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Taxation by Litigation: The Economics of Civil Justice Reform in Massachusetts

Executive Summary

Tort law plays an essential role in the American civil justice system. Traditionally, tort law supplemented commercial prudence and government regulation in deterring wrongful behavior. Over the last half century, however, there has been a substantial expansion in producers' liability for damages purportedly sustained from the use of their products. The result is a reduction in the capacity of American business to create jobs and capital. Tort law has come to impose costs - implicit tort taxes - that penalize business for creating jobs and capital, with predictable negative effects on the economy. Various states have initiated reform measures aimed at restoring tort law to its traditional role in the civil justice system. In Massachusetts, the legislature is considering the Civil Justice Reform Act (S-896). The legislation is an effort by its advocates to improve tort law by addressing standards of liability and other factors relating to principles of predictability and fairness within the current civil law system.

Taxation by Litigation: The Economics of Civil Justice Reform in Massachusetts assesses the economic implications of the tort liability system and estimates the economic effects that adoption of the proposed act could be expected to exert. The Beacon Hill Institute estimates that adoption of the act would create:

  • 71,649 to 241,224 new jobs;

  • $9.3 billion to $31.9 billion in new capital;

  • $2.4 billion to $8.2 billion in new annual payrolls; and

  • $144.9 million to $488 million in new annual tax revenues.1

Our estimates reflect the dramatic increase in tort costs that has occurred as a result of the expansion in the tort system. According to Tillinghast-Towers Perrin, the U.S. tort system cost $161 billion in 1995, or 2.3% of gross domestic product (GDP), up from approximately .6% of GDP in 1950 and 1.4% in 1970 (though down from a peak of 2.5% of GDP in 1986).2

These data reflect a shift in the role of tort law in deterring wrongful behavior by producers. Under an earlier, traditional regime, tort law played a secondary role in deterring such behavior. Commercial prudence and insurance and, to a lesser degree, government regulation played the primary roles. Under the existing, more expansive regime, tort law has come to play a far more prominent role, deterring not just wrongful behavior by producers, but production itself. Under this expansive regime, the costs imposed on producers seeking to protect themselves from increased liability amount to an implicit tax on sales or production.

In 1992, the average Massachusetts resident incurred 32% more in tort costs than the average American. In 1994, federal individual income tax collections were $550 billion. The $151.5 billion in tort costs incurred in the same year could be interpreted as a 27.6% surtax on the federal income tax. In 1992 (the latest year for which published data are available), Massachusetts tort costs totaled $4.13 billion, or 2.55% of gross state product (GSP), amounting to a tort cost of $687 for every Massachusetts resident. Assuming that Massachusetts tort costs fall entirely on residents, the average Massachusetts resident incurred 32% more in tort costs than the average American. We estimate that in 1995, Massachusetts tort costs were $5.1 billion, or $833 for every Massachusetts resident, accounting for 2.68% of GSP. If revenue equal to 2.55% of GSP were raised explicitly through the Massachusetts tax on income taxable at 5.95%, it would be necessary to impose an additional tax rate of 5.24% on that income. Hence, the total tax burden from the combination of the explicit income tax and the implicit tort tax would approach 11.19% of taxable income.

Adoption of the Civil Justice Reform Act would substantially reduce this tax and, as shown, confer substantial economic benefits. By raising the cost of living and by putting upward pressure on prices and state taxes, tort costs diminish Massachusetts' ability to compete for business and workers. The reason is not hard to understand. Once tort law abandoned its traditional, contractual foundations in favor of the current expansive regime, it came to impose a strikingly high, even if implicit, tax on economic activity undertaken within Massachusetts.

By raising the cost of living and by putting upward pressure on prices and state taxes, tort costs diminish Massachusetts' ability to compete for business and workers. Reducing tort costs would, by contrast, increase the state's competitiveness and its capacity to attract new business and to create jobs.

Overview

A sea change has taken place in the United States regarding the place of tort liability in the civil justice system. This change, which began in the 1950s, has brought about a substantial transformation not only in the civil justice system but also in the capacity of American business to create jobs and capital. In its modern incarnation, the tort system imposes an implicit tax - a "tort tax" - that penalizes business for creating jobs and capital, with predictable, negative effects on the economy.

