Wealth Archives – Southern California Law Review

Litigation Finance in the Market Square

October 2025October 2025Suneal Bedi* & William C. Marra†

Litigation finance is the subject of a contentious scholarly and policy debate. Litigation funders provide capital to litigants or law firms in exchange for a share of case proceeds. The current debate centers on how litigation finance impacts the civil justice system. Proponents of funding argue it helps litigants get their day in court, while opponents argue funders pervert the judicial process. Policymakers are torn between these two competing viewpoints, without a clear path forward.

This Article reframes the debate about litigation finance. Scholars and policymakers have focused too narrowly on the “litigation” part of litigation finance, that is, on how funding impacts the legal system. We shift the focus to the “finance” implications of litigation finance. We explore for the first time how litigation finance affects competition not only in the courtroom but also in the marketplace—how companies use funding to access not just the courts but also the capital markets. To do this, we offer a novel interdisciplinary approach drawing on the classic business concept of “nonmarket strategies.” This scholarship, which has been all but ignored by legal scholars, studies how companies leverage “nonmarket” institutions like courts to increase their competitive advantage in the market. While we introduce this scholarship with reference to litigation finance, it holds promise to reframe the debate around legal issues far beyond the realm of litigation funding.

Our central claim is that any regulation of litigation finance is a regulation not only of the courts but also of the capital markets, with significant but unexplored implications for contemporary debates about funding. We show that the regulation of funding affects competition in the marketplace and is especially likely to harm small and medium-sized enterprises, which are more likely to rely upon litigation funding to pursue nonmarket strategies. Our approach also offers new insights into the ongoing debate about funding’s impact on the civil justice system. We conclude by inviting scholars and policymakers to further study these new questions about litigation finance’s impact outside the courthouse gates and in the market square.

Introduction

This Article reframes the contentious scholarly and policy debate about litigation finance. Third-party litigation funders provide capital to litigants or law firms in exchange for an interest in the potential recovery from a legal claim.¹ The standard approach to litigation funding focuses exclusively on how litigation finance affects litigation: that is, how it impacts the civil justice system and access to the courts.² Scholars have explored whether funding improves or impairs the legal system, benefits or harms litigants, prolongs or expedites cases, impairs or supports the attorney-client relationship, and so on.³ In the political arena, a fight over how funding should be regulated pits those who argue funding levels the litigation playing field against those who contend it spurs frivolous suits and encourages speculation on lawsuits.⁴

These are important themes but not the full story. Litigation finance is not just “likely the most important development in civil justice of our time,”⁵ it is also a highly important development for the capital markets and business arena. To fully appreciate the welfare effects of third-party funding, scholars and policymakers must study not only how litigation finance impacts litigation but also how it impacts finance; how it affects not only access to the courts but also access to the capital markets. This Article starts that process.

This Article is the first to shift the debate about litigation finance to a host of vital questions that are not currently being considered: How does litigation finance affect business competition? What impact does the rise of this new corner of the capital markets have on corporate strategy, including the use of litigation to gain a strategic advantage in the marketplace? Why do some companies finance litigations and other business activities with third-party litigation funding, rather than with more traditional third-party debt and equity financing? Who wins—and who loses—in the business arena when we impose regulations designed to restrict access to litigation finance? How do the answers to these questions bear upon the existing debate about funding?

One reason these questions about litigation finance have not yet been explored is that legal scholars do not have an accepted framework for analyzing how companies engage with litigation for strategic business purposes. We provide that framework by drawing on foundational business scholarship about “nonmarket strategies,” which provides an account of how companies leverage the courts, legislatures, and other “nonmarket” institutions to jockey for position in the market.⁶ The nonmarket strategy literature speaks directly to how companies interact with the judicial process to gain an advantage in the market, yet it has been almost entirely ignored by legal scholars.⁷ Although we introduce a nonmarket strategy approach in the context of how companies engage with litigation finance, this framework holds the promise of influencing legal scholarship across the waterfront of issues pertaining to business litigation.⁸

