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G. Thomas Woodward, U.S. Congressional Budget Office
Updated October, 2003

The Economics of US Tort Liability: A Primer

Several bills now before the Congress seek to address concerns that critics have raised about the tort system or about certain types of tort cases. Among those concerns are that:

• The "transaction costs" of the system, particularly attorneys' fees, are too high;
  
  
• Punitive damages and compensatory damages for pain and suffering are often awarded arbitrarily, with no beneficial effect on safety;
  
  
• The class-action mechanism (whereby many claims that cover similar factual ground are combined into a single larger case) is easily abused by plaintiffs' attorneys;
  
  
• Medical malpractice lawsuits are driving up the costs of liability insurance for physicians to the point that some of them are restricting their practices or retiring; and
  
  
• In suits over exposure to asbestos, too much money and court time are being devoted to people who do not yet show any signs of physical impairment.

Conversely, supporters of the existing tort system argue that it serves important policy goals, such as compensating victims, holding injurers responsible for their actions, and improving safety. Supporters say that critics overstate the extent and severity of the perceived problems with the system. They further argue that many of the proposed changes are too broad and that major problems can be addressed by the courts or through more narrowly targeted legislation, perhaps at the state level, where the vast majority of tort lawsuits are filed.

This primer looks at the current tort system--and various options for changing it--from an economic perspective, focusing on the goals of efficiency (minimizing the system's total cost to the economy) and equity (treating all parties fairly). Data about the overall costs and benefits of tort liability are too scarce to allow economists to judge the efficiency of the current system. However, those data suggest that the system is a relatively expensive way to compensate victims and, thus, that any justifications for it must be based on its effects on deterring injuries, promoting equity, or both.

The economic perspective leads to some other general conclusions about tort liability:

• Using the tort system to supplement market forces may improve or reduce efficiency, depending on what incentives the system creates for potential injurers and potential victims and on the interactions between those incentives, government regulations, and private insurance policies;
  
  
• Altering the tort system generally involves some trade-offs--in particular, changes that seem likely to improve efficiency may be problematic in terms of equity, or vice versa;
  
  
• Federal involvement in what is now mainly a matter of state law might yield more-efficient interstate commerce, but it could limit innovation at the state level (as well as restrict the states' ability to offer contrasting liability regimes to appeal to different residents); and
  
  
• The same policies may not be appropriate for all types of tort cases, because efficiency requires minimizing the sum of several kinds of costs, which may vary in their relative importance from one category of tort to another.

Tort Liability in the United States

The U.S. tort system is not centralized, which makes collecting comprehensive data about it difficult. Roughly 95 percent of lawsuits over torts are filed in state courts, rather than federal courts, the Congressional Budget Office (CBO) estimates. Moreover, in the vast majority of cases, plaintiffs and defendants reach out-of-court settlements, whose terms typically remain private. (For example, 97 percent of tort cases that "terminated" in federal district courts in fiscal year 2000 were disposed of before a verdict was reached.)

Data from the Bureau of Justice Statistics that cover 45 of the nation's 75 largest counties indicate that plaintiffs won 48 percent of the cases that reached a verdict in state courts in 1996 (the latest year for which that information is available).⁽²⁾ In those cases, the average time between filing and completion was 22 months. Automobile-related torts accounted for 49 percent of the cases, followed by premises liability (22 percent) and medical malpractice (12 percent). The median award to successful plaintiffs was $31,000 for all cases, but it varied widely for different categories of torts: from $18,000 in automobile-related cases to $286,000 for medical malpractice and $309,000 in asbestos cases.

Looking at trends over time, data from 16 states tracked consistently by the National Center for State Courts show that the number of tort cases filed each year rose by 70 percent between 1975 and 1990 (its peak) and then fell by 19 percent by 2000. Relative to population, the rate of filings was 8 percent lower in 2000 than in 1975--212 cases per 100,000 residents compared with 230 cases.⁽³⁾

Figures that suggest an overall decline in tort cases, however, mask continuing growth in the number or impact of some important categories of torts. For example, the Physician Insurers Association of America reports that median court judgments for medical malpractice rose from $100,000 in 1990 to more than $300,000 in 2001--an increase of 138 percent after correcting for inflation. And researchers at RAND report that the number of claims filed for asbestos exposure nearly tripled in just two years, between 1999 and 2001.
 

The Basic Economics of Tort Liability

From the economic point of view, the efficiency of the tort system is measured by how well it minimizes the sum of several types of costs:

• The costs of injuries (including medical costs, lost productivity, and pain and suffering);
  
  
• The costs of efforts to prevent or avoid injuries (including efforts to make products safer, which tend to raise consumer prices) and the opportunity costs of goods and services that are not provided (such as potential medical drugs that do not reach the market or municipal pools that are closed for fear of lawsuits) or goods and services that are provided but forgone by some risk-averse consumers (such as air travel);
  
  
• The costs of administration and implementation (particularly attorneys' fees and the administrative costs of insurance that potential injurers and victims buy to redistribute the risks they face); and
  
  
• Indirect costs to the economy (such as the disruption costs of plant closings and bankruptcies).

