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Against the Reductionism of an Economic Analysis of Contract Law

  • Sina Akbari

Abstract

Contemporary economic analysts of the law argue that certain legal institutions, such as contract law, ought to be designed to promote wealth maximization, while different legal institutions ought to seek to achieve non-wealth maximizing aims, such as distributive justice. In order to preserve the normative claim that the sole aim of any single legal institution should be the promotion of wealth maximization, economists rely on the “specialization principle”: each legal institution must be organized around a single normative criterion, partitioned from and without regard to the normative aims of other legal institutions. I argue that this idea of a strict normative division of labour between institutions is problematic. On any instrumentalist view, the normative justification of the ends of a particular legal institution cannot ignore the normative aims of the legal system of which it is a part. I develop this argument by critically examining the economic analyst’s claim that commercial contract law should be limited to helping firms maximize profit.

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1. For a general overview of the evaluative project in economic analysis of the law, see Kornhauser, Lewis, “The Economic Analysis of Law” in The Stanford Encyclopedia of Philosophy ( Spring 2014 Edition), online: http://plato.stanford.edu/archives/spr2014/entries/legal-econanalysis/.

2. See Kornhauser, Lewis, “Economic Rationality in the Analysis of Legal Rules and Institutions” in Martin, P Golding & William, A Edmundson, eds, The Blackwell Guide to the Philosophy of Law and Legal Theory (Oxford: Blackwell, 2005) 67.

3. The chief proponents of the contemporary view are Kaplow and Shavell. See Kaplow, Louis & Shavell, Steven, Fairness Versus Welfare (Cambridge: Harvard University Press, 2002) [Kaplow & Shavell, Fairness]. The central thesis in Fairness Versus Welfare is that the law should be evaluated exclusively by its effects on the well-being of individuals (i.e. welfare) and never by principles that give weight to factors that are independent of individuals’ well-being (such as corrective or retributive justice, to which Kaplow and Shavell assign the broad label of “fairness”). This claim provoked substantial academic commentary. See, e.g., Coleman, Jules L, “The Grounds of Welfare” (2003) 112:6 Yale LJ 1511; Ripstein, Arthur, “Critical Notice: Too Much Invested to Quit” (2004) 20:1 Economics & Philosophy 185; Kornhauser, Lewis A, “Preferences, Well-Being, and Morality in Social Decisions”(2003) 32:1 J Leg Stud 303; Waldron, Jeremy, “Locating Distribution” (2003) 32:1 J Legal Stud 277. This essay does not engage in the debate at the level of substantive moral theory; it assumes, with Kaplow and Shavell, that the sole normative criterion for evaluating law should be welfare. The focus of this essay is on a further claim that Kaplow and Shavell make in defense of their broader thesis. Kaplow and Shavell argue that, while concerns about the overall distribution of income are encompassed by the welfare economics approach, legal rules should be evaluated according to the goal of wealth maximization, and distributive aims can be ignored because distribution should be addressed more directly using income tax and transfer programs. Part II of this essay provides a more detailed discussion about distributive objections to normative economic analysis of law.

4. Kaplow states the principle in general terms: “It is generally best to use a separate instrument to address each distinct problem; moreover for each problem it tends to be desirable to employ the instrument that addresses it most directly.” Kaplow, Louis, “Taxes, Permits, and Climate Change” in Metcalf, Gilbert E, ed, U.S. Energy Tax Policy (New York: Cambridge University Press, 2011) 168 at 186.

5. Schwartz, Alan & Scott, Robert E, “Contract Theory and the Limits of Contract Law” (2003) 113:3 Yale LJ 541 [Schwartz & Scott, “Limits of Contract Law”].

6. Ibid at 543.

7. Ibid.

8. Ibid at 544.

9. Ibid. Schwartz and Scott, at various times, use the terms “welfare” (ibid), “wealth” (ibid at 550) and “profit” (ibid at 545) when making their argument. I understand them to be making a normative claim defending welfare maximization narrowly understood as wealth or profit maximization. The general structure of their argument is that commercial “firms rationally pursue the objective of maximizing profit” (ibid at 551) and, therefore, commercial contract law should facilitate firms in doing so. Accordingly, the right way to understand Schwartz and Scott’s claim is as an argument for commercial contract law to be designed according to the evaluative criterion of profit maximization.

