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Defining the Costs of Tort Liability
The most easily measured "costs" of the liability system are its direct costs--that is, those incurred by plaintiffs, defendants, and their insurance companies in litigating and settling specific claims, as well as the court costs that are ultimately paid by taxpayers. For the purposes of policy analysis, however, that measure of costs is too large in one respect and too small in another.

It is too large in that some direct "costs" merely shift money from injurers to victims and thus are not true costs to society as a whole. In economic terms, payments that do not involve any use of resources to produce goods or services are called "transfer payments." Those that do involve using resources for production are known as "real resource costs" (also "social costs" or simply "costs"). Specifically, the portion of a settlement or judgment that goes to the plaintiffs is a transfer payment. The portion that goes to the plaintiffs' attorneys, in contrast, is a real cost because it reflects the value of the resources (attorneys' time, office space, equipment, and so on) devoted to that case and thus not available for other uses.(1)

Conversely, measures of direct costs are too small for policy purposes in that they naturally exclude indirect costs--those associated not with specific claims but with actions that businesses and consumers take or forgo because of the incentives of the liability system as a whole. Indirect costs include various kinds of real resource costs, such as:

The costs of precautions taken by potential injurers,

The opportunity costs (forgone value) of goods and services that potential injurers withdraw from the market or do not create because of liability concerns,

The opportunity costs of goods and services that consumers do not buy because of liability-induced price increases, and

The disruption costs of layoffs and bankruptcies caused by liability problems.(2)
Indirect costs are not necessarily bad: from the perspective of efficiency, the question is whether they yield benefits larger than the costs.

Evidence About the Costs of the Tort System
The most comprehensive estimates of tort liability costs--which cover only direct costs--come from studies by Tillinghast-Towers Perrin, an actuarial and management consulting firm.(3) Those estimates take advantage of the fact that most tort costs are paid through the insurance industry, in the form of legal costs to defend policyholders, benefits paid to victims and their attorneys on behalf of policyholders, and internal costs for handling claims. Thus, Tillinghast uses financial data from the insurance industry to estimate insured costs for all types of policies except medical malpractice insurance. (Those costs are estimated separately using the firm's proprietary database of state-level costs, controlling for the changing mix of insured versus self-insured providers.) Finally, Tillinghast estimates self-insured costs (again, except for medical malpractice) on the basis of various specialized studies. Because of a lack of data, the estimates exclude awards and settlements that cannot be insured in particular states (such as those for contract and shareholder litigation or for punitive damages) and certain extraordinary self-insured costs, such as those of the tobacco settlements.(4)

By that definition of costs, the U.S. tort system cost a total of $205.4 billion in 2001, Tillinghast estimates. That figure represented 2.04 percent of gross domestic product--the largest share among the 12 industrialized countries that Tillinghast investigated.(5) Of that amount, 46 percent constituted transfer payments to plaintiffs: 22 percent for economic damages and 24 percent for noneconomic damages. The other 54 percent represented true costs: transaction (procedural) costs for plaintiffs' attorneys (19 percent), defense costs (14 percent), and insurance companies' administrative costs (21 percent).(6)

Estimates for most of the indirect costs of the tort system do not exist--which is not surprising given that many of those costs are difficult to observe. For example, even firms that keep track of their safety-related spending would probably have trouble identifying the share driven by tort liability rather than by regulation or other factors. One notable exception to the lack of estimates of indirect costs comes from a recent study released by the U.S. Chamber of Commerce, which estimated that asbestos liabilities have caused $0.6 billion to $2.1 billion in disruption costs from bankruptcies and layoffs.(7)

Are Tort Costs Excessive?
Costs can be considered excessive if they do not contribute positively to either efficiency or equity. Even transfer payments may be excessive costs in that sense. Although transfers do not use real resources directly, the incentives they provide can have real costs that reduce efficiency. In addition, transfers that are arbitrary or otherwise unfair can reduce equity.

The Efficiency of the Tort System as a Mechanism for Compensation
On the question of whether tort costs contribute to efficiency--which is the focus of economic analysis--the available data allow a partial conclusion: even leaving aside the largely unknown indirect costs, the current tort system seems to be an inefficient way to compensate victims. As noted above, Tillinghast estimates that only 46 percent of the total direct costs of the tort system go to victims in the form of economic and noneconomic damages; 54 percent go to transaction costs. By comparison, in the no-fault compensation systems for on-the-job and vaccine-related injuries, administrative costs make up only about 20 percent and 15 percent of total costs, respectively.(8)

Those comparisons are not entirely apt, however. The administrative costs of those compensation systems exclude spending on claimants' attorneys--which has reportedly grown in the workers' compensation system as the regulations governing it have become more complex. Moreover, linking injuries to particular injurers (so their premiums can be adjusted to reflect their own track record, as the workers' compensation system does) would be more difficult with torts in general. Nonetheless, given the large percentage differences between the tort liability system and no-fault compensation systems, it seems safe to conclude that the tort system costs more than does an available alternative method of compensating victims.

Some types of torts clearly have little impact on deterring injuries; virtually their entire value to society is as a mechanism for compensating victims. Asbestos torts are an example: the injurious actions generally took place decades ago, and asbestos is now in limited use (as a combined result of litigation and government regulation), so today's cases serve no role in deterring additional asbestos injuries. The same reasoning applies to any torts that deal with injuries whose source was unknown at the time.(9) For such torts, liability costs are indeed inefficient.