What constitutes equity in relation to the tort system is ultimately subjective, but there is consensus that compensating victims for their injuries--at least in some cases and to some degree--is equitable.

Tort liability is only one means by which society addresses the efficiency and equity issues posed by injuries; other means include market forces, regulation, and public insurance funds. Market forces can help control injury costs in several ways. Under conditions of competition and good information, producers of goods and services respond to consumers' desires for safer products, employers respond to employees' desires for safer workplaces, and insurance companies offer policies to respond to potential victims' desires to reduce the uncertainty they face.

One efficiency rationale for supplementing market forces with some form of government involvement is simply that many injuries--automobile accidents, releases of toxic chemicals, and so forth--are unrelated to any economic transaction. Indeed, some academic economists favor restricting the scope of tort liability to such "stranger" injuries. For other types of injuries, making an efficiency argument for government intervention requires the existence of some market imperfection: perhaps potential victims lack good information about the risks they face, suffer from biases that limit their ability to use the information, or have few choices because of monopoly or collusion in the market.⁽⁴⁾ Of course, government actions have their own weaknesses and thus may not improve efficiency in practice. For example, regulation requires centralized information about costs and benefits, and regulators may be co-opted by the parties they regulate.

Tort liability supplements the market in a more decentralized way. The basic idea is that making injurers pay for the harm they cause not only compensates victims but also gives injurers (if not victims) appropriate incentives to reduce the frequency and severity of that harm. The different liability standards used by the courts aim to achieve those goals in different ways: in particular, under the doctrine of strict liability, injurers are responsible regardless of how much care they exercise in trying to minimize injuries, whereas under the doctrine of negligence, they are responsible only if their actions fail to meet a standard of due care.⁽⁵⁾

The tort system is no panacea, however, even in principle--it is difficult if not impossible to craft liability rules that can consistently achieve the desired levels of both efficiency (taking into account all of the relevant costs) and equity. For example, because the expected level of compensation may affect the degree of care that potential victims exercise, the efficiency objective of cost-effective deterrence can conflict with the equity objective of compensation. Moreover, because the terms of that trade-off can vary, a single rule may not achieve the desired balance between efficiency and equity in all cases.

In practice, tort liability is further limited because information--particularly the information needed to determine the cause of an injury--is incomplete and costly. The transaction costs of the tort system derive from information problems: lack of complete information is what allows plaintiffs and defendants to hold divergent views and encourages them to devote resources to proving their respective cases. Information problems are also the root cause of courtroom errors, and they can make it hard to set standards for due care at efficient levels.
 

The Costs and Benefits of Tort Liability

Analyzing the policy questions that surround tort liability is difficult because of incomplete data not only on tort cases themselves but also on the indirect costs and benefits of the tort system. Indeed, from the standpoint of economic efficiency, the actions that the system encourages potential injurers and victims to take (or refrain from taking) to avoid injuries can be more important than some of the direct "costs" associated with individual cases.

In efficiency terms, the primary benefits of the tort system are measured not by payments to victims--which represent transfers of wealth but not gains or losses to society as a whole--but by reductions in injury costs. Those benefits arise indirectly, through precautions taken by potential injurers (for example, efforts to design safer products or reduce production defects).⁽⁶⁾ Thus, they are not observable in data on trials or settlements.

Several important types of costs are also indirect, including the costs of specific actions that firms take to reduce the injury risks associated with their products (such as including air bags in automobiles), the opportunity costs of goods and services not offered because of liability concerns or not purchased because of liability-related price increases, and the disruption costs of layoffs and bankruptcies.

Arguments About the Effectiveness of Tort Liability's Incentives

Indirect benefits and costs are very difficult to measure. In general, data do not exist to show how liability affects the degree of care that potential injurers take--let alone how injury costs change as a result of that care. Moreover, theoretical analysis alone cannot answer the key questions, because the extent to which the potential efficiency benefits of tort liability are realized depends on the relationship between the true costs of injuries and the expected costs to injurers. If potential injurers expect to pay one dollar more for each additional dollar of injuries they cause, they will have the optimal incentive to take all (and only) cost-effective precautionary actions. But they might anticipate paying more than one dollar per dollar of additional injury (for example, because of excessive punitive damages) or less than that (for example, if some of their torts go undetected or if their liability costs are insured and their premiums do not rise commensurately). For potential injurers whose actions are thought at the time to be harmless--such as the firms that manufactured or used asbestos before its health risks were identified--there is no expectation of increased liability costs and hence no specific incentive for precaution.⁽⁷⁾

Controversy over both the efficiency and equity effects of liability has particularly focused on nonpecuniary damages (punitive damages and compensatory damages for pain and suffering). Critics argue that large nonpecuniary damages are awarded arbitrarily and unpredictably, with little connection to the actual harm or to the character of the injurer's conduct. In that view, such damages are not only inequitable but also inefficient: arbitrary and unpredictable awards do not provide incentives for precaution but do raise costs, thereby distorting price signals. Critics further argue that nonpecuniary damages, whether arbitrary or not, have a separate adverse effect on the distribution of risk--in particular, that liability for pain and suffering implicitly provides consumers with a form of inefficient overinsurance.⁽⁸⁾

