192Tort Law
§6.10
The Function of Tort Damages
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§6.11 Damages for Loss of Earning Capacity
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When an accident disables the victim, the court, rather than order the defendant to make periodic payments during the period of disability (analogous to alimony payments), will order him to pay the victim a lump sum so calculated as to equal the present value of the expected future stream of earnings that has been lost. This is different from simply multiplying earnings per period of disability by the number of periods. That would overcompensate the victim (assuming no inflation during the period of disability, a matter taken up shortly). For at the end of the disability he would have received not only the sum of the periodic payments but interest on that sum, which he would not have received had payment been made periodically rather than in a lump at the outset. The lump sum should be equal to the price that the victim would have had to pay in order to purchase an annuity calculated to yield the periodic payment for the expected duration of the disability, and no more. This is the present value of the future loss, and paying it in a lump is preferable to periodic payments stretching into the future. It both economizes on administrative expense and avoids the disincentive effects of tying continued receipt of money to continued disability. Having received the lump sum the victim has every incentive to overcome his disability sooner than had been predicted. A system of periodic disability payments, in contrast, would be the equivalent of a 100 percent tax on earned income. ~ A potential offset, however, is that the incentive to exag-
§6.11 1. The tax effect would be exacerbated by the fact that working imposes costs (income tax, commuting, work clothes, etc.) that are avoided by staying home and collecting disability payments. Work might however yield nonpecuniary income that would equal or exceed these expenses--or might yield additional disutility.
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gerate one's injury at the trial is less under the periodic-payments approach. Can you see why?
Courts have had difficulty determining damages in cases involving disabled housewives. To value a housewife's services by adding up the amounts that would be required to hire providers of the various components of these services (cleaning, child care, cooking, etc.)--the "replacement cost" approach--although the one most commonly used by courts is unsatisfactory because it ignores opportunity cost. The minimum value of a housewife's services, and hence the cost to the family if those services are eliminated, is the price that her time would have commanded in its next best use. Suppose that she had been trained as a lawyer and could have earned $100,000 working for a law firm but chose instead to be a housewife and that the various services she performed as a housewife could have been hired in the market for $20,000. Since she chose to stay home, presumably her services in the home were considered by the family to be worth at least $100,000; 2 if not, the family could have increased its real income by her working as a lawyer and hiring others to perform her household functions. 3 Therefore, the loss when she was disabled was at least $100,000. Although it may have been greater, just as the value (discounted lifetime earnings) of an opera singer may exceed her value in an alternative occupation, the valuation of a housewife's services is difficult because of
the absence of an explicit market in housewives. 4 Courts do, however, allow testimony about the quality of the housewife's household services. This is an oblique
method of avoiding the pitfall of valuing such services at the cost of domestic servants. ~
The opportunity cost approach has its own problems of estimation. For example, if a woman becomes (and remains) a housewife, her market earning capacity will not reach the level it would have reached had she not become a housewife. Properly applied, the opportunity cost concept would require estimating what her probable market earnings would have been (net of any cost of investment, for example in education, related to her market job) had she entered the market at the time when instead she became a housewife.
Where the earnings lost as a result of a disabling injury would have been obtained over a long period of time, both the assumptions made concerning future changes in the victim's earnings and the choice of the interest rate to use to discount those
2. This ignores, for the sake of simplifying the exposition, the incentive that the income tax system gives a woman to remain at home even if the value of her services outside of the home would be greater than that of her services as a housewife. See §17.8 infra. An additional possibility is that the woman derives nonpecuniary income, perhaps in the form of leisure, from remaining at home. This income may or may not (see next section) be affected by the disability. Suppose the value of the wife's services in the home, say $100,000, is composed of $60,000 in services rendered and $40,000 in leisure produced. If the value of her leisure time is unaffected by the disability, the cost of the disability is $60,000 rather than $100,000 a year. It is also possible, however, that the job outside the home would have yielded nonpecuniary income on top of her salary, in which event that figure might underestimate the cost of the accident to her.
