THE DETERMINANTS OF STATE‐LEVEL CAPS ON PUNITIVE DAMAGES: THEORY AND EVIDENCE

I. INTRODUCTION Despite the traditional function of the tort system to "make victims whole," punitive damages are monetary awards set at levels greater than pure compensation. These damages are imposed to punish and deter wrongdoing and are most frequently awarded in cases involving business-related activity. In recent years, however, some states have placed statutory ceilings--conventionally known as damage caps--on the magnitude of punitive damages awards. The purpose of this article is to develop a theory of these damage caps and then to test the implication of that theory using state-level data. According to the standard economic model, punitive damages are imposed as a solution to the underdetection problem (Cooter 1982, 1989). If an injurer can escape liability for a tort with a positive probability, then in those cases in which the injurer is in fact held liable, the injurer's total liability (compensatory plus punitive damages) "should equal the harm multiplied by the reciprocal of the probability that [the injurer] will be found liable when he ought to be" (Polinsky and Shave11 1998, 889). There are a number of reasons why injurers are sometimes able to escape liability. First, victims may have difficulty establishing the essential elements of a valid cause of action at trial. This is especially true in cases where victims have difficulty proving causation as a result of the background risk of injury. Second, litigation costs may outweigh the potential benefit of filing suit and hence deter some victims from ever pursuing a valid cause of action. Finally, injurers may sometimes have an opportunity to conceal their identity or engage in other conscious efforts to evade liability. Although the foregoing considerations justify the imposition of punitive damages, courts regularly neglect them, focusing instead on the mental state of the injurer. For example, courts tend to focus on whether a tortfeasor's actions were intentional or malicious (Polinsky and Shave11 1998, 898-99). (1) (Of course, one might argue that intent could lead injurers to take conscious efforts to avoid detection.) (2) The empirical literature on punitive damages has been primarily devoted to examining the frequency, magnitude, and determinants of punitive damage awards. For instance, Eisenberg et al. (1997) surveyed tort cases decided in state courts between 1991 and 1992 and found that only 6% of cases won by plaintiffs involved punitive damages. However, the study was not able to identify a predictable pattern regarding when they were awarded. Indeed, Polinsky (1997) argued that the results were consistent with the possibility that punitive damages are randomly awarded. Karpoff and Lott (1999) reached a similar conclusion based on a sample of lawsuits filed against public corporations during 1985-1996 (most of which were products liability). Both studies, though, did find that the level of punitive damages was strongly correlated with the size of compensatory damages, as did the study by Schmit, Pritchett, and Fields (1988).3 Finally, Hersch and Viscusi (2004) found that juries were more likely than judges to award punitive damages, and that jury awards were generally larger. A factor complicating any study of punitive damages awards, however, is that cases involving punitive damages are frequently reversed or reduced on appeal (Landes and Posner 1987, 302-07; Shanley 1991). Economists clearly have an imperfect understanding of the determinants of punitive damages, but they know even less about the factors underlying the enactment of statutory caps on punitive damages. This article begins to remedy this deficiency by examining caps from both a theoretical and empirical perspective. In terms of theory, we ask what economic justifications (if any) there are for limiting punitive damages. The simple "deterrence" theory described above does not provide an adequate basis because a limit on punitive damages only blunts the deterrence function of tort law. …