10. Ibid.

11. Ibid at 594-609.

12. Ibid at 594.

13. Ibid at 608.

14. Ibid at 601-08.

15. Ibid at 608-09.

16. Ibid at 546-47.

17. Ibid at 557-59.

18. Ibid at 565-68.

19. Ibid at 562-65.

20. Ibid at 559-62.

21. Ibid at 547-50, 584-91.

22. Ibid at 547.

23. Alan Schwartz & Robert E Scott, “Contract Interpretation Redux” (2010) 119:5 Yale LJ 926.

24. Ibid at 928.

25. Schwartz & Scott, “Limits of Contract Law”, supra note 5 at 545.

26. Ibid at 545-46.

27. Ibid at 549.

28. Ibid at 555.

29. Ibid at 545-46, 555.

30. Ibid at 546.

31. Ibid at 555.

32. Schwartz and Scott use the example of pollution and environmental law several times in making their argument. See ibid at 545-46, 555.

33. Demsetz, Harold, “Toward a Theory of Property Rights” (1967) 57:2 American Economic Rev Papers & Proceedings 347 at 350.

34. Schwartz and Scott point to employment law both as grounds for restricting the scope of their theory to commercial contracts (i.e., employment law regulates firm-to-individual contracts) and in making their assumption regarding externalities. See Schwartz & Scott, “Limits of Contract Law”, supra note 5 at 544, 555.

35. Schwartz and Scott point to consumer protection law as an example of Category 3 contracts, i.e., consumer protection law regulates contracts which firms enter into with individuals, in their capacity as consumer. See ibid at 544.

36. Ibid.

37. Schwartz and Scott further refine the general “firm-to-firm” subcategory by restricting their discussion to only those firms that are “sophisticated economic actors”. See ibid at 545.

38. Ibid at 555, emphasis in original.

39. Ibid.

40. Ibid.

41. Ibid at 546.

42. See, e.g., the speech given by Ben Bernanke, Chairman of the Federal Reserve, discussing the causes and effects of the Global Financial Crisis: Ben S Bernanke, “Four Questions About the Financial Crisis” (Speech delivered at the Morehouse College, Atlanta, Georgia, 14 April 2009), online: The Board of Governors of the Federal Reserve System (US) www.federalreserve.gov/newsevents/speech/bernanke20090414a.htm.

43. US, Permanent Senate Subcommittee on Investigations, Committee on Homeland Security and Government Affairs, Wall Street and the Financial Crisis: Anatomy of a Collapse, (S Hrg 112-675) at 319, online: www.hsgac.senate.gov//imo/media/doc/Financial_Crisis/FinancialCrisisReport.pdf.

44. Ibid.

45. See G20, Leaders’ Statement: The Pittsburgh Summit, 24-25 September 2009, online: https://g20.org/wp-content/uploads/2014/12/Pittsburgh_Declaration_0.pdf.

46. Schwartz & Scott, “Limits of Contract Law”, supra note 5 at 555.

47. See, e.g., Eisenberg’s discussion of the theory of efficient breach wherein he criticizes economic analysis for taking “a static and short-run approach to the issue of breach, because it addresses only the efficiency of performing or breaching an individual contract” rather than a “dynamic, long-run approach to the issue of breach [which] addresses the efficiency of the contracting system as a whole.” Eisenberg, Melvin A, “Actual and Virtual Specific Performance, the Theory of Efficient Breach, and the Indifference Principle in Contract Law” (2005) 93:4 Cal L Rev 975 at 1012.

48. Linzer, Peter & Perillo, Joseph M, eds, Corbin on Contracts, revised ed, vol. 6 (Lexis Nexis, 2010) at § 26.8.

49. UCC § 1-304 (2014).

50. Ibid at § 201(b)(20).

51. Ibid at § 302(b).

52. Restatement (Second) of Contracts § 205 (1981).

53. Linzer, supra note 48 at § 26.8.

54. Ibid at § 26.9.

55. Bhasin v Hrynew, 2014 SCC 71, [2014] 3 SCR 295 [Bhasin].

56. Schwartz & Scott, “Limits of Contract Law”, supra note 5 at 601.

57. Ibid at 618.

58. Ibid at 610.

59. Ibid at 609-10.

60. The Supreme Court of Canada considered the claim that a good faith standard would create uncertainty that would negatively impact on commercial contracts. The Court stated that “[r]ecognizing a duty of honesty in contract performance poses no risk to commercial certainty in the law of contract. A reasonable commercial person would expect, at least, that the other party to a contract would not be dishonest about his or her performance.” Because of the bijural nature of the Canadian legal system, the Court pointed to the experience under the Civil Code of Québec which “recognizes a broad duty of good faith which extends to the formation, performance and termination of a contract” to respond to the worry of uncertainty. See Bhasin, supra note 55 at paras 80-83.

