In mid-January, Senator Patrick Leahy (Dem. Vt.) proposed—again—legislation that would prevent businesses from deducting from taxable income any punitive damages they have paid during the relevant tax year.

Although it would seem that this legislation has little chance of being enacted in the current Republican-controlled Congress, out of an abundance of caution we think it is worth reciting the reasons why this proposal is a bad idea.

First, the ostensible premise for this legislation—expressed in a press release issued by Senator Leahy the last time he introduced it—that “[p]unitive damages are assessed only in cases of severe misconduct that result in extreme consequences” is badly misguided.  As the facts of BMW v. Gore—involving undisclosed and virtually imperceptible refinishing of the paint on some of the surfaces of an automobile—aptly demonstrate, punitive damages often are not limited to cases of “extreme consequences.”  As for the severity of the misconduct, some states allow punitive damages to be awarded for conduct that doesn’t rise beyond gross negligence—a very squishy concept that allows some conduct that is far from “severe” to slip through the net.  In fact, Alabama doesn’t require even that much in wrongful-death cases.

In addition, many states allow punitive damages to be imposed vicariously for the torts of low-level employees.  In some of those states, the plaintiff need not prove any level of fault at all on the part of company supervisory personnel, and in others the plaintiff need show only simple negligence in hiring, supervising, or retaining the employee.  In such circumstances, it is inappropriate to attribute the kind of moral culpability hypothesized by Senator Leahy to the business that is forced to bear the punitive damages.

Moreover, in many states and under federal law, punitive liability may be established by a mere preponderance of the evidence.  Without the protection of a heightened burden of proof, the risk of an erroneous finding of liability is substantial.  And in fact, whatever the standard of proof, it is not uncommon for some juries to exonerate a defendant entirely or find its conduct not punishable even though other juries have imposed punitive damages for the same conduct, thus demonstrating that guilt is uncertain even when liability has been found.

It is one thing to say that principles of federalism and deference to juries demand that businesses pay punitive damages in these circumstances, but it is quite another to indulge the fiction that all or even most punitive awards are exacted against egregious miscreants or that punitive damages are not a hazard even for honest and punctilious businesses.

Second, Senator Leahy’s claim that the current system is costing the fisc hundreds of millions of dollars is almost surely false.  He is smart enough to know that his proposal to eliminate the deductibility of punitive damages is likely to benefit the plaintiffs’ bar far more than the U.S. Treasury.  By eliminating the deductibility of unpredictable punitive damages awards, the proposal would create substantial incentives for defendants to settle rather than go to trial, because a settlement can be cast purely in terms of deductible compensatory damages, whereas trial would expose the defendant to the risk of non-deductible punitive damages.

This in turn would increase plaintiffs’ leverage to extract settlements from defendants, including settlements of weak claims that ought to be resisted.  That may be good for plaintiffs’ lawyers and their clients, but the cost of those settlements will ultimately be borne by consumers in the form of higher prices.

Even after a verdict, plaintiffs and defendants in most cases are likely to be able to settle in a manner that allocates all of the agreed settlement amount to compensatory damages and, if necessary, attorneys’ fees in order to prevent even one penny from being taxable.  And because defendants will effectively recoup 35% of every dollar of punitive damages thereby converted into compensatory damages, the settlement amount, and the fee reaped by plaintiffs’ counsel, would inevitably go up.

To make matters worse from a tax revenue standpoint, when a settlement in a personal-injury case recharacterizes what might otherwise be punitive damages as compensation, the entire amount of the settlement becomes non-taxable.  So the proposed legislation may actually reduce the amount of tax revenues, not increase them as the Senator claims.

In short, the principal effects of disallowing deductibility of punitive damages would be to line the pockets of plaintiffs’ lawyers and to deter businesses from defending themselves even when they have viable defenses.  Those are hardly outcomes worth promoting.

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