The case for clawing back some of that Wall Street pay

Justin, to understand what's going on with the economics of selling earthquake insurance it's helpful to look not just at the first two letters of the Greek alphabet (alpha and beta), but also the third: gamma. Selling out-of-the-money options like earthquake insurance is intrinsically a gamma-negative strategy. Like all gamma negative strategies, even in an efficient market it makes a little money (called theta) most of the time, but occasionally loses a lot of money. That leads to the agency problems you describe. But in this kind of example it's really more of an alpha-theta confusion than an alpha-beta confusion.

Sorry, I never got past the first two letters of the Greek alphabet.

Justin, I don't know if you saw my comment to your last FairTax post, but the claim that "a consumption tax [such as the FairTax] effectively amounts to a wealth tax" is bogus on multiple levels.

As you know, some commenters were confusing the FairTax with a flat (income) tax, but that's actually less wrong analytically than conflating it with a wealth tax.

Consider one family ("the spenders") that spends all it's money as it earns it and another family ("the savers") that eventually spends all the money they earn but only after an average delay of a century. Under a wealth tax, the spenders would pay nothing no matter how high the rate. However, the savers would pay more almost no matter what the wealth tax rate (the break even is a measly 0.23% even making the assumption that all their spending is taxable under the FairTax).

On the other hand, if we assume that:

1. all savings are eventually spent
2. all that spending is on new stuff in the United States (so that's it captured by the FairTax)
3. ignore the difference between simple and compound interest
4. and assume that tax law after radically changing as proposed then remains unchanged far into the future

then the FairTax actually starts to look like a flat tax. All I needed was four major assumptions.

I'm pretty certain that assumptions 1,2 and 4 are in fact part of Kotlikoff's calculations and 3 probably is. So yeah, it's a wealth tax! (In a vacuum, at least.)

I'm pretty certain that assumptions 1,2 and 4 are in fact part of Kotlikoff's calculations and 3 probably is. So yeah, it's a wealth tax! (In a vacuum, at least.)

Un, no. Under those (implausible) assumptions it is an income tax. It's still a million miles away from a wealth tax.

I agree with Mr. Rajan's statement. Bonuses should be paid based on how the outcome of the prediction was, also portions of the compensation should be held to be paid only after said prediction materializes.

Sorry, I never got past the first two letters of the Greek alphabet.

Touche. I used too much jargon. My basic point is it's important to understand the asymmetry of returns involved in selling options and how it naturally leads to such situations.

@Crust: Unless you conflate spending with wealth. This is what Kotlikoff et. al. are doing: Saying that lifetime spending, not assets at any particular time, is the true measure of a person's wealth. Leaving aside whether that's total nonsense or not, there's still the issue of passing on that wealth to future generations. I guess you could have an estate tax with the same rate as the sales tax, but I assume the FairTaxers would hate that. Which leaves you with nothing but the hope that the sales tax will hit profligate future generations.

Justin, in countries that have a wealth tax (e.g. France) it is a tax that it is levied every year on a person's wealth. Really, that's the essential feature -- love it or hate it -- of a wealth tax: the same money gets taxed over and over again. That just doesn't happen under the FairTax. We can grant Kotlikoff all his assumptions about multi-generational spending and so on, but that still doesn't happen. Even if you conflate spending, income and wealth. Sorry.

Got it. It might just be--in the same sense that *any* tax, except maybe a poll tax, can be construed to be, by those who are really inclined to do so--a tax, sort of, on wealth. But it's not a wealth tax.

I'm pretty certain that assumptions 1,2 and 4 are in fact part of Kotlikoff's calculations and 3 probably is. So yeah, it's a wealth tax! (In a vacuum, at least.)

well, it would have to be in a vacuum, because only in a vacuum would things like irrevocable trusts whose principal can't be touched not exist.

Crust is right. Its not a wealth tax. Bill and Milinda, and their kids, and their kids, and their kids, and THEIR kids, could live off the wealth accumulated by Gates and not even come close to touching the principle.

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But back to the subject of the thread... what I'd do to deal with the Wall Street pay dilemma is impose a tax of 63% over all income over $70K, thereby discouraging extravagant compensation packages for both alphas and betas -- alphas, being alphas, can't help but continue to work, and one beta is as good as another, and there is no shortage of them!

Sorry, Justin, my keyboard got a little carried away. I just don't know how that happens ...

P. Lukasiak -- Woof. Believe it or not, I'm a proponent of progressive taxation, too, but punitive taxation is right out. Slap a 63% tax on anyone and just watch how fast we all move to the Maldives. I don't like New York City that much. Just watch what happens to the tax base when 5% of the population and 50% of the wealth moves offshore: ouch.

Believe it or not, I'm a proponent of progressive taxation, too, but punitive taxation is right out. Slap a 63% tax on anyone and just watch how fast we all move to the Maldives. I don't like New York City that much. Just watch what happens to the tax base when 5% of the population and 50% of the wealth moves offshore: ouch.

oh, It looks like I forgot to mention my 90% tax on assets switched to offshore accounts?

that being said, of course the 63% tax rate thing was a joke -- a reference to Justin's obsession (which I like) with Denmark. Nevertheless, I do think all these tax cuts for the upper income brackets have had seriously negative consequences for the economy, because while such cuts may have a marginal positive impact on productivity, they have a massive impact on encouraging greed by switching the focus for corporate profits from reinvestment/better wages to executive compensation and short-term capital gains distribution.

(i.e. lower taxes on high incomes wind up being counter-productive to the long term economic health of companies. Instead of long-term reinvestment strategies designed to increase the overall real value of a corporation's assets, its turned into a get rich quick scheme. And while stock prices go up, its not because the companies are really worth more, its because the growth in capital available for investment lags way behind the creation of good places to put the money that the rich are getting -- and anytime that the demand for an item exceeds the supply, the price of that item inevitably rises not because its intrisically worth more, but merely because its in short supply.)

The notion that CEO positions will remain vacant unless they offer an extravagant compensation package is an untested idea that should be tested soon. The CEOs of non-profits, such as those at universities and hospitals, are compensated at levels that are several orders of magnitude lower than what their counterparts receive in the for-profit sector, yet the former often endure the same levels of stress, work the same long hours, and require the same level of talent and creativity to get the job done. The Boards of Directors at corporations should rethink their assumptions on executive compensation as soon as possible. At the very least, it could serve to improve the morale of the vast majority of the workforce.

The CEOs of non-profits, such as those at universities and hospitals, are compensated at levels that are several orders of magnitude lower than what their counterparts receive in the for-profit sector, yet the former often endure the same levels of stress, work the same long hours, and require the same level of talent and creativity to get the job done.

good point. I would also add that there have been a spate of multimillionaires all over the country running for office (usually with self-financing campaigns) -- and lots of multimillionaires willing/eager to take upper level positions in government....and their pay is a pittance compared to private sector compensation.

Nor do I hear a lot of the people who celebrate the huge amounts of money being made on Wall Street demanding much higher wages for public officials because we'll get better qualified people if we institute those raises...

I worked at Goldman for 11 years. They do not have a clawback mechanism on an individual basis. While the quality of people I worked with was generally good, and the review process and hiring process better than many other places, I still worked with a number of bull market 'stars' who turned turned into frogs when the various market segments crashed. Being in the right seat at the right time is still a good money making strategy (if hard to reliably implement)