Of Punitive Damages, Tax Deductions, and Tax-Aware Juries: A Response to Polsky and Markel

IN “Taxing Punitive Damages,” Gregg D. Polsky and Dan Markel argue that defendants paying punitive damages are under-punished relative to juries’ intentions, because tax-unaware juries do not take into account the fact that the deductibility of punitive damages significantly reduces defendants’ after-tax costs.  They note that the Obama administration has proposed addressing the under-punishment problem by amending the Internal Revenue Code to disallow deductions for punitive damages (and for settlements paid on account of punitive damage claims)  They conclude, however, that the proposal would be ineffective because defendants could avoid its impact by disguising nondeductible punitive damage settlements as deductible compensatory damage settlements.  They argue that a superior approach would be to leave federal tax law unchanged and to change jury instructions in punitive damage cases instead.  If juries were explicitly told that punitive damages were deductible, they could “gross up” the awards to impose the desired level of after-tax punishment on defendants. In contrast with the Obama administration’s proposal, this non-tax, non-federal solution to the under-punishment problem would not be undermined by pre-trial settlements: “Gross ups, in addition to increasing jury verdicts, would increase settlement values because litigants determine these values in the shadow of what a jury would be expected to award.” 

Their argument is powerful and original. It may have dramatic real-world effects, if it inspires plaintiffs’ lawyers across the nation to request the jury instructions required to produce tax-aware juries, and if courts grant those requests. In this brief Response, however, I raise two possible objections to their analysis. The first objection is that they do not consider the alternative of a nondeductibility rule applicable to punitive damages but not to settlements of punitive damage claims. This narrower nondeductibility rule is arguably superior to both broader nondeductibility and tax-aware juries. The second objection is that they do not consider how their analysis would change if deterrence, rather than punishment, were viewed as the primary function of punitive damages. Although these are considerably more than quibbles, they do not detract from my view of their article as a major contribution to the scholarly literature on the intersection of torts and taxes, with the potential for significant real-world impact. The Response closes with a brief observation on the relationship between the article, plaintiffs’ attorneys, and ten dollar bills on sidewalks.