Every year, billions of dollars are awarded as compensation for pain and suffering. A hard question—one that has vexed courts, legislators, and academics alike—is how we should tax them (if, indeed, we should tax them at all). In this Note, I articulate a new answer. If we take seriously the value of equality between injured people and uninjured people, we ought to tax compensatory damages for pain and suffering.
In Part I, I criticize an influential approach to the taxation of compensatory damages for pain and suffering. This approach appeals to various intuitive normative principles to justify exempting pain and suffering damages from tax. I argue that these principles are estranged from their normative foundations. Such principles are intuitive because they seem to embody an ideal of equality between injured people and uninjured people. But, as I show in Part I, equality does not always justify exempting pain and suffering damages from tax. Sometimes, a well-designed tax on pain and suffering damages serves equality better than an exemption does.
In Parts II and III, I determine which tax regime best respects the ideal of equality between the injured and the uninjured, giving that value neither too little nor too much weight. Following the optimal tax literature, I divide the work into two parts. First, I determine which tax policies would be best under the assumption that no one modifies their behavior in anticipation of tax consequences. To do this, I formulate an appropriate social welfare function, I estimate the relevant parameters, and I simulate optimal tax rates. I then consider whether the resulting taxes should be modified in light of behavioral responses that we should expect in the real world.
I conclude that we should tax some, and likely many, compensatory damages for pain and suffering—and we should do so at rates that increase with damages. Perhaps counterintuitively, this tax scheme is the best way of balancing the competing demands of creating well-being and distributing it equally.