California Governor Arnold Schwarzenegger is proposing to tax punitive awards at a 75% rate. The idea has some merit, punitive awards are intended to punish the defendant but to serve that purpose it is not necessary that they should flow to the plaintiff. Moreover, punitive awards often have more to do with the defendant’s deep pockets or other arbitrary factors like whether the plaintiff is headquartered in or out-of-state than with proof of malice. Giving punitive awards to the plaintiff, therefore, may over incentivize plaintiff’s and their lawyers (under the plan contingency fees would be calculated on the compensatory portion of the award only).
Schwarzenegger, however, is putting forward the proposal as a revenue source and calculating revenues under the assumption that punitive damages will not decline after the tax. On the contrary, as with any tax we can expect fewer punitive damages after the tax than before. In this case, that’s a benefit of the tax.
But tort reformers shouldn’t be too happy, however, because there are ways around the tax. In particular, the tax will encourage settlements. Suppose the plaintiff and defendant estimate that there is a good chance of a 10 million dollar punitive award only 2.5 million of which will go the plaintiff. See the gains from trade? The plaintiff and defendant can agree to settle at say $5 million, making both of them better off. In this way, punitive awards decline but “compensatory” awards increase. Increasing the incentive to settle is not necessarily a bad idea but it doesn’t help revenues.
Of ocourse, the Governor is being disingenuous when he claims this is tax policy not tort reform. Just like bad ideas, good ideas usually don’t get passed on the merits but need some otherwise irrelevant impetus (like a big budget deficit).
Addendum: Glen Whitman says we should burn the money – which is not as crazy as you might think!