Opponents and perceived victims of the expanded tort liability system have, with some success, initiated tort reform measures in various states. A Civil Justice Reform Act now before the Massachusetts legislature would, in accord with this trend, place new limits on the rights of tort plaintiffs under Massachusetts law. Our purpose here is to assess the economic implications of the tort liability system in Massachusetts and, concomitantly, to estimate the economic effects that adoption of the proposed Act could be expected to exert.

Table 1 summarizes the results of our analysis. There, we present a range of estimates of the economic effects of the Civil Justice Reform Act, showing a reduction in the implicit tort tax (I) to the current (1992) U.S. average; (II) by an estimated 26.6% reduction in tort filings; 3 (III) to the 1970 Massachusetts level; and (IV) to the 1970 U.S. level. These scenarios show progressively larger economic effects.

    Scenario    
  I II III IV
Reduction in Tort Costs to Current U.S. Average of 2.2 GDP Proportionate to Filings Decrease of 26.6% 1970
Mass Costs of 1.8% of GSP
1970
U.S. Costs of 1.4% of GDP
Equivalent Tax Impact
(% point change)
-0.72 -1.39 -1.54 -2.36
         
Employment Impact 71,649 139,940 155,303 241,224
         
Capital Impact $9.3 billion $18.3 billion $20.4 billion $31.9 billion
         
Payroll Impact $2.4 billion $4.7 billion $5.2 billion $8.2 billion
         
Tax Revenue Impact $144.9 million $314.1 million $314.1 million $488.0 million

At the low end of the range (Scenario I), the Civil Justice Reform Act would cause a 0.72-percentage-point reduction in the tort tax. The result would be the creation of almost 72,000 new jobs, which is to say, a 2.38% increase in Massachusetts employment. The new jobs would be filled by Massachusetts residents who are currently unemployed and by the entry of persons (some of whom would come from out of state) into the Massachusetts labor force. A further effect would be the creation of $9.3 billion in new capital spending. The expansion in jobs would cause annual payrolls to expand by $2.4 billion. The state would collect $144.9 million annually in new tax revenue. At the high end of the range (Scenario IV), the tort tax would fall by 2.36 percentage points. The result would be the creation of more than 241,000 new jobs and of about $32 billion in new capital spending. The inescapable conclusion is that tort reform would confer substantial benefits, however estimated, on Massachusetts.

The Tort Transformation

The reason is not hard to understand. Once tort law abandoned its traditional, contractual foundations in favor of its now expansive regime, it came to impose a strikingly high even if implicit tax on economic activity undertaken within Massachusetts. The severity of the economic consequences should surprise nobody. The purpose of tort law is to deter wrongful behavior and to provide compensation to the victims of such behavior. Traditional tort law played a secondary role within our economy in serving this purpose. The primary roles were played by commercial prudence and by insurance, along with some support through government regulation. Deterrence and compensation were generally organized according to the contractual principles that govern commercial relationships. Traditionally, a producer was liable for a consumer's injuries only if the injuries were attributable to the producer's wrongful behavior. Consumers depended largely on the producer's commercial sense as a deterrent to such behavior. The reason is that wrongful acts typically cost an enterprise more, through various forms of indemnification and through loss of reputation, than they save in production costs, and so are bad for business. In this traditional framework, government remedies generally mirrored the contractual relationships that characterize normal commercial activity. Hence, workers compensation was introduced as an insurance program that indemnifies workers for injuries suffered on the job.

