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Abstract:
Private equity is very much in the public eye. The prototypical private equity fund purchases, restructures, and resells ailing companies. The managers of such funds are typically paid with a share of the fund's profits. Over the last several months, the favorable income tax treatment of these compensatory profits interests has been the subject of an ever swelling stream of headlines, editorials, and Congressional hearings. But despite the attention the issue has received, the tax advantage of compensatory profit shares is not well understood, and the reasons for reform are, accordingly, not well developed. This article clarifies the nature of the tax advantage and, with that understanding in mind, critically assesses some of the chief arguments for and against the current tax treatment.

Private equity, profits interests, carry, capital gains, ordinary income, inputed income, deferral

Abstract:
An influential theme in recent legal scholarship is that law is not as important as it appears. Social control, many scholars have noted, is often achieved through social norms - informal, decentralized systems of consensus and cooperation - rather than through law. This literature also displays a guarded optimism that social evolutionary processes will tend to favor the adoption of efficient norms. Using concepts from evolutionary game theory, we demonstrate that efficient norms will prevail only in certain settings and not in others: survival of the fittest does not imply survival of the efficient. In particular, we show that in many games of interest to legal scholars - games describing fundamental interactions in property, tort, and contract - evolutionary forces lead away from efficiency. We describe how law rights this trend.

Abstract:
An influential theme in recent legal scholarship is that law is not as important as it appears. Social control, many scholars have noted, is often achieved through social norms - informal, decentralized systems of consensus and cooperation - rather than through law. This literature also displays a guarded optimism that social evolutionary processes will tend to favor the adoption of efficient norms. Using concepts from evolutionary game theory, we demonstrate that efficient norms will prevail only in certain settings and not in others: survival of the fittest does not imply survival of the efficient. In particular, we show that in many games of interest to legal scholars - games describing fundamental interactions in property, tort, and contract - evolutionary forces lead away from efficiency. We also describe how law rights the trend.

Abstract:
One of the major developments in legal scholarship over the last decade has been a shift of attention away from formal legal rules toward informal, decentralized methods of social control, or social norms. Many scholars suggest that social norms, not legal rules, are the mainstay of social control. Such a view requires a theory of why individuals would follow norms against their immediate self-interest without threat of formal legal sanction. In seeking an explanation, the norms literature draws heavily on the game theoretic idea that individuals follow norms because of the possibility of community retaliation. Norms scholars express concern, however, that such threats are not credible because there is a free rider problem in inducing community members to engage in costly enforcement. We demonstrate that this "third-party enforcement problem" is, in fact, illusory. Yet there are other important reasons for skepticism about game theoretic approaches to social control that norms scholars have not recognized. We highlight the "counterfactual problem": the fact that the game theory of norm enforcement requires individuals to continue to believe that their community has adopted the norm even in the face of proof that this belief is false. The counterfactual problem opens up avenues for law that the literature has not yet identified. We contend that law does not enter simply to help players arrive at a normative equilibrium, but is required to sustain that equilibrium. This observation has the virtue of consistency with actual patterns of law enforcement.

social norms, game theory, repeated games, counterfactual problem, third-party enforcement problem, subgame perfection, tit-for-tat, def-for-dev, grim strategy

Abstract:
In drawing on the theory of repeated games, norms scholars have devoted much attention to the so-called third-party enforcement problem: the seemingly inevitable reluctance of members of a community to carry out their implicit threat to punish deviators. We argue that the third-party enforcement problem - as currently represented in the literature - is illusory. To be sure, third party enforcement is always a problem for tit-for-tat, the norms literature's canonical example of a cooperation-sustaining strategy. The problem is not, however, endemic to strategies that support cooperation. Thus, we propose re-focusing on an alternative strategy, which we call def-for-dev (defect-for-deviate). Under def-for-dev third parties find it in their interest to punish deviators lest they themselves be labeled as deviators in future rounds.

Although the third-party enforcement problem as conceived of in the literature is illusory, there is still reason for skepticism about the application of mainstream repeated game theory to law and norms. We highlight the counterfactual problem: the fact that the theory of games requires that players continue to believe that other players have adopted a particular equilibrium strategy even off the equilibrium path, when it is evident that this belief is false. The counterfactual problem opens up avenues for law that the literature has not yet identified. We contend, for example, that law does not enter simply to help players arrive at the cooperative equilibrium, but is required to sustain that equilibrium. This observation has the virtue of consistency with actual patterns of law enforcement.

Abstract:
"Welfarism" is the principle that social policy should be based solely on individual well-being with no reference to "fairness" or "rights." The propriety of this approach has recently been the subject of extensive debate within legal scholarship. Rather than contributing (directly) to this debate, we identify and analyze a problem within welfarism that has received far too little attention. Call this the "ex ante/ex post" problem. The problem arises from the combination of uncertainty - an inevitable feature of real policy choice - and a social preference for equality. If the policymaker is not a utilitarian, but rather has a "social welfare function" that is equity-regarding to some degree, then she faces the following choice: Should she care about the equalization of expected well-being (the ex ante approach), or should she care about the expected equalization of actual well-being (the ex post approach)? Should she focus on the equality of prospects or the prospects for equality?

In this Article, we bring the ex ante/ex post problem to the attention of legal academics, provide novel insight into when and why the problem arises, and highlight legal applications where the problem figures prominently. We ultimately conclude that welfarism requires an ex post approach. This is a counterintuitive conclusion because the ex post approach can conflict with ex ante Pareto superiority. Indeed, the Article demonstrates that the ex post application of every equity-regarding social welfare function - whatever its particular form - must conflict with ex ante Pareto superiority in some choice situations. Among other things, then, the Article shows that legal academics must abandon either their commitment to welfarism or their commitment to ex ante Pareto superiority.

