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Alistair Darling today presented his much anticipated budget report, and apart from raising National Insurance (which most people will have to pay) and capping public sector pay increases at 1% (which will mean a decline in real salary for a lot of people), he has come up with another really good plan: Bankers’ bonuses will be subject to a “super tax” of 50%.

I don’t really care about taxing bonuses either way, but what annoys me is that apparently, nobody in the government or their advisory staff thought to consult an introductory Microeconomics textbook (or even Wikipedia - it’s free!) before they came out with this statement:

 Alistair Darling attempted to appease critics who feared the tax on bonuses would prompt defections from the City by insisting the 50% tax rate on bonuses of more than £25,000 would be paid by the banks rather than employees. (guardian.co.uk)

 So… Since Greg Mankiw’s book is copyrighted, see this link for a primer on tax incidence. If you can’t be bothered, here’s the gist: It doesn’t matter who pays a tax, the effect is the same. The tax is “wedged” between the supply and demand curve, and who pays what portion of it depends on the shape and slope of the two curves - NOT on the structure of the tax!

It’s simple, really: if the tax is taken out of bankers’ paychecks, that lowers their total income. But assuming the banks pay them the same total amount of money they would have in absence of the tax, this means that for every pound the banks pay, the banker receives less. This is going to discourage some individuals from further pursuing their high-flying career and the total quantity of bankers’ hours worked (or whatever particular Q you are looking at) decreases.

If the tax is taken from the banks, again holding constant the total amount they want to pay for bankers, they can afford fewer hours. Unless of course people are willing to work for less but I think if we’re completely honest, it may be easy to demand that other people do it, but we’d be quite upset if we were asked to take a paycut ourselves! (Of course, “we” didn’t cause the greatest recession in the history of mankind and therefore aren’t morally obliged to, because the banking system operates completely independent of the rest of the economic system of which we are a part… Let’s just pretend the economy is purely supply-driven, shall we.)

To summarize, a tax makes bankers more expensive to banks, while bankers receive less money. So a smaller quantity of “banking” will be bought, at a higher cost per unit.

Another point I find at least amusing is that there is a continuous collective outcry about the size of bankers bonuses. What we seem to forget is that there are incentives in place that encourage banks to shift payments to their employees from base salaries to bonuses. The obvious ones are the power to reward or punish etc. I don’t claim to have a complete picture of the banking industry, but in my (all be it short) time in the City, my base salary was rather low - hardly enough to live modestly in London, in fact. This was also the case at a certain (now rather broke) large bank from the self-governed North. As a rule, base salaries are low and bonuses make up for it, at the same time keeping people nicely in line with corporate policies. But another aspect is rarely mentioned.

Bonuses are not pensionable.

This is analogous to the argument above. From the point of view of the bank, their pension contribution (usually a percentage of base salary) works like a tax. If the choice is to pay a reasonable base and reasonable bonus, or to pay a low base and a huge bonus, the second option probably works out cheaper for the bank.

The question is why bankers, who are know to be the cream of the mathematically-minded crop, put up with this, because it obviously has implications for their pensions down the line. I can only come up with the usual behavioural econ explanation: People are irrational. This may manifest itself as follows.

• A preference for a certain amout of money NOW rather than an uncertain amount much much later, when we’re too old to enjoy it anyway.
• Not grasping that we are actually forgoing a benefit there. The book “Nudge” has a nice story about membership in company pension schemes where employers make matching contributions, yet loads of people neglect to join them.
• Or, just maybe, bankers expect to make so much money up to retirement that the measly employer contribution won’t make much of a difference, thus defying the law of non-decreasing marginal utility of money.

Rather than proposing more taxes which all no doubt cause some hassle for the administration and, more importantly, can be easily avoided by paying bonuses late, it would make more sense to a) stop subsidising and bailing out banks and instead support home owners and small businesses and b) set those incentives right.

Comments very welcome!