The contractual principles that govern the provision of private insurance were imported into the provision of workers compensation, even if the precise details of workers compensation differed from what market-based providers might have offered. Playing its supporting role in this overall system of deterrence and compensation, tort law came into play in accidents, where the contractual principles that governed market relationships were not directly applicable. Automobile accidents were a principal example. The doctrine of privity of contract restricted the range over which tort liability roamed. A manufacturer might sell a ski-like exercise apparatus and perhaps be liable for the buyer's injuries if he failed to caution the buyer about the proper use of the equipment. The manufacturer would not, however, be liable for injuries to a guest of the buyer who used the apparatus, or to a subsequent owner to whom the buyer had sold the apparatus, unless the product itself was defective.4

Today the same manufacturer faces a much-expanded range of liability, one that goes well beyond liability for product defects. A new expansive regime has elevated tort law in the American system of deterrence and compensation from a supporting role to one of star performer. There are two ways to increase safety. One way, associated with the traditional, contractual principles of tort law, diverts economic resources from the business of repairing the harm done by unsafe products to that of producing safer products, leaving consumers with fewer injuries but also leaving overall economic activity undiminished. Another way, associated with the modern, expansive principles of tort law, discourages the production of all products, including products aimed at increasing safety. Tort law, as it has currently evolved, increases safety at the expense of economic activity and, hence, of jobs and investment.

A reduction in Massachusetts tort costs would represent a shift toward a tort system that values both safety and economic activity. Tort Costs The economic consequences of the change in tort law have been dramatic. According to Tillinghast-Towers Perrin, a management consulting organization, the U.S. tort system cost $161 billion in 1995, up from $151.5 billion in 1994.5 In 1995, tort costs accounted for 2.3% of GDP, up from approximately .6% of GDP in 1950 and 1.4% in 1970, but down from a peak of 2.5% of GDP in 1986.6 In 1994, federal individual income tax collections were $550 billion. The $151.5 billion in tort costs incurred in the same year could be interpreted as a 27.6% surtax on the federal income tax. If U.S. tort costs had remained at 1.4% of GDP, those costs would have been $97 billion in 1994 rather than $151.5 billion. Instead of representing a 27.6% surtax on the individual income tax, they would have represented only a 17.6% surtax. If tort costs had remained at 0.6% of GDP, as in 1950, they would have amounted to $41 billion in 1994, representing but a 7.5% surtax. The data compiled by Tillinghast-Towers Perrin pertain to the United States as a whole. Using a methodology similar to theirs, we calculate the cost of the tort system for each of the 50 states and the District of Columbia. In 1992 (the latest year for which published data are available), Massachusetts tort costs totaled $4.1 billion, or 2.55% of GSP, amounting to a tort cost of $687 for every Massachusetts resident.

Assuming that Massachusetts tort costs fall entirely on Massachusetts residents, the average Massachusetts resident incurred 32% more in tort costs than the average American. As a percentage of GSP, Massachusetts tort costs were 18.6% higher than tort costs as a fraction of GDP. We estimate that in 1995, Massachusetts tort costs were $5.1 billion, or $833 for every Massachusetts resident, accounting for 2.68% of GSP. Considering the Tort Tax Defenders of this state of affairs point out, correctly, that the increase in tort costs has brought certain benefits. With increased deterrence, there is a lessening of certain kinds of risks, at least those that are deterrable through the court system. In thinking about accidents, however, it is vital to think about both sides of the equation - about the costs as well as the benefits of deterring harm. Automobile accidents exact a large toll each year in lives lost, people injured and property damaged or destroyed. It is reasonable for society to limit accidents in an efficient manner and degree. It is not reasonable, however, to seek to eliminate accidents. Why? Because doing so would be too costly.

We could reduce substantially the number and seriousness of automobile accidents by imposing a highway speed limit of 25 miles per hour. However, people would almost universally object to such a measure because the cost of securing this degree of accident prevention would outweigh the value of the added safety thus gained. In other words, and more generally, it is important to consider the cost as well as the benefit side of any system of accident deterrence. Since the costs of deterrence may well exceed the benefits, an understanding of the cost side is a necessary part of any effort to reach an informed judgment about desirable levels of and approaches to accident deterrence.

