Representatives Soak Some of the Rich

The House has just passed a bill taxing Bonuses of employees (and consultants I hope) who earn over $ 250,000/year of TARP recipients at a rate of 90%.

I think this is an excellent bill. My reasoning is simple.

If I were to ignore incentive effects, I would support a 90% tax on income over 250,000 for egalitarian reasons. Generally I oppose such rates as they would have bad incentive effects. I think in this case, the tax has good incentive effects as the general lesson people will take are that if you gamble and lose a lot of money for shareholders and the US treasury you will suffer.

more after the jump.

It is certainly true that some people who did their job well will pay the high tax. However, the incentive effect depends on the expected future tax as a function of actions and the average actions of people taxed at this rate were destructive and should be discouraged.

Now, I certainly don’t approve of something like jailing a group of people because the average person in the group has committed at least one felony. That would violate human rights. However, I don’t think that people have any natural right to income over $250,000. Allowing people to keep more money than that is, for me, always a pragmatic decision.

Other people believe in natural property rights, that people have a right to some share of their income and more should be taken in fines or taxes only if it is proven in court that they broke the law. The US constitution is, at the moment, inconsistent with this view as it gives congress the right to tax income from any source derived (the 16th amendment). Before the 16th amendment, the US Constitution established (or in the minds of the other people who disagree with me recognised) property rights. Now , according to my reading of the constitution, these rights are essentially cancelled (no guess as to how the current Supreme Court would judge, as Bush v Gore showed (and that before O’Conner was replaced by Alito) they are willing to do whatever it takes to get what they want).

update: A long comment I posted at Ezra Klein’s blog. I’ve made a promise to myself to not dump comments here, but this is in “there’s more” so I decided it was OK. If this choice implies negative externalities, it would be optimal for you to get angry with me and punish me even if the punishment were not pleasant to you — a commitment to punish increases your welfare even if it forces you to undertake the painful task of writing sever comments (which you don’t enjoy doing). Therefore acting from anger sometimes leads to better outcomes than acting with a level head.

I think that punishing the financiers who created the mess is a wise policy. There is a fancy name for this argument in economics “moral hazard,” but it is really very simple.

Many people made mistakes which were very costly for the world. It would be better if in the future, people in similar positions were very afraid of making such mistakes. This is just internalizing externalities — trust in banking is like breathable air a public good.

Now some of the tax will fall on people who made no such mistakes. That part of the incentive effects will be undesirable, but we are talking about taxing rich people (the bill only applies to incomes over $ 250,000) which is desirable for distributional reasons.

In this case, I think the overall incentive effect will be good. The lesson financiers will take away is “if we mess up the financial system, we will suffer.” This is a good lesson to teach, on balance a good shift in incentives.

Acting from anger is not always a mistake. Consider the prisoners dilemma. A tit for tat player (who is honest and vindictive automatically rewarding good behavior and punishing bad behavior of the other player) wins a higher score than a rational player. It seems odd, but this is a common result in game theory, the optimal strategy is not sub game consistent (involves bluffs which can be called if the player is rational) so a precommitment to irrational vindictiveness is optimal if possible.

Last of all, I think it is perfectly normal for changes in the tax code to have retroactive effects. According to the US constitution (16th amendment) taxation is not like a fine, it is not legally a punishment which can’t be retroactive.

No one objected to retroactive tax cuts for the non rich (at least no one I heard or read). In times of financial need, retroactive tax increases are normal. I’d say a reasonable evaluation of the House Bill should be strictly utilitarian and consequentialist. In no way does it remove or infringe rights that people in the US have had in the past hundred years.