An Empirical Evaluation of Two Methods for Estimating Economic Damages

Abstract

An Empirical Evaluation of Two Methods For Estimating Economic Damages A variety of approaches have been proposed and are used by economists to estimate economic damages in personal injury/wrongful death tort cases. These approaches vary from the straightforward offset or Alaska method, which enables one to calculate economic damages by multiplying the current earnings level by the number of years of worklife expectancy, to more complex approaches involving the use of real wage growth and discount rates and an age-earning's profile adjustment. Although each approach has some theoretical foundation, no one has attempted to empirically evaluate which method does the best job in forecasting earnings losses for a large sample of workers. This article will attempt to fill this void in the economic damages literature by examining a longitudinal sample of workers whose earnings are available from 1968 through 1983. A longitudinal sample is ideal for this type of study since it can be assumed that, as of a certain age, workers either die or become permanently disabled. From the earnings of the individual prior to the hypothesized year of death or diablement, future wages may be projected and the present value obtained. The predicted present values may be compared with the actual present values using the individual's wages after this arbitrary year. Two methods will first be presented that will be used to estimate economic losses. Next the data set to be employed along with the empirical methodology will be discussed. The following section will present the empirical results followed by conclusions. Estimating Economic Damages The methods used by economists to estimate economic damages vary considerably. An approach which has received a great deal of support in recent years and is required in some states is the offset method. This method simplifies the analysis by assuming that the rate of wage growth equals the rate of discount. (1) Because these two rates are equal, the present value of the earnings losses is simply the product of the current earnings level and the number of years of worklife expectancy. The theoretical justification for this approach is that wage growth rates and interest rates are both affected by inflation implying that these two variables are highly correlated. One major benefit of this approach is simplicity of presentation to a jury of non-economists. Disadvantages include the fact that these two rates are not exactly equal so this method represents an approximation at best. Furthermore, this method can over estimate earnings losses when one considers income and social security taxes that will be paid on these gross earnings amounts. (2) The approach that will be compared to the offset uses an age-earnings profile to adjust earnings for each year. (3) It is well known that earnings for the typical person follow an inverted U pattern with respect to age. (4) Earnings increase rapidly earlier in the life cycle due to the continued investments in human capital, level off in the middle years, and then decline due to the depreciation of human capital as well as declines in hours of work. The rationale for using this approach is that in addition to the increases in wages due to inflation and aggregate increases in productivity, individual's earnings may increase or decrease depending upon their age. For example, a typical 25-year old's earnings increase quite rapidly. Therefore, the offset approach alone may underestimate the loss for this individual. Conversely, an individual at the upper end of the age distribution may have decreasing earnings so that a slight overestimation may occur. Data and Models The data for this study come from the random portion of the Panel Study of Income Dynamics (PSID) for 1968 through 1983. The PSID is a longitudinal survey with detailed information on the financial and demographical characteristics of the sample families. …