In contrast, supporters of the liability system argue that large punitive damages can serve equity by expressing society's disapproval of behavior that reflects wanton disregard or contempt for potential victims. Such damages can also promote efficiency, they say, by providing proper incentives for the prevention of injuries that have a significant probability of going undetected. (For example, if bolt manufacturers expect the role of defective bolts to go unrecognized in four out of five accidents that their products cause, they will have inefficiently low incentives to prevent defects unless they expect to pay five times the actual damage on those occasions when they are penalized.) Supporters further argue that pain and suffering represent real losses that should be reflected in the prices of products (to send consumers efficient signals) and that limiting awards for such losses might undercompensate some injury victims.

Evidence About the Effects of Tort Liability

Without direct data or clear theoretical predictions about the incentive effects of tort liability, analysts have tried to tease out the truth statistically. However, their most detailed efforts to date, which have focused mainly on punitive damages, have not yielded conclusive results. The best available study of the effects of punitive damages in the United States found no evidence that the 46 states that allow such damages have fewer environmental or safety torts than the four states that do not allow them. However, that lack of evidence may simply reflect the limitations of the data.⁽⁹⁾

Given the scarcity of data on the benefits and many of the costs of the current tort system, economists cannot judge the system's efficiency. But they can answer a narrower question about its cost-effectiveness as a means of compensating injury victims. The best available data on the direct costs of tort cases suggest that victims who file claims receive an average of 46 cents from each direct dollar spent on the system (with the other 54 cents going to attorneys' fees and insurance expenses).⁽¹⁰⁾ The best available data show that such transaction costs are proportionately much smaller in public insurance programs--20 percent nationwide in state workers' compensation programs (though that figure excludes spending on claimants' attorneys, which is reportedly rising) and 15 percent in the federal Vaccine Injury Compensation Program. A no-fault public insurance program for other torts would probably not lower transaction costs to those levels, in part because of the costs of establishing which injurers were responsible for particular injuries. Nonetheless, it is safe to say that the existing tort system is a relatively costly way to compensate victims and, thus, that any justifications for it must rest on its effects on deterrence, equity, or both.
 

Policy Options for Changing the Tort System

The controversies over the costs and benefits of the tort system have led to numerous proposals for change at the federal level. This report discusses the potential advantages and disadvantages of various policy options in qualitative terms. Those options--which were chosen to illustrate the trade-offs between efficiency and equity that lawmakers face--fall into three main categories.

Policies for reducing the scope of tort liability include options that would eliminate liability for all injuries or all "nonstranger" injuries, exempt products certified as safe by a federal regulatory body (such as the Food and Drug Administration or the Consumer Product Safety Commission), or replace tort liability with a federal compensation system for injury victims, like the present state-level workers' compensation system and the federal fund for vaccine victims.

Policies that are more incremental in nature but that could be applied broadly to all types of torts include options that would restrict compensation for pain and suffering or punitive damages, limit fees charged by plaintiffs' attorneys, reduce the use of joint-and-several liability (under which one or a few injurers can be held responsible for paying all of the damages caused by a number of injurers), or modify the "collateral-source rule" (under which the amount of damages owed by a defendant does not take into account any benefits that an injured plaintiff has received from an insurance policy or other independent source).

Policies targeted toward particular types of tort cases include options that would create specialized courts to hear medical malpractice cases, establish minimum medical criteria for asbestos claims and perhaps set up a victims' compensation fund, tie the fees received by plaintiffs' attorneys in class-action suits more closely to benefits actually received by the class members, or allow defendants to shift more class-action cases from state courts to federal courts.

In most cases, data limitations make it impossible for CBO to determine whether a particular option would be likely to improve or reduce economic efficiency. Nonetheless, the economic perspective leads to some general conclusions that decisionmakers may wish to keep in mind as they consider proposed changes to the liability system.

• The impact on efficiency of using tort liability to try to improve on market outcomes may be either positive or negative--depending on the incentives that liability provides for potential injurers and potential victims and on how those incentives interact with incentives and constraints from other sources, such as government regulations and private insurance policies.
  
  
• Most, if not all, options for changing the tort system involve some trade-offs. In particular, policies that seem desirable on efficiency grounds may be problematic from the equity perspective, or conversely.
  
  
• Federal involvement in an area governed predominantly by state law may be justified by its benefits for interstate commerce, but it limits state innovation and experimentation (as well as the ability of U.S. residents to "vote with their feet" by choosing to live under one state's liability regime rather than another's).
  
  
• Because the efficient solution is the one that minimizes the sum of several different costs, which may vary in their relative importance, different policies may be appropriate for different types of tort cases.

The full report, from which this summary is drawn, is available here.

This document is not necessarily endorsed by the Almanac of Policy Issues. It is being preserved  in the Policy Archive for historic reasons.

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