Taxes and Compensation for Lost Earnings

Abstract

THIS paper analyzes several problems associated with evaluating lifetime income streams within the context of a rising marginal tax structure. Our analysis was prompted by a recent U.S. Supreme Court decision in which the court held that evidence concerning the effects of federal income taxes on a decedent's future earnings is admissable in assessing damages in cases brought under the Federal Employer's Liability Act.' Income taxes have an impact at two points in the determination of a proper award: (a) they influence the disposable income which would have been available to the decedent had he lived; and (b) they influence the amount of the award required to reproduce this disposable income. Although the award proper is not taxable, the future interest earnings from the award are taxable, and the Court recognized that the amount of the award should be adjusted to reflect the tax on these interest earnings. The typical procedure for determining an award has been to calculate a present value by discounting future gross earnings of the decedent at some appropriate discount rate and using the present value of future earnings as the basis for an appropriate lump-sum award. It turns out, however, that adjusting for taxes makes it difficult to determine the appropriate award by applying standard discounting procedures. Our approach, therefore, is from the point of view of consumption alternatives rather than present values.2 This means that we ask first what consumption patterns (through time) would have been available had the decedent lived. For a given lifetime earnings pattern, the alternative consumption pat-