Sunday, March 22, 2009

Instead of Taxing Bonuses, Why Not Tax Assets?

The outrage over the AIG bonuses is understandable. Taxpayers fork over $170 billion plus in bailout bucks because of AIG's mistakes, and AIG gives already well-paid executives hundreds of millions in bonuses. These bonuses were possible only because the taxpayers kept AIG on life support, not because AIG's management and employees did a great job running the company.

But bonuses aren't the heart of the problem. The core problem is the humungous size of AIG's balance sheet. The company took advantage of its erstwhile AAA credit rating, based on years of building a traditional insurance business, and leveraged it in the derivatives market. One subsidiary in particular, AIG Financial Products, sold so many credit default swaps they became almost ubiquitous in the world of finance, to the point where they threatened the viability of a disturbing large number of major banks in the U.S. and Europe.

Size is the critical problem. If AIG's credit default swap business had been much smaller, no taxpayer bailout would have been necessary. If Bear Stearns, Fannie Mae, Freddie Mac, Citigroup and various other crippled financial institutions hadn't been so large, their problems would not have required taxpayer funded blank check bailouts.

Taxing bonuses may be emotionally satisfying; but it's more complex than it may first appear. At least on a going forward basis, some people at large banks may actually deserve big bonuses if they serve the banks well. A bonus tax also doesn't focus on the huge balance sheets that led to the bailouts.

A better idea would be to tax assets at the too-big-to-fail financial institutions, which might include the top 50 to 100 firms. The tax should be progressive, with rates getting higher as the institution becomes larger, because larger institutions tend to present ever greater risks. Not only should banks be taxed, but brokerage firms, insurance companies and other institutions that might be deemed too big to fail should be included. Such a tax wouldn't be a form of insurance--we're not talking about establishing an insurance fund for all major financial institutions. That already exists: it's called the U.S. Treasury. An asset tax would give taxpayers some compensation for the enormous risks that the financial system poses to them. It would also create a reason for financial institutions to pause and think before ballooning up their balance sheets.

It is axiomatic within the world of money management that there are only a limited number of good investment opportunities. That's why mutual funds sometimes close the doors to new investors. When they get to the size where they can't identify enough good investments for new investor money, they decline to take the money rather than make bad investments. If only the big banks had taken such an approach, we wouldn't now be stuck funding multi-trillion dollar bailouts. But they chose the path of short term profits from rapid and highly leverage expansion of their balance sheets. Taxing such a business strategy would discourage socially undesirable behavior, just as tobacco taxes discourage smoking.

The asset tax would have to apply not only to balance sheets, but also to assets in off-balance sheet vehicles when banks are exposed (as a matter of law or of practical realities) to such off-balance sheet assets. Much of today's problems stem from off-balance sheet exposures (recall Bear Stearns, Merrill Lynch and Citigroup, among others). The asset tax would also apply to other assets that the banks may be required (by law or commercial practicalities) to buy back or support in the event of default or other impairments to value. It's important to include assets for which taxed institutions have commercial responsibility, even without clear legal liability, because some major banks have bought back bad investments they underwrote even when they weren't on the hook legally speaking, in order to protect their reputations. These repurchased assets likely have contributed to the need for taxpayer funded bailouts. A broad scope to the asset tax would discourage the use of smoke and mirror devices such as off-balance sheet financing and improve the clarity and accuracy of bank financial statements. We certainly need that.

How much should the asset tax be? First, let's guess what quantity of assets would be encompassed by such a tax. The FDIC website ( indicates that the total assets of federally insured banks approaches $14 trillion. Of course, the vast majority of insured banks would be too small for an asset tax, since it would be imposed only on the largest, too-big-to-fail institutions. But the big banks are very large. For example, Citigroup, although shrinking, may still have close to $2 trillion in assets. Let's assume the too-big-to-fail banks have a combined total of $10 trillion in assets. We'd have to count other large financial institutions as well, since the AIGs of the world also fall into the category of too big to fail. AIG has perhaps $800 billion in assets. We'll assume that $5 trillion in assets from these non-bank institutions is taxed. That would make a total tax base of $15 trillion.

As noted above, a progressive rate structure would be ideal. But, for the sake of simplicity, we'll use an average rate of 0.25% of total assets per year. That would raise $37.5 billion per year. By contrast, the financial sector bailouts have exceeded $1 trillion and are probably headed for $2 trillion. Individual taxpayers pay about $1.1 trillion a year in federal income taxes. $37.5 billion would surely be more than the amount a bonus tax on bailed out bankers would raise, and an asset tax in this amount would certainly be fair considering that taxpayers are now funding the largest federal corporate welfare program in history.

Inflicting punishment on those that deserve it can be cathartic. But addressing the core problem is likely to be more fruitful in the long run. Let's try an asset tax.

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