Bailouts and the Optimal Taxation of Bonus Pay

Little undermines the case for a market economy more than the perception that there is injustice in the rewards that it generates. In that sense, the recent financial crisis is a body blow, and has spawned a series of noisy but so far largely ineffectual campaigns for radical change from the Left (e.g., the Occupy Wall Street movement). But the greatest clamor for reform should come from those who support the market system. When push came to shove, it was the government that came to the rescue of financial institutions and public money that proved to be the cornerstone of the financial system. And there is a more than respectable case that a sizeable transfer of resources from public to private hands have enriched workers in the financial sector at the expense of citizens at large. And this is put into sharp relief by the observation that a good deal of the increase in inequality that has been seen in recent years is due to bonus pay in the financial sector and beyond – see Brian Bell and John Van Reenen (2010) and Thomas Lemieux, W. Bentley MacLeod, and Daniel Parent (2009). At the same time, and partly in response to the financial crisis and its fiscal consequences, societies are revisiting the question of how the rich should be taxed. The rules of the game in advanced democracies have evolved to view the tax system as the primary legitimate source of redistribution. Broad-based progressive income tax systems are central to this and are seen as a fair and equitable way of paying for transfer programs and public services. But the question of whether and how the tax system should differentiate by source of income is not clear. For both practical and theoretical reasons, taxes on income from capital are structured differently from taxes on labor earnings. And bonus pay,