The Efficiency of the Tort System as a Mechanism for Deterrence
In the more typical case of torts that are intended to provide deterrence as well as compensation, economists have not reached a consensus about whether costs are efficient. The tort system may conceivably improve efficiency, despite its high transaction costs, if it is particularly effective in reducing the number and severity of injuries. Such effectiveness has not been demonstrated, however.

One key issue is the relationship between actual costs to victims and the liability costs that are faced by injurers. In a situation in which potential injurers anticipate paying an extra dollar for every additional dollar of injuries or transaction costs they cause, they have the right incentive to take cost-effective steps to reduce future costs.

However, potential injurers may expect to pay more or less than one extra dollar in liability for each additional dollar of social costs they cause. If liability awards exceed actual injury losses--for example, because of punitive damages--potential injurers may be motivated to overspend on precaution (provided they can identify enough promising ways to do so). As an example, suppose a firm expects to pay two dollars in liability for every dollar of actual social costs it produces. In that case, it will perceive investments in precaution to be twice as valuable as they are to society as a whole, and thus it will have an incentive to spend up to two dollars for every additional dollar in actual costs saved. All of the spending that returned less than one dollar per dollar from society's standpoint would reduce the net savings from precaution, making it less likely that tort costs on the whole were efficient. Ironically, the inefficiency associated with excessive precaution may result in increased risk. For instance, drug manufacturers may withdraw or withhold otherwise valuable medicines from the market, and physicians may withdraw their services.(10)

Efficiency may also suffer if potential injurers find ways to reduce their liability exposure without reducing the actual risk of injury. Such avoidance efforts typically have real resource costs but do not add to the social benefits of tort liability. That problem arises from errors in assigning liability: if injurers were held responsible for all of (and only) the injuries that they truly caused, they would have no opportunities to reduce expected liability costs without reducing actual risks. A commonly cited example is "defensive medicine," in which medical professionals conduct low-value procedures in hopes of avoiding the costs and stigma of being sued.(11)

Finally, if potential injurers expect to pay less than one dollar in liability costs per dollar of additional social costs--or, more to the point, expect to save less than one dollar per dollar of reduced social costs--they will have too little incentive to take preventive action. That situation may occur if liability judgments have a significant arbitrary component, if avoidance efforts succeed in obscuring injurers' roles in causing some losses, or if injurers insure their liability costs and the premiums they pay do not fully reflect their injury record. Underinvestment in prevention can even arise from perverse incentives that associate increased care with higher liability costs--as in the case of a company that refrains from researching ways to make its products safer lest it create a paper trail of safety-related data that could be used against it in court.(12) Whatever the cause, underinvestment in prevention has the same effect on efficiency as overinvestment: the net savings from precaution are lower than they would be in the ideal case (here, because some worthwhile opportunities are neglected), and thus they are less likely to outweigh the other costs of the liability system.

The Efficiency and Equity of Nonpecuniary Damages
Critics of the tort system have particularly questioned the deterrence benefits of nonpecuniary damages (punitive awards and compensatory awards for pain and suffering). They argue that large nonpecuniary damages cannot provide useful incentives for precaution because they are awarded in a subjective, arbitrary, and unpredictable way, with little connection to the actual harm or, in the case of punitive damages, to the character of the injurer's conduct. In that view, such awards are inequitable as well as inefficient. Indeed, the Supreme Court has ruled that punitive damages violate the Due Process Clause of the Constitution if they are not "both reasonable and proportionate to the amount of harm to the plaintiff and to the general damages recovered."(13)

The accuracy of that characterization of nonpecuniary damages is a matter of some debate. Supporters of the status quo argue that large awards for punitive damages can promote efficiency by sending appropriate signals for precaution in regard to torts that have a significant probability of escaping detection and judgment. Moreover, they say, large punitive damages can serve equity by punishing egregious behavior on the part of large injurers. Supporters further argue that noneconomic losses such as pain and suffering are as real as economic losses (albeit harder to quantify), so setting artificial limits on awards for such losses may undercompensate some injury victims and may produce some product prices that are inefficiently low because they do not fully reflect the products' true risks.

Economists have tried to shed empirical light on the question of the efficiency of tort costs, focusing primarily on punitive damages. However, the limited data have not yielded a compelling answer. A 1998 study investigated the deterrent effects of punitive damages by comparing the four states that prohibit such damages with the 46 states (and District of Columbia) that allow them. The study found no statistically significant differences in deterrent effects--and in many cases, differences of the "wrong" sign--for more than a dozen indicators of environmental and safety risks.(14) The author of the study posited two arguments to explain the lack of an effect: that punitive damages are awarded too randomly to influence behavior, and that federal regulations and market forces other than liability are stringent enough to leave no room for additional deterrence. However, two follow-up papers suggested that the statistical results of that study could merely reflect limitations of the data. Those papers argued that four states do not provide a strong basis for comparison and that punitive damages could be serving their intended purpose of deterring the most egregious torts--which by definition are relatively rare--without having a discernable impact on overall injury rates.(15)

Conclusions
In short, the current state of data and economic analysis do not allow CBO to judge whether the costs of the tort system are efficient or excessive on the whole.(16) What is clear, however, is that those costs are large enough to be significant for the U.S. economy. That fact helps raise the question of whether changes to the current tort system could reduce the system's costs without undermining its benefits.

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(St. Paul, Minn.: West Group, 1999), p. 926.
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