Social Welfare, Welfarism, Fairness, Utilitarianism, Consequentialism, Inequality, Equity, Uncertainty, Ex Post Social Welfare, Ex Ante Social Welfare, Cost Benefit Analysis, Pigou-Dalton Principle, Sure Thing Principle, Time Inconsistency, Compensation, Insurance

Abstract:
Humans are imperfect information processors, a fact almost universally bemoaned in legal scholarship. But when it comes to how the legal system itself processes information, cognitive limitations are largely good news. Evidentiary procedure - inclusive of trial, discovery, and investigation - relies heavily on the fact that human mental capacity is limited. Such limits are crucial to separating sincere from insincere testimony. Moreover, notes and other "cognitive artifacts" that individuals make to compensate for their limited cognitive ability are an important source of evidence. This article's primary objective is to elucidate the extent to which cognitive imperfection is beneficial rather than detrimental to evidentiary process and thus to law as a whole. Secondarily, the article discusses how the law of evidentiary process tilts the playing field of litigation in a manner that exacerbates the cognitive limitations of the potentially insincere and offsets the limitations of competing participants.

Evidence, Procedure, Cognitive Error, Cognitive Biases and Illusions, Cross Examination, Witness Preparation, Real Evidence, Eyewitness Memory

Abstract:
Humans are imperfect information processors, a fact almost universally bemoaned in legal scholarship. But when it comes to how the legal system itself processes information, cognitive limitations are largely good news. Evidentiary procedure - inclusive of trial, discovery, and investigation - relies heavily on the fact that human mental capacity is limited. Such limits are crucial to separating sincere from insincere testimony. Moreover, notes and other cognitive artifacts that individuals make to compensate for their limited cognitive ability are an important source of evidence. This article's primary objective is to elucidate the extent to which cognitive imperfection is beneficial rather than detrimental to evidentiary process and thus to law as a whole. Secondarily, the article discusses how the law of evidentiary process tilts the playing field of litigation in a manner that exacerbates the cognitive limitations of the potentially insincere and offsets the limitations of competing participants.

Evidence, procedure, cognitive error, eyewitness testimony, jury deliberation

Abstract:
Many firms have instituted a policy of conducting their own "environmental audits" to test compliance with a complex array of environmental regulations. Yet, commentators suggest that self-auditing is still not as common as it should be because firms fear that the information they gather will be used against them. This paper analyzes the two-tiered incentive problem raised by self-auditing-viz., incentives to both test for and effect compliance. We find that conventional tort remedies fail to produce an efficient amount of self-auditing. To fix the problem we propose three separate solutions, each with differing informational requirements and efficiency benefits, and each distinct in its own way from current EPA policy. First, we propose that punitive fines be reduced for firms that conduct their own investigation, whether or not the firm has "fixed" the harm that its investigation uncovers. Importantly, we argue that the nature of the self-auditing incentive problem makes conditioning on investigation informationally feasible, since it is the potential observability of investigative effort that produces the disincentive to investigation in the first place. Our second solution conditions on firm disclosure. While this
solution allows for additional savings in government enforcement costs, it raises serious informational issues regarding the verifiability of disclosure. Lastly, we consider a solution that we call "inverse negligence," wherein firms are fined additionally for harms that they would have fixed, had they learned about them through investigation. This solution requires neither verifiable disclosure, nor observable investigation effort, but does require additional information about the
firm's private cost of fixing harms.

Abstract:
We consider an infinitely repeated Bertrand game, in which prices are publicly observed and each firm receives a privately observed, i.i.d. cost shock in each period. We focus on symmetric perfect public equilibria, wherein any "punishments" are borne equally by all firms. We identify a tradeoff that is associated with collusive pricing schemes in which the price to be charged by each firm is strictly increasing in its cost level: such "fully sorting" schemes offer efficiency benefits, as they ensure that the lowest-cost firm makes the current sale, but they also imply an informational cost (distorted pricing and/or equilibrium-path price wars), since a higher-cost firm must be deterred from mimicking a lower-cost firm by charging a lower price. A rigid-pricing scheme, where a firm's collusive price is independent of its current cost position, sacrifices efficiency benefits but also diminishes the informational cost. For a wide range of settings, the optimal symmetric collusive scheme requires (i) the absence of equilibrium-path price wars and (ii) a rigid price. If firms are sufficiently impatient, however, the rigid-pricing scheme cannot be enforced, and the collusive price of lower-cost firms may be distorted downward in order to diminish the incentive to cheat. When the model is modified to include i.i.d. public demand shocks, the downward pricing distortion that accompanies a firm's lower-cost realization may occur only when current demand is high.

Abstract:
We consider an infinitely-repeated Bertrand game, in which prices are perfectly observed and each firm receives a privately-observed, i.i.d. cost shock in each period. We focus on symmetric perfect public equilibria (SPPE), wherein any "punishments" are borne equally by all firms. We identify a tradeoff that is associated with collusive pricing schemes in which the price to be charged by each firm is strictly increasing in its cost level: Such "fully-sorting" schemes offer efficiency benefits, as they ensure that the lowest-cost firm makes the current sale, but they also imply an informational cost (distorted pricing and/or equilibrium-path price wars), since a higher-cost firm must be deterred from mimicking a lower-cost firm by charging a lower price. A rigid-pricing scheme, where a firm's collusive price is independent of its current cost position, sacrifices efficiency benefits but also diminishes the informational cost. For a wide range of settings, the optimal symmetric collusive scheme requires (i) the absence of equilibrium-path price wars, and (ii) a rigid price. If firms are sufficiently impatient, however, the rigid-pricing scheme cannot be enforced, and the collusive price of lower-cost firms may be distorted downward, in order to diminish the incentive to cheat.