Analyzing litigation finance through the lens of nonmarket strategies, we highlight three ways the use of litigation finance affects competition in the market square. First, companies use litigation finance not only to finance litigation but also to raise working capital to support business growth, leveraging the courts (a nonmarket institution) to strengthen their capital position in the market. In this way, litigation finance is simply a new dimension of the financial markets and one that is especially likely to provide a lifeline to small and medium-sized enterprises (“SMEs”) that have relatively thin access to traditional equity and debt capital markets.⁹ Second, companies use litigation finance to pursue litigation as a nonmarket strategy—that is, they use litigation to obtain a strategic advantage relative to other marketplace actors, the same way well-resourced companies have done since long before the advent of the modern litigation finance industry.¹⁰ Third, we recast lobbying efforts to regulate litigation finance and the actions of related trade associations to support or attack litigation finance as, themselves, nonmarket strategies used by companies that stand to lose or gain from the growth of litigation finance.¹¹

These insights provide a fresh perspective on debates about litigation funding. First, we identify an entire set of funding’s policy implications that scholars and policymakers have overlooked. Existing discussions of litigation finance present only one view of the cathedral.¹² Litigation finance’s impact on litigation is explored at length but its impact on finance and business strategy is ignored. Scholars and policymakers cannot fully understand or effectively address litigation finance unless they explore its implications for both litigation and finance. Indeed, one could set aside entirely the debate about whether litigation finance is good for the legal system and still be left with a host of questions about whether litigation finance is good for business and finance.

Our study of the business and finance implications of litigation finance reveals that almost all companies use some form of third-party financing—“other people’s money”—to pay for litigation and other legitimate business pursuits.¹³ Some companies use traditional debt and equity financing. But for many companies—primarily SMEs—structuring a capital raise as a litigation finance investment is the most efficient, or even the only, way to raise new third-party capital. Litigation finance is thus used disproportionately by SMEs to pursue nonmarket strategies that might allow those firms to better compete against larger incumbent players. Regulation of modern commercial litigation finance may undermine SMEs’ ability to compete in the marketplace, likely diminishing welfare.

Second, our study of the finance implications of litigation finance also brings fresh insights to the existing debate about how litigation finance impacts the civil justice system.¹⁴ The traditional debate first defines third-party litigation funding and then zooms in on its impact on the legal system. We instead zoom out and place the modern litigation finance industry in the broader context of the many ways companies use third-party capital to finance litigation and other legitimate business pursuits. When we do this, we show that many arguments that third-party litigation finance adversely affects the civil justice system—that it might promote frivolous litigation, invite foreign control of litigation, and impair the principle of party control—apply equally or even more forcefully to the many other ways claimholders raise third-party capital to support litigation (for example, via traditional debt and equity capital). These insights both expose existing efforts to regulate litigation funding as vastly underinclusive relative to their stated goals and help us see the (mostly negative) welfare effects of targeting only one specific form of third-party funding—that is, the kind of third-party funding supplied by the modern litigation finance industry and especially demanded by SMEs.

This Article proceeds in five parts. Part I describes litigation finance and how it has been framed in the scholarly and policy debate, demonstrating that the narrow focus on litigation finance as a purely “litigation” phenomenon has led to ad hoc regulations and confusion by legislatures on how to manage litigation finance. Part II introduces the concept of nonmarket strategies and describes the various “nonmarket” strategic behaviors that companies pursue. Part III identifies three ways companies use litigation finance (and the regulation of funding) as a nonmarket strategy to jockey for position in the financial and commercial markets. Part IV offers policy implications of this new framework. Part V draws out implications of our framework for legal and business scholars.

I. Today’s Debate About Litigation Finance

We first provide a background on litigation finance, defining what it is and reviewing its scholarly and public policy debate.

A. What is Litigation Finance?

Imagine you are the CEO of a small, family-owned technology company. You invented high-flying weather balloons that operate as airborne communication systems. A much larger company suggests a joint venture, signs a nondisclosure agreement, and learns your trade secrets. In the end, no deal happens—but the larger company soon copies your tech anyway and recreates its own version of your weather balloons.¹⁵

Assume that to rebuild you need $15 million, including $5 million to bring a $150 million trade secret misappropriation case against your one-time joint venture partner and another $10 million to research and develop a next-generation weather balloon transceiver. You have a strong, and therefore valuable, legal claim.¹⁶ But you do not have $15 million. You approach the traditional debt or equity markets, but you experience the same problems many SMEs face: a thin capital market, high lending rates, and reluctant equity investors.¹⁷ What can you do?

An emerging solution is litigation finance, the practice where a third party provides capital to a litigant or law firm in exchange for an interest in the potential recovery of a legal claim.¹⁸ “Litigation funding agreement[s],” one court recently acknowledged, “are a fact of contemporary complex litigation.”¹⁹ Instead of trading away equity in the company or pledging assets to a traditional lender, you can pledge expected proceeds from your legal claim as collateral for the $15 million you need.