3. The decision that she remain at home may have been quite rational, for her skills as a housewife, particularly in child care, may have greatly exceeded what the family could have obtained in the market at the same price.
4. But see the Gronau study cited in §5.3 supra, note 2, which attempted to estimate the value of the average housewife's output. And notice the dependence of the estimate of loss on the hired house-worker's being worth no more than her salary (explain). Another question: Should tort damages include economic rents, i.e., income in excess of opportunity cost?
5. Suppose a law school professor who has a salary of $100,000 is disabled. He could have earned $200,000 a year practicing law. What are his lost earnings?
194Tort Law
Table 6.2
Present Value of Future Receipts of $25,000 a Year, for Various Periods and Discount Rates
Discount rate
Period2%5%10%12%
10 years $224,565 $193,043 $153,615 $141,255
20 years 408,785 311,555 212,840 186,735
30 years 501,603 384,313 235,673 201,138
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earnings to present value can greatly affect the size of the award. The effect of discounting is shown in Table 6.2.
Setting to one side the problem of determining whether the victim might have changed his occupation at some time, the court must first determine the earnings the victim would have been likely to receive each year between accident and retirement. The starting point for the inquiry is the wage profile by age for the victim's occupation. If the victim was a truck driver, age 25, we would need to know the wages not only of 25-year-old truck drivers but, assuming permanent disability and a retirement age of 65, those of 26- to 64-year-old truck drivers. The next step is to determine how the wages in the occupation are likely to change in the future. Many of the factors that might alter the wage level in a particular occupation are very difficult to foresee--such as changes in the demand for the output of the industry in which the worker is employed 6 or in the level of unionization in the industry. These sources of future wage change will generally have to be ignored. Foreseeable sources of wage change include probability of layoff based on past employment experience in the industry, rising labor productivity, and inflation.
Productivity is the ratio of output to input. An increase in the productivity of labor is an increase in the amount of output per hour of labor. By reducing the employer's production costs, an increase in labor productivity enables him--and competition for workers will compel him--to pay higher wages. Rising labor productivity appears to be responsible for an average annual increase in the real (i.e., inflation adjusted) earnings of workers of about 3 percent. 7
Having derived an estimate of the real wages that the truck driver would have earned in each year during his working life (by adjusting his current wages for life cycle, unemployment, and productivity-growth effects), the court must next multiply each year's estimated wages by the actuarial probability that he will still be alive at the end of that year. We could also--although as we shall soon see need not--adjust the estimate of his real wages to reflect the effect on nominal wages of the inflation expected to occur over his working life. If we didthat, we would use investors' expectations, as reflected in interest rates on long-term riskless financial instruments such as U.S. government bonds, to estimate long-term inflation.
An interest rate has three main components. 8 The first is the opportunity cost of capital net of any risk of loss and of any expectation of inflation (or deflation). The second is the risk premium necessary to compensate the investor for the pos-
6. In what circumstances would a change in demand for an industry's product alter the wage rate of the workers employed in the industry?
7. The effect is felt even in industries where productivity is not increasing: Employers in such industries must raise wages to levels competitive with those in other industries or lose their work force.
8. Ignoring the lender's expenses of negotiating and administering the loan. Cf. §14.3 infra.
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sibility that he will never get his capital back, a premium that will be affected by the investor's attitude toward risk. 9 But risk is not a factor in U.S. government securities. The third is the anticipated inflation rate over the period in which the loan will be outstanding. If the loan is for one year and the purchasing power of the dollar is expected to decline by 4 percent during that year, then even if there is no risk of default the lender will demand the opportunity cost of being without his capital for a year plus 4 percent to compensate him for the reduction in the buying power of that capital during the year.
A reasonable estimate of the real riskless cost of capital is 2 percent; ~0 the current
interest rate on long-term government bonds is about 7 percent; ii and this implies
an expected long-term inflation rate of 5 percent, which is therefore the relevant figure to use in estimating inflation when the accident victim's disability is expected to last many years. So we should add 5 percent (compounded) to each year's estimate of the worker's lost earnings.
