Windfalls.

• Author: Kades, Erick

1. INTRODUCTION

   [W]indfall as a term for an unexpected piece of good fortune goes back to medieval England, when commoners were forbidden to chop down trees for fuel. However, if a strong wind broke off branches or blew down trees, the debris was a lucky and legitimate find.(1)

   In common usage, a windfall is a "casual or unexpected acquisition or advantage," or an "unexpectedly large or unforseen profit."(2) A rare discussion in the legal literature did not stray far from the dictionary, defining a windfall as "value which is received by a person unexpectedly as a result of good fortune rather than as a result of effort, intelligence, or the venturing of capital."(3) This definition, however, adds critical economic content to the term: It distinguishes gains due to luck from those due to effort or enterprise. This Article defines windfalls as economic gains independent of work, planning, or other productive activities that society wishes to reward.

   The common law has long provided clear protection for the fruits of labor, planning, and risk-taking. Property and tort law protect Farmer Black's wheat crop from theft, negligent destruction, and other harms traceable to wrongful human conduct. Contract law protects Black's right to transfer the wheat in a private bargain for whatever price the market will bear. Modern constitutions, via contract and just compensation clauses, and modern statutes, in myriad ways, have further expanded protections for private property.

   Perhaps surprisingly, Farmer Black receives as much legal protection for manna fallen from heaven or, to use a less religious hypothetical, for a golden meteor that falls onto Blackacre. Most commentators simply presume, in passing, that the law treats property obtained by luck no differently than it treats property earned through effort. In upholding the constitutionality of a Washington, D.C., rent control law enacted during World War I, Justice Holmes noted that the measure would deprive landlords "in part at least of the power of profiting by the sudden influx of people to Washington caused by the needs of Government and the war, and thus of a right usually incident to fortunately situated property."(4) A recent scholarly discussion of the famous Coronation Cases(5) notes in passing that although "this asset came to [apartment owners] by the purest windfall, it was entitled to no less protection than any other species of property."(6) Thus, Richard Epstein accurately describes a "uniform rule [that] leaves the thing with its founder, without any effort to isolate luck from skill."(7)

   I take issue with this deeply ingrained notion, both as a positive description of the law and as a normative prescription for the law. Some legal rules do--and should--dictate that the state capture windfalls, i.e., tax them away from their lucky recipients and redistribute the gains to the rest of the population. Part II develops a theoretical framework to demonstrate that such sharing of windfalls is sometimes desirable. Societal capture of windfalls, by definition, does not affect incentives to engage in productive activity and therefore does not discourage effort or enterprise. Windfalls, compared to earnings, are thus an attractive source of revenue. Moreover, to the extent that citizens are risk-averse, they will desire, if possible, to share windfalls rather than leave them with a few lucky individuals. There is no private market mechanism for redistributing windfalls (a hypothetical product that I label "reverse insurance"), despite these desirable attributes, because parties experiencing gains are unlikely to report their good luck. In contrast, those with ordinary insurance have clear incentives to report bad luck covered by their policies. I label this the "reporting problem"; it explains why society cannot count on the market to redistribute windfalls.

   The state, however, can redistribute windfalls. Society must weigh the benefits against two types of costs incurred in capturing and redistributing windfalls. First, there are significant transaction and administrative costs. Second, any sharing regime that accidentally affects earnings, as opposed to windfalls, will create disincentives to effort and especially to planning.

   Another important limitation on capture is that, more often than not, one person's windfall is another person's loss. Unfortunately, golden meteors fall from the sky much less frequently than people find the property of others, receive overpayments, or benefit from other "redistributionary" windfalls. I label cases where the number of parties to a windfall is small (including both losers and winners) "private windfalls."