Litigation finance investments are typically “non-recourse,” which means the litigation funder receives its return only if the case succeeds.²⁰ If the case loses, the funder receives nothing.²¹ The non-recourse nature of litigation finance can make it attractive even to companies that can access the traditional equity and debt capital markets, because (unlike new equity investment) litigation finance does not dilute existing shareholders,²² and (unlike debt finance) funders do not have the right to regular payments of interest and principal or the power to put the company into bankruptcy or sue for recovery if those payments are not made.²³

The key insight, then, of the modern litigation finance industry is an insight not so much about the civil justice system but about corporate finance: legal claims are assets against which companies can secure financing, no different than inventory, real estate, and accounts receivable. In short, litigation funders are asset-based investors, and the asset is law.²⁴

Asset-based investing typically requires specialized expertise,²⁵ and litigation finance is no different. Instead of valuing a company’s real property or inventory, litigation finance companies expend great time and effort studying the merits of legal claims before advancing capital against those claims.²⁶ The need for subject-matter expertise has led to specialization among litigation funders.²⁷ Some litigation finance companies invest primarily in business-to-business disputes. These “commercial litigation funders” include publicly-traded companies like Burford Capital and Omni Bridgeway, multi-strategy hedge funds like the D.E. Shaw Group, and privately-held groups like Parabellum Capital and Certum Group.²⁸ Other financiers focus instead on financing mass tort claims, where they typically help law firms advertise for clients who have been injured in a particular mass tort.²⁹ Still other entities are consumer litigation funders, primarily providing small-dollar advances to individuals with personal injury and medical malpractice claims.³⁰

Commercial litigation finance companies typically undertake months-long due diligence processes before they invest in a case.³¹ Funders are staffed with highly experienced lawyers who develop specialized expertise in evaluating whether a case is a winner or loser.³² Funders frequently consult subject matter experts to assist with their evaluation, including outside diligence counsel and third-party damages experts.³³ The net effect is that commercial funders invest in only a tiny fraction of cases they see—typically less than 10% of opportunities.³⁴ In the end, it is likely that a funder’s evaluation process is even more rigorous than the evaluation provided by contingent fee law firms or by companies deciding whether to pursue a case with their own retained earnings.³⁵

In this Article, we focus on the commercial litigation finance space, which is by all accounts the largest and most prominent segment of the litigation finance industry and is also the emerging target of regulation by policymakers.³⁶ In 2023, there were an estimated thirty-nine active commercial litigation finance companies, with a total of $15.2 billion in assets under management.³⁷ These companies made $2.7 billion in new litigation finance commitments that year, with funding distributed across 353 new deals.³⁸ Commercial litigation finance companies invest in a range of business-to-business disputes, including contract, business tort, antitrust, patent infringement, trademark, copyright, and trade secret misappropriation cases.³⁹ Commercial litigation funders can finance either claimants or law firms,⁴⁰ and they can invest at any stage of the case, from pre-suit through appeal and post-judgment proceedings.⁴¹

Litigants and law firms can use litigation finance in two different ways: to pursue their legal claims and to raise general-purpose working capital. To begin with the first point, litigation is very expensive.⁴² Many litigants are liquidity-constrained: they lack access to the thousands or even millions of dollars it takes to pursue litigation.⁴³ Even if prospective litigants have the money to pursue the case, they may be risk-constrained: that is, they may not want to risk their capital in an uncertain litigation.⁴⁴ Law firms can litigate cases in exchange for a contingent fee—effectively operating as a third-party funder—but law firms are usually uniquely ill-suited to invest in litigation, for reasons that scholars have explored at length.⁴⁵ Litigation finance provides an alternative path for litigants and law firms to finance their cases.