Abstract:
We consider an infinitely-repeated Bertrand game, in which prices are perfectly observed and each firm receives a privately-observed, i.i.d. cost shock in each period. We focus on symmetric perfect public equilibria (SPPE), wherein any "punishments" are borne equally by all firms. We identify a tradeoff that is associated with collusive pricing schemes in which the price to be charged by each firm is strictly increasing in its cost level: such "fully-sorting" schemes offer efficiency benefits, as they ensure that the lowest-cost firm makes the current sale, but they also imply an informational cost (distorted pricing and/or equilibrium-path price wars), since a higher-cost firm must be deterred from mimicking a lower-cost firm by charging a lower price. A rigid-pricing scheme, where a firm's collusive price is independent of its current cost position, sacrifices efficiency benefits but also diminishes the informational cost. For a wide range of settings, the optimal symmetric collusive scheme requires (i) the absence of equilibrium-path price wars, and (ii) a rigid price. If firms are sufficiently impatient, however, the rigid-pricing scheme cannot be enforced, and the collusive price of lower-cost firms may be distorted downward, in order to diminish the incentive to cheat.

Abstract:
Professors Polinsky and Che advocate decoupling what plaintiffs recover from what defendants pay in damages, specifically arguing that lowering recovery and raising damages (by appropriate amounts) delivers the same level of primary activity deterrence with fewer filed suits. Professors Kahan and Tuckman extend Polinsky and Che's analysis to account for the effect of parties' litigation stakes on the cost of each filed suit, provisionally concluding that Polinsky and Che's basic argument remains intact. This article reaches a different conclusion. We show that when the effect of litigation stakes on litigation effort is more fully taken into account, lowering recovery and raising damages may no longer improve social welfare. In addition, we characterize the kinds of suits in which the optimal level of recovery is no less than the optimal level of damages. Of rhetorical significance in the current policy debate, we find that such suits resemble the negative picture of modern litigation invoked by some advocates of reduced recovery. Our basic findings are robust to the possibility of out-of-court settlement, plaintiffs' employment of contingent fee lawyers, and alternative fee-shifting rules.

Abstract:
Professors Polinsky and Che advocate decoupling what plaintiffs recover from what defendants pay in damages, specifically arguing that lowering recovery and raising damages (by appropriate amounts) delivers the same level of primary activity deterrence with fewer filed suits. Professors Kahan and Tuckman extend Polinsky and Che's analysis to account for the effect of parties' litigation stakes on the cost of each filed suit, provisionally concluding that Polinsky and Che's basic argument remains intact. This article reaches a different conclusion. We show that when the effect of litigation stakes on litigation effort is more fully taken into account, lowering recovery and raising damages may no longer improve social welfare. In addition, we characterize the kinds of suits in which the optimal level of recovery is no less than the optimal level of damages. Of rhetorical significance in the current policy debate, we find that such suits resemble the negative picture of modern litigation invoked by some advocates of reduced recovery. Our basic findings are robust to the possibility of out-of-court settlement, plaintiffs' employment of contingent fee lawyers, and alternative fee-shifting rules.

Abstract:
Almost all Law and Economic analysis evaluates legal rules solely on the basis of the efficiency criterion with no consideration of distributive justice. Recently, the rationale for this long standing practice has been called into question by scholars within the Law and Economics community. In response, proponents of pure efficiency have offered new counterarguments in an attempt to shore up the consensus methodology. This comment critically evaluates these counterarguments. It finds that they mischaracterize and misconceive the recent criticisms of pure efficiency. Assessing the overall debate, the comment concludes that Law and Economics' exclusive focus on efficiency continues to lack justification even within the limited purview of modern economic reasoning. [Note: The current version of this paper is incorporated into Parts III and IV of Deconstructing the New Efficiency Rationale, 86 Cornell L. Rev. 1003 (July 2001)]

Optimal Taxation, Equity, Income Tax Only Results

Abstract:
This paper concatenates the introductions to two volumes of collected articles on the economic analysis of evidence, procedure, and litigation. These introductions survey, assess, and contextualize the most important economic research in the field.

Litigation, Procedure, Evidence

Abstract:
Current writing on evidence tampering - inclusive of the destruction, fabrication, and suppression of evidence - creates the impression that our system of litigation is in a state of fundamental disrepair. This article suggests that this perception may merely reflect defects in the conventional view of trial's purpose. The conventional view sees trial as a stand-alone device for uncovering micro-historical truths about what has already come to pass. In contrast, this article advocates viewing trial as but one component of the overall mechanism by which the legal system influences everyday behavior. When trial is viewed less in terms of discerning past events, and more in terms of shaping future events, several apparently troublesome aspects of the existing system's treatment of evidence tampering gain substantial justification, and the way is paved for a more fruitful evaluation of current doctrine.

perjury, obstruction of justice, contempt, evidence tampering, spoliation, document retention policy, discovery sanctions, Rule 11 sanctions, inherent powers, spoliation tort, professional responsibility

Abstract:
Current writing on evidence tampering - inclusive of the destruction, fabrication, and suppression of evidence - creates the impression that our system of litigation is in a state of fundamental disrepair. This article suggests that this perception may merely reflect defects in the conventional view of trial's purpose. The conventional view sees trial as a standalone device for uncovering micro-historical truths about what has already come to pass. In contrast, this article advocates viewing trial as but one component of the overall mechanism by which the legal system influences everyday behavior. When trial is viewed less in terms of discerning past events, and more in terms of shaping future events, several apparently troublesome aspects of the existing system gain substantial justification, and the way is paved for a more fruitful evaluation of current doctrine.

