An Empirical Evaluation of Two Methods for Estimating Economic Damages: Comment

Abstract

Lambrinos and Harmon (1989) empirically evaluate two methods that have been used to estimate economic damages. The two approaches they evaluate are the offset approach and the augmented offset approach. The augmented offset approach is adjusted by an age-earnings factor. The estimated present values using each approach are calculated and then evaluated by comparing them with the present values of actual worker earnings drawn from the Panel Study on Income Dynamics (PSID). Discussing their comparison of estimated present values using the offset and augmented offset methods with the calculated present values using the PSID longitudinal survey earnings data, the authors state that both methods underestimate the loss ... (p. 737). The use of an inappropriately low interest rate to discount PSID earnings could cause both methods of estimation to underestimate the loss. If an inappropriately low interest rate is used to discount actual PSID earnings, the resulting lump-sum awards will be higher than if higher interest rates were used. The resulting higher calculated lump-sum awards for actual PSID earnings would cause the estimated awards using both the offset and augmented offset methods to be low in comparison. The authors state that the rate chose for discounting the workers' actual earnings from 1971 through 1983 is the nontaxable municipal bond yield average from 1961 through 1970, 4.10 (p. 735).(1) It can be argued that the use of the average municipal bond yield from 1961 through 1970 to discount actual 1971 through 1983 earnings is inappropriate. To the extent that interest rates rise with inflation, it is likely that the discount rate would be higher if one rolled-over short-term instruments rather than invested in long-term bonds in an environment of rising inflation. Returns from a portfolio of long-term bonds do not change as interest rates rise. Thus, while Lambrinos and Harmon state that Because this period spans three full business cycles, the results are not likely to reflect the influence of a particular stage of the business cycle, (p. 738) they overlook an important postwar event-the rise of inflation in the 1970's. The authors, constrained by data availability, used the period 1971 through 1983 to compare the estimated present values using the offset and augmented offset approaches with present values using actual PSID earnings. Table 1 shows that this 13 year period (1971 through 1983) exhibited higher inflation, wage growth, and interest rates than the 1961 through 1970 decade that preceded it. Recall that Lambrinos and Harmon used the 1961 through 1970 period to calculate the average municipal bond yield which they used to discount actual PSID earnings. Table 1 A Comparison of the 1961 through 1970 and 1971 through 1983 periods* 1961-1970 1971-1983 (percent) percent annual average inflation rate 2.7 7.5 annual average rate of wage change 4.0 6.8 annual average Treasury bill rate 4.6 7.9 annual average municipal bond rate 4.1 7.3 * The inflation rate is for the consumer price index. The rate of wage change is for total private average weekly earnings. The Treasury bill rate is for 9 through 12 month issues for 1961 through 1970 and one year issues for 1971 through 1983. The municipal bond rate is the S&P high grade series. See: Economic Report of the President and the Federal Reserve Bulletin. The use of short-term Treasury instruments to reduce exposure to inflation risk would have resulted in a higher discount rate. That is, the discount rate employed by the authors based on the 1961 through 1970 period was lower than would have been the case if interest rates that prevailed on short-term instruments during the 1971 through 1983 period had been used. …