Having done all this, we must discount our estimates to present value--a sum that when invested will equal (principal plus interest) the lost earnings in each year. The higher the discount rate, the smaller the present value (see Table 6.2), for a higher rate will make that value grow more rapidly over time, and thus a smaller value will generate the future annual earnings that the plaintiff has lost. We could use the nominal interest rate on long-term bonds, that is, an interest rate with an inflation component. This would be a high rate and thus lead to a smaller present value than if a lower interest rate were used, yet the plaintiff would not be hurt by this approach. The nominal interest rate is high because it contains an inflation factor that will already have been used to jack up the estimate of the plaintiff's lost future earnings. If we figured the plaintiff's lost future earnings in real--inflation-free--terms, each estimate would be 5 percent (compounded) lower, but we would discount these estimates to a present value using a 5 percent lower interest rate. ~2
In either case, however, should the riskless interest rate be used (the rate on federally issued or insured securities)? No. The stream of lost earnings of which the damages award is the present-value equivalent is not a riskless stream--death, unemployment, and disability from other causes could have cut it off, and other contingencies could have increased it (such as working beyond the normal retirement age). If, therefore, the plaintiff is risk averse, he will consider the riskless equivalent of his lost risky stream of earnings to be worth more to him. A risk factor must be added to the discount rate to bring the present value down to a level that confers the same utility as the risky stream of earnings that it is intended to replace.
9. Suppose a loan of $100 carries a I percent risk of default each year. If the interest rate without risk of default is 5 percent, then a risk-neutral lender will demand 6 percent, because $100 × .99 × 1.06 = $105. (These figures are rounded.) A risk-averse lender will demand more than 6 percent, a risk-preferring lender less.
10. See economic studies cited in Doca v. Marina Mercante Nicaraguense, S.A., 634 F.2d 30, 39 n. 2 (2d Cir. 1980). Doca, by the way, was the first judicial decision to use modern economic methodology to determine lost earnings in a tort case. Since then, there have been a number of others, illustrated by Jones & Laughlin Steel Corp. v. Pfeifer, 462 U.S. 523 (1983); O'Shea v. Riverway Towing Co., 677 E2d
1194 (7th Cir. 1982); Culver v. Slater Boat Co., 688 F. 2d 280 (5th Cir. 1982) (en banc); In re Connecticut National Bank, 928 F.2d 39 (2d Cir. 1991); Quinones-Pechecho v. American Airlines, Inc., 979 F. 2d 1 (lst Cir. 1992); Edgar v. Secretary of Health & Human Services, 989 F. 2d 473 (Fed. Cir. 1993). See generally Michael I. Krauss & Robert A. Levy, Calculating Tort Damages for Lost Future Earnings: The Puzzles of Tax, Inflation and Risk, 31 Gonzaga L. Rev. 325 (1996).
11. This is a nominal rate; it includes expected inflation as well as the real cost of capital.
12. On the general problem of inflation and tort damages, see Keith S. Rosenn, Law and Inflation 220-234 (1982).
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Although the probabilities of death, unemployment, etc. were taken into account in estimating the lost earnings stream, it is not double counting to use the existence of those probabilities to reject use of the riskless interest rate to discount future earnings to present value. Explain.
Here is another complication: The theory of household production discussed in Chapter 5 implies that an individual's real earnings are not limited to the market income that he earns in 40 of the 168 hours in a week. ~3 A serious accident that disables a person from working in the market may also impair the productivity of his nonmarket hours, which he would have been using to produce recreation, love, or other household commodities. Wage rates for second jobs (moonlighting) might be used to estimate the opportunity costs of being disabled from productive use of hours not devoted to earning market income. But if this is done, then the portion of a person's moonlighting wages that represents compensation for the costs of working (including the forgone nonpecuniary income from leisure, and any hazards or disamenities involved in the job) must be subtracted to determine the worker's net loss from disability.
13. See Neil IL Komesar, Toward a General Theory of Personal Injury Loss, 3J. Leg. Stud. 457 (1974).