Abstract:
One of the most important developments in law and economics over the last decade has been the emergence and rapid acceptance of a new type of justification for the field's long-time practice of evaluating legal rules solely on the basis of the efficiency criterion. This Article challenges these new arguments. It contends that these arguments are alternatively logically flawed or reliant on untenable assumptions. The article concludes that law and economics' exclusive focus on efficiency continues to lack justification even within the limited purview of modern economic reasoning.

Abstract:
The enormity of the earnings reported by some private equity fund managers has drawn sustained public attention to how such earnings are treated under the income tax. Reformers call for eliminating the preferential capital gains treatment accorded to the carried interest portion of fund managers' service compensation.

One of the most prominent and thus far successful arguments against reform compares the tax advantage of carried interest to the supposed tax advantage routinely enjoyed by business owners who work in their own business and compensate themselves with sweat equity rather than salary.

This paper argues that sweat equity is not only an inapt analogy for carried interest, but is, on its own terms, misconceived. The tax advantage of carried interest is a matter of exploiting differences in the marginal tax rates of fund managers and fund investors. The tax advantage to sweat equity is largely nonexistent.

Carried Interest, Carry, Profits Interest, Sweat Equity, Private Equity

Abstract:
Legal rules may be general (that is, applicable to a broad range of situations) or specific. Adopting a custom-tailored rule for a specific activity permits the regulator to make efficient use of information about the social costs and benefits of that activity. However, the rule maker typically relies on the regulated parties for such information. The regulated parties may attempt to influence the rule maker, producing rules that reflect their private interests. We show that in some cases limiting the rule maker to a single rule for multiple activities will moderate this influence and maximize welfare.

legal rules, general versus specific rules, lobbying, rules versus standards, simple versus complex rules

Abstract:
Contract theory identifies verifiability as a critical determinant of the incompleteness of contracts. Although verifiability refers to the cost of proving relevant facts to a court, very little scholarship connects explicitly the evidentiary process to the drafting of substantive contract terms. This paper begins to explore this relationship to provide a more rigorous explanation of contract design. In particular, the paper concerns the very core of verifiability - truth-finding by a court - and examines the impact of the prospect of evidence fabrication on contracting. It thereby also explores the puzzling tolerance of the adjudicatory system for fabrication and the incentives to fabricate created by thresholds in burdens of proof. The paper suggests that, despite undermining truth-finding, evidence fabrication may be harnessed by contracting parties to improve the (evidentiary) cost-efficiency of performance incentives in their relationship.

Abstract:
Evidence of an individual's character may not in general be offered to prove that she acted in conformity with that character on a particular occasion. Most analyses of this general rule - and its many exceptions - start from the premise that trial is at heart an exercise in finding facts. Yet a clear and robust rationale for the rules governing character evidence has yet to be found on this basis. This article views trial and character evidence in a different light. Trial is regarded as but one part of the overall mechanism by which the state regulates behavior in the larger world outside the courtroom. The article focuses specifically on trial's role in the provision of incentives that induce individuals to account for the welfare of others in their daily activities. It is shown that the rules governing character evidence are much easier to explain - and so more fruitfully evaluated - when trial is explicitly placed in this broader context. From this finding the article draws the larger lesson that the real object of trial lies more in shaping events than sorting them out after the fact.

Abstract:
Evidence of an individual's character may not in general be offered to prove that she acted in conformity with that character on a particular occasion. Most analyses of this general rule?and its many exceptions?start from the premise that trial is at heart an exercise in finding facts. Yet a clear and robust rationale for the rules governing character evidence has yet to be found on this basis. This article views trial and character evidence in a different light. Trial is regarded as but one part of the overall mechanism by which the state regulates behavior in the larger world outside the courtroom. The article focuses specifically on trial's role in the provision of incentives that induce individuals to account for the welfare of others in their daily activities. It is shown that the rules governing character evidence are much easier to explain?and so more fruitfully evaluated?when trial is explicitly placed in this broader context. From this finding the article draws the larger lesson that the real object of trial lies more in shaping events than sorting them out after the fact.

Abstract:
The following is an author's description of the abstract, not the actual abstract.

In civil procedure, plaintiffs are said to bear the "burden of proof." Informally, this means that unless they prove their cases with a "preponderance of the evidence," the defendant will prevail. The law and economics literature on the burden of proof has attempted to give this concept formal meaning within the theory of decision making, but it has had difficulty providing a compelling explanation for why uncertainty in the court's final assessment should act to the detriment of one party rather than the other. We show how mechanism design is useful in providing one explanation for the asymmetry. The burden of proof emerges from the optimal design of a system of fact-finding tribunals in the presence of: i) limited resources for resolving private disputes, and ii) asymmetric information about the strength of cases prior to the court's expending the resources necessary for a hearing. The paper shows that if the objective in designing a trial court system is accuracy, the "value" of hearing a case will depend partially on the certainty with which the court makes its final award. An optimal court system will filter-out "less valuable" cases by precommitting to a policy in which plaintiffs recover nothing unless they prove their cases with a threshold degree of certainty.

Abstract:
The existing literature on the burden of proof has sought the rule's raison d'etre solely within the court's problem of decision making under uncertainty. While this search has yielded many insights, it has been less successful in providing a compelling explanation for why uncertainty in the court's final assessment should act to the detriment of one party rather than the other. By viewing the problem as one of mechanism design, this paper provides one explanation for the asymmetry. A rule resembling the burden of proof emerges from the optimal design of a system of fact-finding tribunals in the presence of: i) limited resources for the resolution of private disputes, and ii) asymmetric information -- as between the parties and the court -- about the strength of cases prior to the court's having expended the resources necessary for a hearing. The paper shows that if the objective in designing a trial court system is accuracy of recovery granted, the "value" of having heard a case will depend in part on the certainty with which the court makes its final award. An optimally designed court system will then effectively filter-out "less valuable" cases by precommitting to a recovery policy in which plaintiffs recover nothing unless they prove their cases with a threshold degree of certainty.