61. Others have defended the view that distributive justice does have a place in contract law. Anthony Kronman argues that “contract law should be used to implement distributional goals whenever alternative ways of doing so are likely to be more costly or intrusive”. Anthony T Kronman, “Contract Law and Distributive Justice” (1980) 89 Yale LJ 472 at 474. Much of Kronman’s argument is in answer to libertarian claims that redistribution away from voluntary transactions is never justified; his arguments in this respect are less pertinent for my present argument because Schwartz and Scott do not deny that redistribution is a legitimate aim. Kronman also rejects liberal arguments that redistribution should be achieved solely through a system of taxation because it is the least intrusive and most neutral means. He argues that taxation may not always be the most neutral (taxes discriminate in the sense that they treat different people differently) or the least intrusive (taxes “cast a shadow” over every economic decision). Ultimately, Kronman believes that the question of whether taxation or contract law is the best means for realizing distributional aims is an empirical one that “will depend, in any particular case, on circumstantial factors; neither method is inherently superior to the other.” (Ibid at 475). Kronman’s view that there is no reason in principle to seek justice only through taxation is consistent with the argument I develop here, but narrower: where Kronman allows that it is possible to seek justice through contract law, my argument below attempts to show that, in designing a just legal system, the principles of justice cannot be dispensed with when justifying a legal institution such as contract. See also Bagchi, Aditi, “Distributive Justice and Contract” in Klass, Gregory, Letsas, George & Saprai, Prince, eds, Philosophical Foundations of Contract Law (Oxford: Oxford University Press, 2014) 193. Bagchi argues that the inclusion of distributive concerns in contract law is not justified on instrumental grounds (i.e., that contract law should be used to achieve just distributive effects); instead, because contract law itself is contingent on political institutional arrangements, the principles of justice condition the content of rules governing contractual exchange. By contrast, the argument I develop here attempts to critique the economists’ view on its own terms—that is, I assume institutions are instrumentally justified, and discuss institutional design in light of that background assumption.

62. Schwartz & Scott, “Limits of Contract Law”, supra note 5 at 546.

63. Ibid at 549.

64. This claim has been vigorously defended by Kaplow and Shavell. They provide three arguments for why distributive concerns may be ignored when analyzing legal rules and claim that the appropriate social goal is “‘wealth maximization’: maximizing the total dollar value of, or willingness to pay for social resources.” Kaplow & Shavell, Fairness, supra note 3 at 35. First, as a matter of analytical convenience, economists develop stylized models in which the distribution of income is assumed to not affect social welfare in a particular domain (e.g., accident prevention and incentives in tort law); this permits a beneficial form of academic specialization where “each work seeks to make a contribution without necessarily being concerned with all aspects of the enterprise”. (Ibid at 32, n 35). Second, they claim that “many legal rules probably have little effect on the distribution of income.” (Ibid at 33). Third, even where legal rules may have distributive effects, they can be ignored because “distributional objectives can often be best accomplished directly, using the income tax and transfer (welfare) programs.” (Ibid). It is more efficient to realize distributive aims through taxation rather than through legal rules because it is less distortionary: redistribution through legal rules entails both the inefficiency of redistribution generally (due to adverse effects on work incentives) and the additional cost associated with adopting less efficient legal rules, whereas redistribution solely through the tax system suffers from the single distortion of the labour-leisure choice in the market. (Ibid at 33-36). See also Kaplow, Louis & Shavell, Steven, “Why the Legal System Is Less Efficient than the Income Tax in Redistributing Income” (1994) 23:2 J Legal Stud 667.

For an economic efficiency-based critique, see Chris Sanchirico, “Deconstructing the New Efficiency Rationale” (2001) 86:5 Cornell L Rev 1003. Sanchirico argues that the double-distortion reasoning is flawed for two reasons. First, the double-distortion argument is a non-sequitur because legal rules have a differential or distributive effect even where the application of the legal rule does not turn on taxable attributes; it only considers the redistribution of income and not the distributive impact on parties on a non-income basis. Second, even in respect of the redistribution of income the argument is problematic because, in making their argument, Kaplow and Shavell fail to account for the fact that distortions may counteract each other; the overall impact of distortions cannot be understood as a simple additive exercise. See also Richard S Markovits, “Why Kaplow and Shavell’s ‘Double-Distortion Argument’ Articles are Wrong” (2005) 13:3 George Mason L Rev 511. For a behavioural economics-based critique, see Christine Jolls, “Behavioral Economics Analysis of Redistributive Legal Rules” (1998) 51 Vand L Rev 1653. Jolls points to empirical evidence to weaken Kaplow and Shavell’s assumption that redistributive legal rules and taxation have equal distortionary effects on work incentives. The argument I develop here is not based on the relative efficiency of legal rules versus taxes.

