On January 23, 1996, President Clinton made a famous declaration in his State of the Union address:
“The era of big government is over.”
The promise, of course, turned out to be untrue: although Clinton moved to the center on welfare reform, among other issues, he later proposed hundreds of billions in additional federal spending.
With the results of the 2008 US election, many in the finance community have been asking a similar question lately:
Is the era of big bonuses over?
Before hitting the “panic” button, we need to break this question down so we can analyze it rather than running around with our heads cut off.
There are 3 major factors that could affect bonuses in coming years: the market, federal regulation, and tax law.
The market has, by far, the biggest impact on bonuses and business in general. Investment banking salaries fell these past 2 years because of the market; they’ll fall again next year due to the market.
When bonuses dropped to almost nothing in 2001-2003, it had nothing to do with tax rates or regulations and everything to do with the lack of deal activity and the recession. A 5% tax increase won’t kill bonuses, but a 25% drop in M&A activity will murder bonuses without mercy.
You could argue that increased taxes and regulations will hurt the market and therefore indirectly hit bonuses. But it’s difficult to quantify this effect, and it’s even harder to know how much longer such changes would prolong the recession.
Regardless of who had won the election, there would be no silver bullet solution to a market downturn: the only cure is time. And taxes can’t go too much lower than the levels they’re at now – so massive tax cuts are not a viable strategy.
Once the US federal government controls all the banks in the country, they’ll limit bank executives to a measly $400,000 per year, right?
Surprisingly, both candidates had promised increased regulation in some form.
Artificially capping pay at banks is one extreme of the federal regulation equation, but it’s not unthinkable. After all, if Lehman really went bankrupt, where did they get that $2.5 billion bonus payment from?
Since Obama has not yet announced his plan for federal regulation of banks, we can’t say specifically how regulation would have differed under either administration.
However, from statements both candidates made and from the public backlash to the financial crisis, we can surmise that regulation would have increased regardless of who had won the election.
When it comes to finance, there are 3 relevant tax policies to look at: the corporate tax rate, the personal income tax rate and the capital gains tax rate.
I recommend reviewing this comparison of both candidates’ tax plans. Yes, I realize it is from a conservative institution and therefore the conclusions are not “fair and balanced,” so just pay attention to the objective parts where they discuss the features of each plan in detail.
Corporate Tax Rates
In the US most companies pay a 35% or 40% corporate tax rate. McCain wanted to reduce it to 25%, while Obama claimed that the effective tax rate was far lower and that a reduction would therefore be unnecessary.
It doesn’t matter who was correct because there’s no way a corporate tax cut would have become law with the financial crisis and the accompanying public outcry for more oversight, not less.
In all likelihood, Obama will keep corporate tax rates the same and banks will continue paying the standard tax rate on their earnings.
Personal Income Tax Rates
So now we get to the famous “Over $250,000 per year” issue – and I do think that this one will become law. As a result, anyone in finance above the entry-level will soon be making 5% less after-taxes.
Of course, this won’t affect most readers since Analysts never make more than $250K per year.
Some Investment Banking Associates and Private Equity/Hedge Fund Associates at the largest firms will be affected, though pay in general will be down over the next few years – so the poor market might make some of them exempt from the tax increase.
Update: As you might have seen in the comments below, one reader points out that Obama’s proposed removal of the payroll cap in FICA (Social Security & Medicare) tax will affect anyone making over $97,500.
Effectively, anyone making over $97,500 will have to pay 6.2% tax on anything over that, which will impact pay more substantially than the increase in income taxes (for most people).
So the situation is worse than what I initially thought, though even this will still be outweighed by the poor market and potential capital gains tax increases.
Capital Gains Tax Rates
Near the end of his campaign, Obama settled on a 5% capital gains tax increase, which would raise the rate from 15% to 20%.
This will marginally affect bankers and anyone else on the sell-side, but it will have far more of an impact on anyone in the private equity or hedge fund world.
But the more frightening prospect is that carried interest (the returns PE firms get from their investments) might be treated as ordinary income – at close to a 40% tax rate – rather than the 15% or 20% rate.
This one may not be at the top of Obama’s agenda right now, but if it does become law, it will be the single most significant tax change.
However, even if it does happen it won’t affect too many people at the Associate level in Private Equity – they rarely get to invest their own money alongside the Partners anyway.
So Who Will Be Affected?
We’ve already seen that hardly anyone at the entry-level will be affected by possible changes to the tax law.
If, however, buy-side firms start getting taxed at much higher rates that could negatively affect hiring practices and bonuses and therefore indirectly impact everyone.
Anyone more senior will be hit by the tax increases, though not dramatically in most cases (ok, I suppose 5% of $5 million is somewhat dramatic).
Increased regulation, of course, will impact almost anyone in finance – but again, most of it will be felt at the top rather than the bottom.
And the market will have the biggest effect of all – and it’s the one factor beyond the control of anyone in Washington. Sure, higher taxes may lengthen the recession, but even if taxes were cut dramatically it would still take years to recover from the mess we’re in.
And Outside the US?
Although I’ve lived and worked abroad before, I’m certainly not an expert on the political and economic systems of other countries.
But if I had to guess, I would say many of them are likely to follow in the footsteps of the US, at least in terms of increased regulation and government intervention.
And that means lower bonuses at international firms, though the market downturn will still have more of an impact than regulation or tax increases.
So, What About Those Bonuses?
Now that you’ve learned all sorts of tax trivia, let’s return to our original question:
Is the era of big bonuses over?
Yes, it is.
But not because it was a Democratic victory specifically.
Regardless of who had won, we would have seen more regulation and restrictions on what banks can do. True, with Obama you’ll now be losing more in taxes – but I don’t think you’d be saving much more had McCain won.
Extreme tax cuts would not have made it through a Democratic Congress, and no one would have miraculously cured the market’s woes.
Every market is cyclical, and in a few years bonuses will return to higher levels as the economy recovers.
But will they ever reach $90,000 for 1st-Year Analysts as they did in 2007?
No, I don’t think so. Not anytime soon, anyway.
Will people still make millions of dollars per year in finance?
Yes, but their ranks will be reduced.
Will everyone still chase after finance jobs with the hope of making millions?
Sure, but fewer people will do so now and even fewer will actually get there.