The most troubling thing about trying to tax back jackpots paid by firms that are now on public assistance is that an effective measure would have to apply retrospectively. That is, the people who are responsible for the terrible decisions made at systemically important financial institutions have already been handsomely paid for their mistakes. Nearly all of them were paid well before December 31, 2008. A measure that only interferes with current and future pay would simply teach the next generation of "rational agents" that if they cash out fast and early, nothing can be done to them. That was precisely what the current crop of malefactors expected. The whole point of a tax clawback would be to violate that expectation, and to eliminate it going forward.

The House has passed a very poor tax clawback bill (ht Conor Clarke). It is almost prospective — the law would apply only to payments made from January 1, 2009 forward. But almost prospective is like half pregnant. The bill is retrospective for just long enough to clawback the politically fetishized AIG bonuses, while leaving those who made out during the thick of the toxic credit bubble completely untouched. It has all of the philosophical distastefulness of an ex post law, and no offsetting benefit whatsoever, other than punishing a few trophy miscreants from AIG. I would support a well-designed tax clawback, but this ain't it. Hopefully the Senate comes up with something better.

I think a good tax clawback

• would apply to employees of all firms that have received public capital and that are unable to repay that capital prior to some reasonable deadline several months in the future (so that healthy banks persuaded by Paulson to accept money can be excluded).

• would tax compensation paid (or accrued) to individuals during the period of the credit bubble, maybe from January 1, 2004 to December 31, 2008.

• would apply to all forms of compensation (not just bonuses), but only above some fairly high floor. (In a previous post I suggested $200K, but I think that's too low. $500K or $1M would be better.)

• would apply at a high rate, but one that is arguably not confiscatory or punitive. 50%, maybe 60%, would be reasonable. 90%? No.

• would be justified in terms of cost-sharing between taxpayers and highly compensated employees when weakness of a systemically important firm occasions public financial assistance.

Future compensation at firms already on life support oughtn't be regulated via so roundabout an instrument as a tax clawback. Henry Blodget has an excellent post on how dumb the House measure is looking forward. If we want to control pay levels at zombie firms, the government should put them into receivership and manage them properly. Setting compensation policy via the IRS no way to run even a very bad bank.

Update: Oh, one other thing that Congress really needs to do already is to restrict the ability of systemically important firms, somehow defined, to file for bankruptcy without first providing an opportunity for the government to intervene. Obviously, a broader regime for resolving sick uberbanks (as called for by Ben Bernanke) would be ideal, but at the very least, firms ought not have the power to play chicken with the government by threatening a disorderly collapse. This is not a new problem, but it's relevant here because if a serious tax clawback were to be passed, a ruthless CEO wishing to avoid the tax could return the TARP money and take a troubled firm into bankruptcy, provoking a large-scale panic.