65. Cohen, GA, “Where the Action Is: On the Site of Distributive Justice” (1997) 26:1 Phil & Pub Affairs 3.

66. Ibid at 3.

67. Nagel, Thomas, Equality and Partiality (Oxford: Oxford University Press, 1995)at ch 6, 9, 10.

68. Ibid at 86.

69. Ibid.

70. Several attempts have been made to amend the carried interest provisions of the Internal Revenue Code. Congressman Levin twice introduced bills in Congress to amend the provision: see US, Bill HR 2834, To amend the Internal Revenue Code of 1986 to treat income received by partner for performing investment management services as ordinary income received for the performance of services, 110th Cong, 2007; and US, Bill HR 1935, To amend the Internal Revenue Code of 1985 to provide for the treatment of partnership interest held by partners providing service, 111th Cong, 2009. Further, in each of the 2010, 2011, 2012, 2013 and 2014 US Federal Budgets, the Obama White House proposed eliminating the beneficial tax treatment of carried interest. Copies of the Obama White House Budget proposals are available online: US Government Publishing Office, Budget of the United States Government, 1996-2016 www.gpo.gov/fdsys/browse/collectionGPO.action?collectionCode=BUDGET.

71. See Drutman, Lee & Furnas, Alexander“Untangling the webs of tax lobbying” (152013April ), Sunlight Foundation, online: www.sunlightfoundation.com/blog/2013/04/15/tax-lobbying/.

72. Nagel observes that “there is a definite tendency in liberal societies for the better off—not merely a rich minority but the majority who are not poor—to resist the pursuit of socioeconomic equality beyond a rather modest level. This is partly due to the distorting influence on democratic politics of large concentrations of wealth, but it also reflects a more general psychological disposition.” See Nagel, supra note 67 at 59.

73. Seana Shiffrin has argued that any normative theory must account for the effects that the public justification of a legal institution may have on the moral agency of legal subjects. She argues that the law “should not, as a general matter, be inconsistent with leading a life of at least minimal moral virtue.” Because of the close relationship between contract and promise, Shiffrin’s claim is that any normative theory of contract law should not compel an individual to act in a way that is inconsistent with her promissory morality. See Seana Valentine Shiffrin, “The Divergence of Promise and Contract” (2007) 120:3 Harv L Rev 708 at 718. Liam Murphy has interpreted Shiffrin’s argument as an articulation of a more general principle “that all acceptable normative legal theories will satisfy the following instrumental criterion: the proposed legal structure must not unduly interfere with people living well, ethically speaking.” Murphy’s defense of this claim is that “[i]t is myopic to think that we can ignore the law’s effects on people’s ethical lives—its effects on how they act in extralegal contexts—since there is not going to be any law pursuing aims, or at any rate, any just law pursuing just aims, if people do not make the extralegal decisions necessary to support the maintenance of just institutions over time.” See Liam Murphy, “Contract and Promise”, online: (2007) 120:3 Harv L Rev Forum 10 http://harvardlawreview.org/2009/10/contract-and-promise/.

74. US, Offshore Profit Shifting and the U.S. Tax Code—Part 2 (Apple Inc.): Hearing Before the Permanent Subcommittee on Investigations of the Committee on Homeland Security and Government Affairs, 113th Cong, (United States Government Printing Office, 2013), online: http://www.gpo.gov/fdsys/pkg/CHRG-113shrg81657/pdf/CHRG-113shrg81657.pdf.

75. See, e.g., Income Tax Act, RSC 1985, c 1 s 245 [ITA] and Income Tax Assessment Act 1936 (Cth) Part IVA. Although the United States does not have a general anti-avoidance rule, two judicially created doctrines of “economic substance” (which has recently been codified as IRC (1986) § 7701(o)) and the “business purpose” test have served as general anti-avoidance rules.

76. ITA, ibid at s 245.

77. See Waldron, Jeremy, “The Core of the Case Against Judicial Review” (2006) 115:6 Yale LJ 1346.

78. Waldron, Jeremy, “How Law Protects Dignity” (2012) 71:1 Cambridge LJ 200 at 214.

79. Ibid.

I am grateful to Liam Murphy, Hillary Nye and Niloshan Vijayalingam for comments and criticisms on earlier drafts. I would also like to thank the Editor of The Canadian Journal of Law & Jurisprudence and an anonymous reviewer for helpful feedback and suggestions.

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Against the Reductionism of an Economic Analysis of Contract Law

  • Sina Akbari

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