Abstract:
According to accepted wisdom, "the tax substitution argument" fairly establishes that it is best to tax only labor income, and not also income from savings and investment. In this Article, I show that the tax substitution argument - which is actually a disjointed collection of arguments - is variously incomplete, incorrect, and conclusory.

Tax policy, equity and efficiency, optimal taxation, tax substitution argument, consumption tax versus income tax, Atkinson and Stiglitz, taxes versus legal rules

Abstract:
In practice, the problem of law enforcement is half a matter of what the government does to catch violators and half a matter of what violators do to avoid getting caught. In the theory of law enforcement, however, although the state's efforts at detection play a decisive role, offenders' efforts at detection avoidance are largely ignored. Always problematic, this imbalance has become critical in recent years as episodes of corporate misconduct spur new interest in punishing process crimes like obstruction of justice and perjury. This article adds detection avoidance to the existing theoretical frame with an eye toward informing the current policy debate. The exercise leads to several conclusions. First, despite recent efforts to strengthen laws governing obstruction and perjury, sanctioning is relatively inefficacious at discouraging detection avoidance. Sanctions send a mixed message to the offender: do less to avoid detection, but to the extent you still do something, do more to avoid detection of your detection avoidance. The article argues that detection avoidance is more effectively deterred through the structural design of evidentiary procedure (inclusive of investigation). Specifically advocated are devices that exploit the cognitive shortcomings of potential avoiders and the strategic instability of their cooperative arrangements, thereby lowering the cost effectiveness of devoting resources to avoiding detection.

Evidence, Procedure, Criminal Law, Administrative Law, Public Enforcement, Obstruction of Justice, Perjury, Discovery Sanctions, Spoliation, Document Retention Policies, Document Destruction

Abstract:
Environmental self-auditing by private firms is generally thought to both deserve and require encouragement. Firms can audit themselves more cheaply and effectively than can regulators, but too often are deterred for fear that the information they uncover will be used against them. To reduce this disincentive, the EPA's Audit Policy lowers punitive fines when firms promptly disclose and correct violations that they themselves discover. While some contend that the Audit Policy is inadequate, EPA touts its success, presenting as evidence the policy's track record to date. Yet our examination of that track record leads us to question EPA's conclusions. While the policy appears to have encouraged firms to self-audit in a number of instances, a comparison of the violations uncovered in these cases with those detected by standard enforcement practices suggests that the typical self-audited violation is relatively minor. For instance, cases arising under the Audit Policy are more likely to concern reporting violations, rather than emissions. The relative insignificance of self-audited violations raises a number of broader policy questions, including whether the Audit Policy could and should be revised to play a larger role in regulatory enforcement.

Abstract:
The question of which party should bear the burden of proof on a given factual issue remains one of the most important and problematic in evidence and procedure. This paper approaches the question from a relatively unstudied perspective, viewing litigation as a device for influencing primary activity behavior rather than as a standalone search for truth. Its main finding is as follows: when a given evidentiary contest concerns the primary activity behavior of one of the parties, placing the burden of proof on the other party maximizes the incentive impact of that contest. Though counterintuitive, the finding accords with a striking regularity in existing law. The adversary of the incentive target typically does bear the burden of proof with regard to the target's primary activity behavior. Thus, in tort, the plaintiff bears the burden on the defendant's negligence, but the defendant typically bears the burden on the defense that the plaintiff was contributorily negligent. And in contract the plaintiff bears the burden on the defendant's nonperformance, while the defendant bears the burden of proof on his defense that the plaintiff failed to perform.

Burden of Proof, Burden of Production, Burden of Persuasion, Procedure, Evidence, Litigation

Abstract:
The income tax taxes the proceeds from market work, but not the proceeds from time otherwise allocated - whether enjoyed as self-provided goods and services or leisure time per se. A two-earner couple that out-sources household and child care services, for instance, pays for these services with after tax earnings, while a single-earner couple that self-provides such services pays no tax on their provision. This article uses data from the Panel Study of Income Dynamics to measure the distributive impact of the implicit exclusion for non-market activity. Viewing the exclusion as a kind of tax benefit, it asks: how is such tax benefit distributed across the income spectrum? The article finds that variation across income levels in the labor-income realization ratio - the portion of potential labor income that is realized as actual labor income - has played a decisive role in shaping the real progressivity of the Federal income tax. On paper, the Federal income tax became more progressive during the 1990s. When average tax rates are measured in terms of potential rather than actual income, however, the income tax shows a decline in progressivity during that decade. The discrepancy arises from a change in work patterns. At the start of the decade, tax units with higher income were realizing a greater proportion of their potential earnings than were tax units with lower income. By the end of the decade, the realization ratio was greater at the lower end of the potential income spectrum. This reversal in labor income realization patterns was substantial enough to overpower the increase in statutory progressivity.

Income taxation, progressivity, endowment taxation, work patterns, potential income, tax incidence, redistribution

Abstract:
This paper investigates the role of evidence production in the regulation of private behavior via judicial and administrative process. The paper presents a model in which the law makes the agent's fine depend on the presentation of evidence whose production cost, in turn, depends on how the agent has behaved in the regulated activity. The targeted behavior becomes more privately beneficial to the agent to the extent that it reduces the agent's evidence costs and so improves its highest obtainable payoffs (net of costs) at the subsequent hearing. This view of evidence production has several notable implications, including that truth-finding has no direct role in deterrence, that non-falsifiable evidence, even when available, is unlikely to be the best choice for the system, and that "overdeterrence" may well be cost effective.