The second way litigants can use litigation finance is by using the funding as working capital to finance general corporate endeavors, including to hire new workers, build new products, or invest in research and development.⁴⁶ In this sense, litigation funders operate similarly to traditional equity and debt providers, advancing capital in return for an interest in potentially valuable assets.⁴⁷ Although the focus of this Article is the use of litigation funding directly by claimholders, law firms may also use litigation finance as working capital—drawing down funding against

existing contingent fee matters to hire new employees and expand client services.⁴⁸

While commentators typically distinguish between funders’ supply of fees and costs funding on the one hand and working capital on the other hand, it is important to remember that money is fungible.⁴⁹ A dollar of third-party financing allocated for one purpose frees capital for other purposes.⁵⁰ Thus, even if a claimholder obtains third-party litigation funding that may be used only to pay its lawyers in a case, this financing frees up the company’s remaining capital to pursue other legitimate corporate purposes like paying employee wages, delivering goods and services, and so on.⁵¹ Similarly, when funders support law firms, this funding typically enables lawyers to enter into a “full contingency” relationship with their clients (with the firm’s fees partially funded by the litigation funder), enabling the claimholder to pursue a case without having to devote its finite resources to paying lawyers.⁵² Thus, even funding directed to law firms helps corporate claimholders free up capital for general corporate purposes.

B. The Scholarly Debate

Legal scholars are paying attention to what Maya Steinitz calls “likely the most important development in civil justice of our time.”⁵³ The scholarship about litigation finance is vibrant and growing. Yet virtually the entire collection treats litigation finance as fundamentally a litigation phenomenon. That is, scholars study litigation finance almost solely as a development in “civil justice,” examining how funding impacts the legal system.⁵⁴ The unit of analysis is the legal system, with proponents of litigation finance arguing that funding creates a better legal system and opponents arguing that funding hurts civil justice.⁵⁵ Indeed, even articles that apply an economic lens to litigation finance apply that lens to study how funding impacts litigation, not how funding impacts the financial markets or the broader business world.⁵⁶

Existing scholarship studies the litigation effects of litigation finance from many different and important angles. Scholars have debated whether litigation funding increases the amount of litigation and whether it results in the filing of frivolous lawsuits.⁵⁷ They have studied how litigation funding affects litigants’ access to the courts⁵⁸ and the price at which claims settle.⁵⁹ Scholars have studied how funding impacts the price of legal services and how it injects competition into the market for legal services.⁶⁰ They have explored whether litigation funding violates background legal rules about champerty and maintenance.⁶¹ They have studied whether litigation funding runs afoul of the legal ethics rules⁶² and whether funders interfere with (or strengthen) the attorney-client relationship.⁶³

An especially large body of scholarship studies whether litigation funding agreements and communications should be disclosed to the court and defendants during litigation, both as a policy matter and under the attorney work product doctrine and attorney-client privilege.⁶⁴ Control is another hot topic, with scholars debating whether funders should be allowed to control litigation strategy decisions.⁶⁵

This scholarship is important, but it studies litigation finance through a narrow lens: the effect that litigation finance has on the legal system. A few scholars have discussed the causes of litigation finance—that is, why companies use third-party litigation funding to finance their cases. But that scholarship (which includes our own) is mostly limited to explaining that companies typically use litigation funding because they are either liquidity-constrained—that is, they do not have the capital to pursue the case—or they are risk-constrained—that is, they do not want to risk their capital on litigation.⁶⁶ This explanation is true as far as it goes, but it goes only far enough to explain why companies would use third-party capital rather than retained earnings to finance litigation or working capital needs. While commentators have recognized the valuable non-recourse nature of litigation finance, no one has studied at depth why companies might use third-party litigation finance rather than the host of other ways they can raise third-party capital like traditional debt or equity finance to support their litigation and business endeavors.⁶⁷

Moreover, the emphasis on the litigation effects of litigation finance has also led to the near-exclusive study of litigation finance as a tool to finance the fees and costs of litigation. But, as explained above, that is only half the story: companies also use litigation finance to raise working capital that can be used to support non-litigation business needs like hiring employees.⁶⁸ And because money is fungible, “fees and costs” funding also frees up other capital for managers to reinvest in a company’s core market pursuits.⁶⁹ Scholars sometimes mention in passing that funding can be used to raise working capital, but the market impact of funding’s role as a source of general business capital has not been analyzed.⁷⁰

The existing scholarship about litigation finance is insightful and important—but it tells only half the story. To fully understand litigation finance, we must study its implications not just for litigation but also for finance—its implications for competition not only in the courtroom but also in the market square.

C. The Policy Debate

Alongside this scholarship stands a four-front policy debate about litigation finance. This policy debate tracks the scholarship by focusing on

funding’s impact on the civil justice system while ignoring its impact on the marketplace.

