A Primer for the Protesters?

The “Occupy Wall Street” movement that started in New York and is moving into major U.S. cities aims much of its anger at the greed and hypocrisy of big U.S. banks. What isn’t clear, however, is exactly what the protesters would like to see changed.  

At least that is how New York Times columnist Nicholas Kristof sees it. In an opinion piece on Sunday, Kristof compared the protesters to their counterparts in the Arab Spring movement earlier this year. “There is a similar tide of youthful frustration with a political and economic system that protesters regard as broken, corrupt, unresponsive and unaccountable,” he writes, going on to say that while he does not share the “anti-market sentiment” of many of the protesters, he does think that during the last few years, “banks got away with murder. It’s infuriating to see bankers who were rescued by taxpayers now moan about regulations intended to prevent the next bailout.” 

As for the protesters, where the movement “falters,” Kristof says, is “in its demands. It doesn’t really have any.” To fill the gap, he offers the following suggestions.

The first: Impose a financial transactions tax. The second: Close the “carried interest” and “founders’ stock” loopholes, which he calls perhaps the “most unconscionable tax breaks in America.” And third, protect big banks from themselves by moving ahead with Basel III capital requirements and adopting the Volcker Rule to limit banks’ ability to engage in risky and speculative investment. He also endorses a proposal already embraced by Obama and others that would institute a bank tax based on an institution’s size and leverage.

KnowledgeToday asked Kent Smetters, Wharton professor of business and public policy, to review and comment on Kristof’s suggestions. As it turns out, he agrees with some of them.  For example, he thinks Basel III is “a modest step in the right direction. But I actually would modify the details so that the capital reserves required of systemically important institutions are tied to better measures of risk, including credit default swaps.”

He would “generally oppose a simple transaction tax — a very klutzy way to deal with a real problem about transparency and accountability of counterparty risk. Instead, I would require that most financial transactions occur through an exchange or clearinghouse so that a private third party, with a stake in the game, does the risk management. In contrast, a tax is an indiscriminate grenade that inflicts pain on both bad and good transactions. To use another metaphor, don’t use a sledgehammer to do CPR.”

He is not sure what he thinks about carried interest because “it really depends on whether we think that carried interest is in lieu of wages (that would normally be taxed at the ordinary rate) or forced investments from wages (that would normally be taxed as capital gains). Answering this question is part of my active research, and I don’t know the answer yet. But, I am fairly confident that Kristof does not know either, at least not enough to justify the hyperbole.”

He disagrees that a loophole exists with regard to founders’ stock. “In particular, founders’ stock [sometimes called restricted stock] is taxed at the capital gains rate because it is a long-term investment that is taken early. To be sure, it could be argued that the par price — how much a founder pays for the stock — is fairly arbitrary and too low. But the entire gain relative to that purchase price is still taxed as a capital gain, which is consistent with most long-term investments. Moreover, stock options, which are usually granted later, are taxed as ordinary income since they are not purchased upfront.”

So while he agrees that there is a legitimate debate about carried interest, “I think we should leave founders alone and let them innovate. Taxing founders above the capital gains rate strikes me as about as sensible as having a tax on sidewalk squatters.”

Jack M. Guttentag, an emeritus professor of finance at Wharton who runs a website called The Mortgage Professor, notes that all of Kristof’s proposals, “whatever their merits or flaws from a structural standpoint, are deflationary and will make the current economic situation worse.” His focus now is “the depressed housing market and the depressed economy, and the two are closely related.”

Guttentag argues that “Fannie Mae and Freddie Mac, which are now in a Federal Government conservatorship, should roll-back their lending terms to where they were before the financial crisis. This would prevent a second round of home price declines, and, in addition to benefitting homeowners and the economy, would reduce Fannie/Freddie losses, which makes it a requirement of responsible conservatorship.”

 

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