Inflation Risk as Determinant of the Discount Rate in Tort Settlements: Comment

Abstract

William G. Harris, in a recent paper in this Journal [ 1], makes two points concerning the selection of the discount rate to be employed in computing awards in tort settlements. His major point is that short-term yields are superior to the more commonly used long-term yields as the discount factor because investments in short-term instruments involve less exposure to inflation risk. A second point, made with very little elaboration [ 1, p. 277], but featured prominently in the conclusions [ 1, p. 2791, is that a tax exempt yield, specifically, a short-term tax exempt yield, is more appropriate than a non-tax exempt yield where legal requirements dictate that earnings net of income taxes be used in computing the earnings stream to be discounted. This comment deals with this second point. It argues that whereas using a tax exempt yield to discount after tax earnings has a legitimate theoretical basis, such a procedure in fact involves a substantial problem, a problem not easily resolved. The theoretical basis for the point is that arriving at an award by discounting an after tax earnings stream with a non-tax exempt yield has the effect of taxing the portion of the earnings stream projected from the award which comes from interest income twice, thereby undercompensating the award recipient. Taxes are paid once in that after tax earnings are used in specifying the earnings for discounting, then paid again as interest income is realized on the award. Of course, since the award itself is tax-free, taxes are paid only once on the portion of the projected earnings coming from exhaustion of principal. The problem with using a tax exempt yield for discounting after tax earnings is that it will often err in the other direction and overcompensate award recipients. Unless awards are large, the tax rates applicable to the interest income on them will fall short of the tax rate implicit in the tax exempt