Abstract:
This paper investigates the role of evidence production in the regulation of private behavior via judicial and administrative process. The paper presents a model in which the law makes the agent's fine depend on the presentation of evidence whose production cost, in turn, depends on how the agent has behaved in the regulated activity. The targeted behavior becomes more privately beneficial to the agent to the extent that it reduces the agent's evidence costs and so improves its highest obtainable payoffs (net of costs) at the subsequent hearing. This view of evidence production has several notable implications, including that truth-finding has no direct role in deterrence, that non-falsifiable evidence, even when available, is unlikely to be the best choice for the system, and that "overdeterrence" may well be cost effective.

Abstract:
[This paper was published in two parts as: 1) Relying on the Information of Interested - and Potentially Dishonest-Parties, 3 Am. L. & Econ. Rev. 320 (2001), and 2) Games, Information and Evidence Production: With Application to English Legal History, 2 Am. L. & Econ. Rev. 342 (2000).]

The paper is a theoretical analysis of incentive setting via civil litigation, with a focus on incentives for care in activities that may be harmful to others (torts). It makes two main contributions: one directly policy-relevant, one conceptual.

In most existing law and economics research, litigation is modeled in reduced form, as a sort of costly audit, without explicit specification of the fact-finding process. In such models it is always more costly to implement higher levels of care, implying that the second best level of care is lower than the first. Here we explicitly consider the court's information problem (in a single agent model; Sanchirico (1997) considers multiple parties). We find that implementation costs tend to decline in care level and the second best tends to exceed the first. This result in hand, we suggest that the familiar claim that current tort systems overdeter may in fact be no indictment.

A second contribution of the paper is its integrated conception of evidence production, endogenous cost evidence. Evidence production in court is modeled as costly signaling, where signal costs are endogenous to unobserved choices made outside the court room. Care is inspired to the extent that it reduces signaling costs and so increases payoffs at the subsequent proceeding. These signaling/evidence costs are in turn costs of incentive setting via evidence production. In contrast to existing models and conventional wisdom, this view has the ironic implication that perfect (non-falsifiable) evidence may not be good enough: less perfect evidence which is sufficiently-but not infinitely-more costly for disobedient actions is likely to be cheaper all around and thus a more efficient means of setting incentives.

While the paper's focus is on tort law, the model it introduces may be useful in analyzing general situations in which a principal attempts to influence the hidden behavior of an agent based on information that the agent herself supplies.

Abstract:
I study the problem of how the legal system regulates activity outside the courtroom on the basis of information supplied, in court, by interested and potentially dishonest parties. I then apply the framework to the historical evolution of Civil Procedure.

I identify a trade-off between the "fixed costs" of holding hearings and the cost of evidence produced therein. When a party's presentation of evidence is used to set its own liability or recovery, such evidence is useful in setting incentives only to the extent that the party's evidence production costs tend to vary with its behavior in the regulated activity. Such production costs are a loss to the system. The less intense an individual's interest in how her information will be used, the less the need for production costs in insuring reliability. But greater reliance on information from others requires increasing the breadth of circumstances triggering suit and the number of parties to each action.

An increase in the cost of legal process (both fixed costs and production costs) warrants increased reliance on the information supplied by interested parties via costly evidence production. This suggests that increases in the opportunity cost of process, due to increases in labor productivity, were one factor in the gradual shift through English legal history from a system relying mostly on relatively disinterested observers (in the form of the ancient jury) to one relying mostly on costly evidence production by the parties themselves.

Abstract:
This paper studies the evidence production game in adversarial litigation, wherein litigating parties choose how much to spend amassing evidence for their side. The payoff structure of this game is such that one party strategically complements (i.e. mimics her opponent's advances and retreats) while the other strategically substitutes (i.e., does the opposite of her opponent). Which party plays which role depends on how litigation is structured. The question thus arises: should litigation be designed to induce the plaintiff to complement and the defendant to substitute, or vice versa? The paper argues that the answer depends on whether and whose primary activity incentives are being set by the particular evidentiary contest in question. Within each subsidiary evidentiary contest, the "incentive target" should be induced to complement and her adversary to substitute. In some cases the defendant will be the incentive target, as when the issue is the defendant's negligence or contractual breach. In other cases, the plaintiff will be the target, as when the defendant defends by claiming that the plaintiff has been "contributorily negligent" or has herself failed to meet a prior contractual obligation. These results resonate with current law. (A companion paper A Primary Activity Approach to Proof Burdens applies these results to the problem of allocating the burden of proof.)

Evidence, procedure, litigation, adversarial process, strategic complementarities, burden of proof, contributory negligence

Abstract:
Commentators have expressed concern that hindsight bias may distort legal fact finding. The worry is that the fact finder, seeing that an accident has occurred, will be too quick to conclude that the accident was likely to have occurred, and thus too quick to hold defendants liable. There is good reason to believe that this form of across-person hindsight bias does affect decision making. But the application of this finding to legal process has been hampered by the failure adequately to separate across-person hindsight bias from a confounding rational use of outcome information in judging others' beliefs. This rational use arises in the case that the defendant was in a position to know and now has reason to be less than forthcoming - a case of particular interest to law. Under those conditions, rational probabilistic reasoning dictates that the fact finder, on seeing that the accident did in fact occur, increase its assessment of how likely a reasonable defendant would have thought the accident to be ex ante. The interaction between this rational use of outcome information, on the one hand, and across-person hindsight bias, on the other, may produce surprising normative implications. Hindsight bias would, for example, be beneficial if it corrected for fact finders' cognitive error in not putting outcome information to its rational use.

hindsight bias, evidence, cognitive error, probability

Abstract:
Law and economic analysis most often evaluates legal rules solely on the basis of the efficiency criterion. The justification usually offered for this exclusive focus on efficiency is that distributive goals are best accomplished through the tax code. This paper adopts the same framework used to formalize this justification and acheives quite different results: It is shown that: 1) even in the presence of an optimally redistributive tax code, any concern for "equity" dictates that legal rules should deviate from efficient standards in a manner that redistributes toward the less-well-off; 2) any showing that differences in taxable attributes such as income or wealth are the dominant components of overall inequality would go only to the direction of the proper equity adjustment to legal rules, not to the fact that some adjustment should be made; and 3) the role of equity adjustments to legal rules is not limited to correcting inequalities that arise within the legal system, but extends to correcting inequalities arising in other areas of the economy.