   Part III first explores how courts have used and abused the windfall label. By failing to appreciate the extent of parties' planning, and the productivity of such planning (recall the definition, above, of a windfall as an "economic gain independent of work, planning, or other productive activities"), courts often find a windfall where none exists (Section III.A). Contracts, primary tools of planning, are always incomplete. Courts create unintended windfalls when they construe contracts without assuming that, had they anticipated subsequent events, risk-averse parties would have adopted terms avoiding (instead of creating) windfall gains for one side and losses for the other (Section III.B). Legal rules sometimes leave windfalls where they land in order to serve larger social goals: Permitting finders to keep property when the true owner is unidentified encourages finders to take control of lost items and attempt to locate the owner; permitting victims of negligent acts to recover from injurers as well as from their insurers preserves tort law's incentives to take reasonable precautions (Section III.C). While society might wish to recover other private windfalls, the same reporting problem that prevents a market in reverse insurance also makes capture of private windfalls unattractive. All the state accomplishes by imposing a tax on private windfalls is to impose transaction costs on the few parties who must act in concert to keep the windfall secret (Section III.D).

   "Public windfalls" involve cases where the number of winners and losers is large. Unlike private windfalls, capture of public windfalls is feasible. Any gain that looks like an economic rent, from higher oil prices resulting from the activities of a foreign cartel to increased wartime demand for apartments, presents an attractive target for taxation and redistribution. Section IV.B explores a wide variety of contexts in which governments have engaged in windfall capture. Section IV.C examines slightly different situations, such as eminent domain and punitive damage awards, where legal roles should and often do permit the state to buy goods or encourage efficient behavior at market cost instead of at negotiated prices that would allow a lucky few to reap windfalls.

   Societal capture of public windfalls was not practical when states were relatively weak and lacked the information or organizational apparatus necessary to separate windfalls from earnings. As governments have developed, however, they have become more and more capable of capturing public windfalls.

2. THE THEORY AND PRACTICE OF CAPTURING WINDFALLS

   There are two reasons why, in an ideal world, the state would capture--tax away and redistribute--windfalls: (1) They are a nondistortionary source of revenue; and (2) risk-averse citizens will desire sharing windfalls as a sort of "reverse insurance." I defend these propositions in Section II.A. Reality, however, imposes significant constraints on even the modern state's ability to capture windfalls: Transaction/administrative costs and the possibility of creating disincentives to productive activity (especially planning) may outweigh the benefits of windfall capture. I examine these costs in Section II.B.

   1. The Desirability of Capturing Windfalls: Optimal Taxation and "Reverse Insurance"

      Almost any tax causes consumers to change their behavior. This process leads to economic losses above and beyond tax revenues--"excess burden" or "deadweight loss" in the jargon of economics.(8) A tax on chicken causes some consumers to substitute, for example, pork, which they might otherwise prefer not to eat; a wage tax causes workers to take leisure time that, in the absence of the tax, they found less attractive than additional income. Whenever taxes cause individuals to alter their behavior, society suffers such deadweight losses.

      Conversely, the less a tax changes behavior, the less deadweight loss it imposes. All else being equal, it is efficient to tax goods for which demand is inelastic--unresponsive to price changes--since consumers will simply pay more rather than switch to a less preferable substitute.(9) Thus, a tax on the insulin that diabetics require to survive, while perhaps inequitable, is efficient in that it generates less deadweight loss than taxing most other goods.

      Taxing windfalls is efficient for precisely the same reason that taxing insulin is efficient: It leads to little if any distortion in private behavior and thus imposes little if any deadweight loss. Windfalls by definition are unearned surprises.(10) Taxing unearned income does not undermine incentives for effort and enterprise; taxing surprises cannot distort agents' economic planning. "Of great appeal to economists are taxes that capture some portion of windfalls to individuals. If these windfalls are due to chance or luck, then taxing them may be less likely to distort behavior than would other taxes."(11) Windfall taxation is nondistortionary since it can only be imposed ex post, after a windfall, which is by definition an unanticipated event. "[T]axing past transactions means that future behavior may be less distorted.... The central idea is that allocative efficiency is served when taxpayers are unable to shift their activities in the face of a tax."(12)

      One court...