Taxing Punitive Damages

Dan Markel and Greg Polsky (both of Florida State) have posted “Taxing Punitive Damages” on SSRN.  Here is the abstract:

Thereis a curious anomaly in the law of punitive damages. Jurors assesspunitive damages in an amount that they believe will best “punish” thedefendant. But, in fact, defendants are not always punished to thedegree that the jury intends. Under the Internal Revenue Code, punitivedamages paid by business defendants are tax deductible and, as aresult, these defendants often pay (in real dollars) far less than thejury believed they deserved to pay.

To solve this problem ofunder-punishment, many scholars and policymakers, including PresidentObama, have proposed making punitive damages nondeductible in allcases. In our view, however, such a blanket nondeductibility rulewould, notwithstanding its theoretical elegance, be ineffective insolving the under-punishment problem. In particular, defendants couldeasily circumvent the nondeductibility rule by disguising punitivedamages as compensatory damages in pre-trial settlements.

Instead,the under-punishment problem is best addressed at the state level bymaking juries “tax aware.” Tax-aware juries would adjust the amount ofpunitive damages to impose the desired after-tax cost to the defendant.As we explain, the effect of tax awareness cannot be circumvented bydefendants through pre-trial settlements. For this and a number ofother reasons, tax awareness would best solve the under-punishmentproblem even though it does come at the cost of enlarging plaintiffwindfalls. Given the defendant-focused features of current punitivedamages doctrine, this cost is not particularly troubling. Nonetheless,a related paper of ours furnishes a strategy for overcoming thistradeoff through some basic reforms to punitive damages law.

ADL