Abstract:
Most formal law and economic analysis evaluates legal rules solely on the basis of "efficiency." The prevailing justification for this focus is that -- as a matter of economic theory -- "equity" goals are best accomplished through the income tax, rather than the legal system. In opposition to that view, we argue that economic theory provides no reason to favor any one economic activity over another-leisure choice over care choice, for instance-in accomplishing redistributional goals. The optimal redistributional program will involve a mixture of methods and deviations from efficiency in one domain may even be used to correct inequalities arising in another.

In a modified version of the same model used to support the prevailing view, we find that: 1) even in the presence of an optimal income tax, any concern for equity dictates that legal rules should deviate from efficient standards in a manner that aids the less-well-off-this, so long as there is any heterogeneity in the way agents respond to the legal system; 2) when, in addition, income differences predominate in overall inequality, legal rules should in fact be adjusted away from efficient standards in a manner that helps low-income individuals; 3) under certain additional conditions, legal rules should be specifically adjusted to correct income-based inequality. Our results are at variance with those found in Shavell (1981) and Kaplow and Shavell (1994).

Abstract:
Two agents with different priors watch a sequence unfold over time, updating their priors about the future course of the sequence with each new observation. Blackwell and Dubins (1962) show that the agentsi opinions about the future will converge if their priors over the sequence space are absolutely continuous: i.e., if they agree on what events are possible. From this Kalai and Lehrer (1993) conclude that the players in a repeated game will eventually agree about the future course of play and thus that irational learning leads to Nash equilibrium.i We provide an alternative proof of convergence that clarifies the role of absolute continuity and in doing so casts doubt on the relevance of the result. From the existence of continued disagreement we construct a sequence of mutually favorable, uncorrelated ibets.i Both agents are sure that they win these bets on average over the long run and this disagreement over what is possible violates absolute continuity.

Abstract:
Suppose we randomly pull two agents from a population and ask them to observe an unfolding, infinite sequence of zeros and ones. If each agent starts with a prior belief about the true sequence and updates this belief on revelation of successive observations, what is the chance that the two agents will come to agree on the likelihood that the next draw is a one? In this paper we show that there is no chance. More formally, we show that under a very unrestrictive definition of what it means to draw priors ?randomly,? the probability that two priors have any chance of weakly merging is zero. Indeed, almost surely, the two measures will be singular?one prior will think certain a set of sequences that the other thinks impossible, and vice versa. Our result is meant as a critique of the ?rational learning? literature, which seeks positive convergence results on infinite product spaces by augmenting the process of Bayesian updating with seeming regularity conditions, variously labeled ?consistency? or ?compatibility? assumptions. Our object is to investigate just how regular these assumption and results are when considered in the space of all possible prior distributions. Our results on the genericity of nowhere weak merging and singularity speak not just to the specific assumptions and results that appear in the literature, but to the ?rational learning? approach generally. We call instead for a different approach to learning, one that recognizes the necessity of genuine, substantive restrictions on beliefs and proposes ?extra rational? restrictions that are explicitly grounded in our best understanding of human behavior, ideally gleaned from experimental data.

Abstract:
A widely held view among tax scholars is that only labor earnings, and not also capital earnings, should be included in the tax base. A companion paper by the same author critiques the economic argument that is provided in support of this view. The present paper takes the additional step of providing an affirmative economic argument for including capital earnings in the base. In the process, it provides a general argument for tax base eclecticism.

Tax policy, equity and efficiency, optimal taxation, tax substitution argument, consumption tax versus income tax, Atkinson and Stiglitz, taxes versus legal rules

Abstract:
This essay is an attempt to shed light on one of the essential processes that drives the engine of cross-examination. Specifically, the essay puts forward several hypotheses regarding the important positive role that human cognitive limitations play in the functioning of cross-examination. In the process, the paper also offers a perspective on such mental limitations that is distinct from predominant approaches in cognitive psychology and law.

Cross-examination, cognitive limits, witnesses

Abstract:
A companion paper, Sanchirico (1996), provides a probabilistic theory of learning in games with the convergence property that, almost surely, play will remain almost always (i.e., forever after some point) within one of the stage game's "minimal inclusive sets." This paper investigates the size of minimal inclusive sets in several classes of games, notably, those for which other learning processes have been shown to converge (in various manners weaker than convergence of actual play). These include certain supermodular games, congestion games, potential games, games with identical interests, and games with bandwagon effects. It is shown that in all these classes, if all of a game?s pure equilibria are strict (a fortiori, if its payoffs are generic), then all of its minimal inclusive sets will be singletons consisting of Nash equilibria.

Abstract:
This paper studies the problem of how the legal system regulates activity outside the courtroom based on information supplied in court by interested and potentially dishonest parties. The supply of information is analyzed along a game-theoretic dimension: the extent to which the supplier has an interest in how the information will be used. Such analysis uncovers a basic trade-off in system design between the 'fixed costs' of hearings (e.g., the productive activity forsaken by participation) and the cost of the evidence produced therein. This trade-off helps to explain and connect several trends in the historical evolution of English civil process.

