Courts and commentators have long recognized that punitive damages awards constitute an unexpected and unwarranted windfall gains to plaintiffs and, as such, the Tax Code mandates that punitive damages awards be included in gross income. Several states have attempted to claim an even larger percentage of the awards by enacting split-recovery statutes that allocate as much as 75% of these awards to the state governments.
While split-recovery regimes have the laudatory goal of redistributing windfall gains, they distort the incentives of both plaintiffs and tribunals to a greater extent than a system that includes punitive damages awards in gross income. Further, taxing punitive damages is a particularly efficient method of recovering and redistributing windfall gains. Unlike the taxation of classic windfalls, such as the discovery of treasure, the taxation of punitive damages awards does not suffer from a reporting problem. The taxation of punitive damages also avoids the many distortion effects of windfall taxes enacted by Congress, such as the Excess Profits Tax and the Windfall Profit Tax.