It is the cost side of the equation that is the central focus in this report. Tort liability adds to the cost of goods, in the same fashion as a tax, even though it is not explicitly levied as such. Massachusetts businesses and residents pay a number of explicit taxes, among them a 5% sales tax and a 5.95% tax on earned and certain unearned income. They also bear burdens through the tort system, as a form of implicit tort tax. To the extent that state government incurs tort costs, and only to this extent, does the "tort tax" show up as an explicit part of the tax burden. By far the overwhelming part of tort liability is embedded in higher prices for the products people buy through regular commercial transactions. It has been estimated, for instance, that the price of stepladders is increased by 30% through the operation of tort liability, which renders tort liability equivalent to a 30% tax on the sale of stepladders.7

We estimate the total tort tax liability in Massachusetts to be 2.55% of GSP. If revenue equal to this fraction of GSP were raised explicitly through the Massachusetts tax on income taxable at 5.95%, it would be necessary to impose an additional tax rate of 5.24% on that income. Hence, the total tax burden on this income from the combination of the explicit income tax and the implicit tort tax would approach 11.19% of taxable income. The share of GSP accounted for by the cost of tort liability was .75 percentage point higher in 1992 than in 1970. This is equivalent to a 1.54 percentage point increase in the Massachusetts tax on earned income (as reflected in Table 1, scenario III).

To be sure, not all of the tort tax borne by residents of Massachusetts can be influenced by Massachusetts legislation. A portion of that tax burden is influenced by legislation in other states. In a scenario such as an accident involving a defendant based in Massachusetts and a plaintiff located elsewhere, a suit may be filed elsewhere if the plaintiff expects to receive a larger judgment in that alternative venue. Some economic activity in Massachusetts is heavily oriented toward export, and, for such activity, Massachusetts can exert only a modest influence over the tort tax borne by its residents.

But other economic activity is almost exclusively confined to the state's borders, and there the legislature can exert full control over the tax burdens borne by state residents. And, of course, there will be a variety of in-between cases, as in a spectrum and not a dichotomy, concerning the relative importance of export production in total state production. Passage of the Civil Justice Reform Act would limit the tort liability of Massachusetts businesses and thus reduce the tort tax borne by Massachusetts residents. By translating tort reform into an equivalent change in the state income tax and by identifying the range into which that change is likely to fall, we can assess its effect on employment, as well as on other economic variables such as capital spending, payrolls, and tax collections.

The question, then, is not whether tort reform, considered as tax relief, would generate economic benefits, but what the magnitude of those benefits is likely to be. We use the Beacon Hill Institute's State Tax Analysis Modeling Program (STAMP), a recognized method for analyzing the effects of state tax-law changes on economic activity, to generate the range of estimates offered in Table 1.8 As applied to the Civil Justice Reform Act, STAMP finds the benefits to be substantial. This finding is consistent with data that show tort costs to be especially high for manufacturing and manufacturing to be a relatively important but declining sector of the Massachusetts economy. By raising the cost of living and by putting upward pressure on state taxes, tort costs diminish Massachusetts' ability to compete for workers and business. Reducing tort costs would have the effect, as shown, of increasing competitiveness and thus the state's capacity to create jobs and attract new business.


Notes

1 See Beacon Hill Institute, Massachusetts Econometric Tax Model (Boston: Beacon Hill Institute, February 1996).

2 Tillinghast-Towers Perrin, Tort Cost Trends: An International Perspective (1995); and Insurance Information Institute, The Fact Book 1997: Property/Casualty Insurance Facts (New York: Insurance Information Institute, 1996), 62-63. These figures rely on data from A.M. Best, the principal publisher of insurance industry data, “several specialized studies” of self-insurance and Tillinghast-Towers Perrin’s internal database of state-by-state medical malpractice costs.

3 In Chapter IV, we estimate this percentage based on the decline in the number of tort filings in Cook County, Illinois in 1996.

4 In the event of injuries to those subsequent parties and in the absence of product defects, liability would reside with the customer and not with the manufacturer. The injuries in these two instances involved contractual relationships between the customer and his guest or the customer and the subsequent owner, and those relationships excluded the manufacturer in either case.

5 Tillinghast-Towers Perrin, Tort Cost Trends; and Insurance Information Institute, The Fact Book 1997, 62-63. See footnote 2. 6 Ibid.7. Peter Huber, Liability: The Legal Revolution and its Consequences (New York: Basic Books, 1988), 3.8. See Beacon Hill Institute, Massachusetts Econometric Tax Model (Boston: Beacon Hill Institute, February, 1996.)

Updated on 08/09/2007 4:31 PM

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