Abstract:
This article investigates the role of evidence production in the regulation of private behavior via judicial and administrative process. It proposes a model in which the law makes the agent's fine depend on the presentation of evidence whose production cost, in turn, depends on how the agent has behaved in the regulated activity. This view of evidence production has several notable implications, including that truth finding has no direct role in deterrence, that nonfalsifiable evidence, even when available, is unlikely to be the best choice for the system, and that overdeterrence may well be cost-effective.

Abstract:
Many firms conduct 'environmental audits' to test compliance with a complex array of environmental regulations. Commentators suggest, however, that self-auditing is not as common as it should be, because firms fear that what they find will be used against them. This article analyzes self-auditing as a two-tiered incentive problem involving incentives both to test for and to effect compliance. After demonstrating the inadequacy of conventional remedies, we show that incentives can be properly aligned by conditioning fines on firms' investigative effort. In practice, however, the regulator may not be able to observe such effort. Accordingly, we propose and evaluate the use of three observable proxies
for self-investigation: the manner in which the regulator detected the violation; the firm's own disclosure of violations; and the firm's observed corrective actions. Each method has its own efficiency benefits and informational requirements, and each is distinct from EPA's current audit policy.

Abstract:
In an influential paper Polinsky and Che (1991) propose that litigation can be made a more cost effective tool for setting primary activity incentives (e.g., for product safety or promissory performance) by reducing plaintiffs' recovery while simultaneously raising defendants' damages. "Decoupling" in this manner reduces the number of filed suits, but increases the deterrent impact of each. Litigation costs fall, but, if damages are raised sufficiently, deterrence is maintained. Yet when the state takes from liable defendants more than it gives to victorious plaintiffs it effectively taxes (probabilistically and collectively) the transaction that led to the present litigation. This tax drives a wedge between the expected social and private benefits of participating in the transaction in the first place. The result is that socially beneficial transactions fail to take place. In this paper we explore the impact of this transactions-discouraging effect on the propriety of decoupling.

decoupling, contracts, torts, private versus social surplus

Abstract:
The design of legal obligations, whether by a public body such as a legislature or by private contract, should anticipate the enforcement process that induces compliance. Judicial enforcement is costly and imperfect, largely because of limits on the court's ability to detect facts accurately. In adversarial litigation, courts are often fooled by fabricated, suppressed, or otherwise manipulated evidence. Given that fabricated evidence is both more costly and less valuable than truthful evidence, one would think that contracting parties should design their agreement so as to deter future evidence fabrication. To the contrary, this article suggests that evidence fabrication may be harnessed by contracting parties to improve the (evidentiary) cost-efficiency of performance incentives in their relationship. This paper thereby addresses the concept of verifiability in contract theory, the puzzling tolerance of the adjudicatory system for fabrication, and the incentives to fabricate created by thresholds in burdens of proof.

Abstract:
The enormity of the earnings reported by some private equity fund managers has drawn sustained public attention to how such earnings are treated under the income tax. Reformers call for eliminating the preferential capital gains treatment accorded to the carried interest portion of fund managers' service compensation.

One of the most prominent and thus far successful arguments against reform compares the tax advantage of carried interest with the supposed tax advantage routinely enjoyed by business owners who work in their own businesses and compensate themselves with sweat equity rather than salary.

This report argues that sweat equity is not only an inapt analogy for carried interest, but is, on its own terms, largely misconceived. Sanchirico concludes that the tax advantage of carried interest is primarily a matter of exploiting differences in the marginal tax rates of fund managers and fund investors, while the tax advantage to sweat equity is arguably nonexistent.

Abstract:
One of the most important developments in Law and Economics over the last decade has been the emergence and rapid acceptance of a new type of justification for the field's long-time practice of evaluating legal rules solely on the basis of the efficiency criterion. This article sets out to deconstruct these new arguments. It contends that these arguments are alternatively logically flawed or reliant on untenable assumptions. It concludes that Law and Economics' exclusive focus on efficiency continues to lack justification even within the limited purview of modern economic reasoning.

Abstract:
I study the basic evidentiary problem of how the legal system regulates primary activities on the basis of information supplied by interested and potentially dishonest parties. I then apply the framework to the historical evolution of Civil Procedure.

Evidence production is analyzed according to the interest of the party supplying it. When a party's presentation directly affects its own trial payoffs, the evidence it presents is useful only to the extent that evidence production costs tend to vary with behavior in the primary activity. Such production costs are a loss to the system. The less a party's interest in what her evidence will be used for, the less the role played by production costs; but the efficacy of relying on information from others is tied to the breadth of circumstances triggering suit and the number of parties to each action.

I show that an increase in the cost of legal process warrants increased reliance on the evidence supplied by interested parties via costly signaling. This result in hand, I suggest that increases in the opportunity cost of process, due to increases in labor productivity, were one factor in the gradual shift through English legal history from a system relying mostly on relatively disinterested observers (in the form of the ancient jury) to one relying mostly on costly evidence production by the parties themselves.

Abstract:
This paper presents a new, probabilistic model of learning in games which investigates the often stated intuition that common knowledge of strategic intent may arise from repeated interaction. The model is set in the usual repeated game framework, but the two key assumptions are framed in terms of the likelihood of beliefs and actions conditional on the history of play. The first assumption formalizes the basic intuition of the learning approach; the second, the indeterminacy that inspired resort to learning models in the first place. Together the assumptions imply that, almost surely, play will remain almost always within one of the stage game?s ?minimal inclusive sets.? In important classes of games, including those with strategic complementarities, potential functions, and bandwagon effects, all such sets are singleton Nash.