one of fairness.  It's one of jealousy.

During the campaign, Barack Obama said he would raise capital gains taxes even if it would cost the government money; he felt it was "fairness" for the rich to be robbed, even if the poor didn't benefit or even if the economy went down.

The past year of bailout billions has only strengthened the call for pitchforks and torches with which to assault the castles of the wealthy; we came perilously close to seeing an unconstitutional confiscatory tax enacted against AIG executives, indeed, the same executives who actually did their jobs correctly and made money for AIG and whom AIG desperately needs to retain to have any hope of repaying your tax dollars that they borrowed.

For all that this economic demagoguery is deadly dangerous and, taken to extremes, has to ability to completely collapse our economy as the productive flee, there is a germ of a point.

People should be able to get rich, even "wealth beyond the dreams of avarice," by founding a successful company that sells something people want.  Nobody complains about the riches of sports heroes and entertainment superstars; people are willing to pay big bucks to see them perform.  Nobody much complains about Bill Gates being rich; his company enabled the modern computerized age.

Where people really get upset is with the wealth of Wall Street types who don't appear to have done anything more than moving numbers around on a piece of paper, and particularly with corporate executives who retire to Monaco and their Swiss bank accounts even as their company collapses in bankruptcy behind them.  Sharing in the success is one thing; fleecing everybody for your own benefit is quite another.

What rightly disgusts Americans is the idea of "privatization of profits, socialization of losses" - in other words, when things go well, private people collect the gains, but when things fail, the taxpayer or little guy is left holding the bag.

The Power of Partnership

It was not always thus.  The idea of a modern corporation is relatively new, as human social constructs go; as a widespread phenomenon, it really only dates back to the 19th century.  The basic idea of for-profit capitalism goes back centuries earlier, however.  How did you run a company in those days?

Through partnerships - and that's where the sense of responsibility came into play.  Consider the partnership of Scrooge and Marley (one of whom since deceased.)  When they founded their mortgage firm, they pooled their own private capital, obtained a loan from an investment bank, and went into the lending business.

Through parsimony and aggressive business practices, they did quite well, but what if they hadn't?  Their firm would have been an unlimited partnership, which means that their creditors had a claim not just on the business assets, but on all of Scrooge and Marley's personal assets as well.

When a business failed before the mid-nineteenth century, not just the employees but the bosses also would be out on the street.  In fact, a company collapse was harder on the boss than on the worker.

The workers would lose their job, of course, but they could keep whatever wages they had already received.  The owner, in contrast, was personally liable for all the company debts, up to the limit of his own personal assets from any source.  Even if he didn't end up in debtor's prison, he could quite realistically wind up standing on the sidewalk owning nothing more than the clothes on his and his family's backs, and depending on the judge and creditors' committee, perhaps not those.

The modern "limited liability" corporation was developed in a desire to reduce the harshness of business failure.  The more harsh a business failure is likely to be, the fewer people will be willing to even try in the first place.  Moderating the personal consequences of a business bankruptcy to the owners has been a key element in modern prosperity.

All good things can go too far, however, and on Wall Street, they have.

What is the most infuriating aspect of the "malefactors of great wealth" the commentariat have been shrieking about?  It's that they still have great wealth even though they created nothing and generated no wealth for anyone save bankruptcy attorneys.  Whatever vast salary a CEO can con his board into giving him is his to keep even if he runs the company into the ground.

And relating specifically to salary, that's as it should be.  If you do a bum job at work, you might get fired and your salary would stop.  But should your company be able to force you to repay the salary you've collected all along?  Of course not, no matter how rotten an employee you were.

In the main, however, corporate bosses don't get huge salaries.  Well, they do - hundreds of thousands of dollars - but you don't enter the ranks of the super-rich with a paltry few hundred grand.

The bulk of their compensation comes by stock options, bonuses, and other non-salary forms of compensation.  Hedge-fund operators, for instance, receive most of their fortune through financial instruments and not via a paycheck.  Their salary alone may fund a comfortable life, but certainly not a lavish one.

This is partly because of our Congress.  In a fit of jealousy some years back, Congress passed a law saying that executive compensation in excess of a million dollars or so was not deductible as a business expense unless compensation was tied to measurable business objectives.  The entire scheme of "performance bonuses" was brought about by this change in the tax code.

In principle, it's a good idea.  In practice, it has been disastrous.

Keeping Incentives Aligned

The fact that, thanks to Congress, most executive compensation is tied - in theory - to performance presents us with an elegant solution to the problem of executives who fiddle while Rome burns.

We can all agree that, once you cash your ordinary paycheck, it's yours, no matter whether you are the CEO or the janitor.  The problem is that, with performance bonuses and stock options, it's not possible to truly connect the risk to the reward.  How many Wall Streeters received massive bonuses for 2007 based on seemingly-successful transactions that went desperately bad in 2008 and wound up costing their company billions?  Yet the bonuses were already paid, in their pockets, out the door, and irretrievable.

That is what needs to change.  For executives of financial firms, leave the rules and taxes for salaries just as they are.  But for non-salary executive compensation, whether it be stock options, bonuses, or anything else, if the corporation takes future losses pertaining to activity on which the bonuses were paid, those bonuses must become reclaimable.

Obviously there would need to be limits - such as, for five or ten years following the end of the executive's employment.  And there's an equally obvious complaint: what about bad things that happen through no fault of one specific executive?

There's the beauty of the partnership model:  It did not matter whose fault bankruptcy was.  It was the job of each partner individually to make sure that every other partner did his job properly and honestly - because they're all on the same hook.  This keeps partnerships honest; and when it doesn't, as with Arthur Andersen, the partners are all liable and get impoverished as an example to others, which is what you want.

Why shouldn't it be the same for top corporate executives?  The CIO may not spend his days digging in the financials and the CFO may not be totally up on the nitty-gritty of the corporate computer network, but there is still a joint responsibility to ensure due diligence all around.

We don't really want to throw people out on the street penniless.  With this plan, we don't have to, as ordinary salary will be safe from failure reclamation.  It's only the lottery-style bonuses and capital gains, many of which are taxed at a lower rate than ordinary income, which would be subject to this change.

An executive doesn't want to risk losing the riches he thought he'd amassed?  Then he has the option of convincing his company to pay it out as ordinary income - at a much higher tax rate.  What could be more fair and just?

The cause of the collapse of our financial system was not excessive greed - human beings have always been greedy and always will be, nothing new there.  With certain exceptions (Bernie Madoff comes to mind) it wasn't caused by outrageous fraud, either.  It was simple stupidity, human error, lack of foresight, and in an old-fashioned phrase, "popular delusions and the madness of crowds."

So?  That's the whole point of being the boss: The Buck Stops Here, and it's precisely for that reason that the big bucks stop here too.  As the CEO, and really as a senior executive of any kind, there is nothing you are not responsible for, directly or indirectly.  You take the profit... and you ought to bear the pain.

If economic justice can be seen to be done - if erstwhile tycoons lose their mega-millions and are left with the far smaller proceeds of their properly taxable salaries - the popular fury against "The Rich" will be cooled.  Our economy, our businesses, and our politics will be far healthier and more honest.

Who knows, maybe even The Rich will be too.