UK tax on £25,000 bank bonuses: Can it work?

Alistair Darling, the head of the UK Treasury, said Wednesday that a 50 percent tax will be levied on bank bonuses paid to execs. It will prove politically popular, but is unlikely to change the bonus culture.

British Treasury boss Alistair Darling announced a one-time, 50 percent tax on hefty bank bonuses on Wednesday, in a reflection of both the increasingly ugly mood over the large annual payouts made to bankers and of the budget hole that the UK is falling into.

Mr. Darling told Parliament that the measure, a tax on bonuses over £25,000 ($40,500), would raise about $890 million and slow the growth of Britain's ballooning budget deficit. The global financial collapse of the past two years has hit the UK hard, and Darling estimated that the British taxpayer remains on the hook for about $16 billion in bank bailouts. The banks, not their employees, would pay the charge. The employees will then be taxed as normal on their bonuses.

But his comments also reveal that the unpopular Labour government of Prime Minister Gordon Brown has a keen eye on the bankers that the general public in Britain, as in the US, blame for the financial collapse and is seeking to modify behavior. The public attitude is that bankers were paid huge bonuses for making what proved to be reckless bets on sub-prime mortgages and other assets, then were bailed out by the general public, and are now back to their old ways. The British government has estimated that senior executives and traders will earn at least $8 billion in salaries and bonuses this year.

"There are some banks who still believe their priority is to pay substantial bonuses,” Darling told Parliament. “I am giving them a choice. They can use their profits to build up their capital base. If they insist on paying substantial rewards, I am determined to claw money back for the taxpayer."

London is one of the world's great financial capitals, only really rivaled by Wall Street. "The City" as banker's call their domain, generates about $97 billion in tax revenue a year.

The measure has kicked up predictable squawking from executives, with Bloomberg news carrying a strong piece with executives predicting a banker exodus to more bonus-friendly climes. "They are killing the golden goose that is the financial system," a hedge fund salesman told Bloomberg. An investment banker said: "It seems both populist and discriminatory."

The move is clearly designed to be politically popular. But it's not likely to end the bonus culture as we know it. And since it's for one year only, it's reasonable to expect any effect it has on 2009 bonuses will be reversed next year. Banks might even quietly defer compensation for some of their stars and make up for it later.

Is a bonus logical?

But in the wake of the sub-prime mortgage collapse, many are now questioning the logic behind huge payouts to bankers. The argument has always been that the industry requires the best and the brightest if it's to provide the financial lubricant for economic growth. If they're not paid handsomely, the argument goes, they'll go elsewhere. But some of the biggest bonuses of the last decade were paid to the men (and sometimes women) who blithely fueled the asset bubble. That ultimately led to corporate bankruptcies, defaults, and a bailout of more than $500 billion in the US.

French President Nicholas Sarkozy, a ferocious critic of bank bonuses, recently won a political battle to appoint his own man as head of the European Union's financial regulatory body. At the September G-20 meeting in Pittsburgh, Mr. Sarkozy pushed the US and other financial heavyweights to follow France's lead and adopt strict regulations over bonuses.

That effort fizzled out. But the fundamental problem with banking's bonus culture has long been understood – that profits and compensation are short term, while the risks and impacts of those decisions are long term. Nick Leeson, the so-called "rogue trader" whose reckless bets on the Singapore International Monetary Exchange in 1995 (when he was 28-years-old) led to the collapse of the venerable British bank Barings, which was then sold to Dutch bank ING for a nominal $1.50.

Mr. Leeson had engaged in deceptive practices to conceal the losses he was racking up. But in previous years he was the banks darling trader, delivering far above-average profits. He was compensated handsomely for this – as were his bosses. Evidence later emerged after the collapse that senior executives turned a blind eye to warning signs.

Nobel Prize winning economist Robert F. Engle III argues that bonuses don't need to be punished or stopped, simply aligned with the long-term interests of the banks they work for and the taxpayers who are ultimately on the hook. In an interview with RT, an English language television station owned by the Russian state, he said: "We shouldn't ban bonuses, but restructure the way they're paid... what's important is we give the banking system the right incentives to figure this out. When companies get too big and too complex to fail, they would face a higher tax rate, which would to into a rescue fund. The banks are not excited about it, they would rather go back to business as usual."


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