First, opponents of litigation finance are asking federal and state legislative bodies to enact regulations of litigation finance.⁷¹ While there are not yet any federal regulations that specifically target litigation funding, several states have acted. The first round of state statutes were essentially consumer protection statutes that targeted consumer litigation finance agreements, that is, agreements that typically concerned smaller-dollar advances to personal injury tort plaintiffs. State regulations in this mold were enacted in Arkansas, Indiana, Nebraska, and Vermont, among other states.⁷² These consumer-rights statutes require consumer litigation funders to register with the state,⁷³ provide funded parties with certain disclosures in the litigation finance contract,⁷⁴ and sometimes limit the interest rates funders can charge customers.⁷⁵ With respect to disclosure during litigation, those older regulations state that litigation funding documents are protected by the attorney-client privilege, thus making it harder for defendants to obtain information on a plaintiff’s funding agreements.⁷⁶

More recent “second wave” regulations focus on the commercial rather than consumer sector, and they demand more rather than less disclosure of litigation funding agreements. Emblematic second wave regulations include newly-enacted laws in Indiana⁷⁷ and Louisiana⁷⁸ and a failed bill in Florida.⁷⁹ The United States Chamber of Commerce, a business advocacy group, was a chief proponent of these bills.⁸⁰ While earlier consumer litigation funding statutes confirmed enhanced protection for litigation funding documents, the Indiana and Louisiana statutes, and the failed Florida bill, all provide that commercial litigation funding agreements are subject to discovery and disclosure to opposing parties.⁸¹ The statutes also contain other regulations designed to restrict litigation finance. For example, Indiana’s statute prohibits funders from exercising any control or even “influence” over litigation decisions,⁸² while the Louisiana statute requires litigation funders to be responsible for costs imposed on funded litigants⁸³ and provides that any violation of the statute renders a litigation finance contract unenforceable by the funder.⁸⁴

Advocacy groups, like the Chamber of Commerce, have recently argued that litigation funding may present a national security risk. They argue that foreign adversaries may use funding to harm American companies and obtain access to U.S. corporate trade secrets.⁸⁵ Supporters of litigation funding have pushed back against this narrative, claiming it is a scare tactic without basis in fact.⁸⁶ However, in response to these concerns, some states have enacted new laws. Indiana’s new law bans litigation funding from foreign adversaries of the United States, including China, Russia, and North Korea,⁸⁷ and Louisiana’s statute requires disclosure of anyone entitled to receive, pursuant to a funding agreement, any information affecting national defense or security disclosed during a litigation.⁸⁸

Second, in addition to the policy fight among legislators, there is a push to have judges themselves enact disclosure rules that target litigation funding.⁸⁹ In 2021, the U.S. District Court for the District of New Jersey became the first federal district court to adopt a disclosure rule targeting litigation finance companies’ involvement across all cases.⁹⁰ Chief Judge Colm Connolly of the U.S. District Court for the District of Delaware has also adopted the rule.⁹¹ This rule requires parties to disclose to the court if any non-party is funding the matter on a non-recourse basis.⁹² If such a funder exists, the litigant must disclose the identity of the funder, “[w]hether the funder’s approval is necessary for litigation decisions or settlement decisions in the action and if the answer is in the affirmative, the nature of the terms and conditions relating to that approval,” and “[a] brief description of the nature of the financial interest.”⁹³ The rule also states:

The parties may seek additional discovery of the terms of any such agreement upon a showing of good cause that the non-party has authority to make material litigation decisions or settlement decisions, the interests of parties or the class (if applicable) are not being promoted or protected, or conflicts of interest exist, or such other disclosure is necessary to any issue in the case.⁹⁴

Lawmakers opposed to litigation funding have also asked the Judicial Conference—the judicial branch’s national policymaking body for the federal courts—to investigate whether mandatory disclosure of litigation finance agreements should be required.⁹⁵ In response, the Judicial Conference has formed a working group to study whether the Federal Rules of Civil Procedure should address litigation funding.⁹⁶

Third, alongside efforts to persuade lawmakers and judges to enact regulations, the practice of litigation funding continues to be tested during litigation. Defendants routinely seek disclosure of litigation funding agreements and communications from plaintiffs.⁹⁷ Most courts reject these attempts, concluding that the communications are either not relevant to the case or protected by the work-product doctrine or attorney-client privilege.⁹⁸ But some courts have allowed some disclosure of litigation funding information, concluding that funding agreements may be relevant to issues including the adequacy of class counsel or the value of the plaintiff’s claim.⁹⁹ Courts have also addressed related legal questions including whether litigation finance violates prohibitions against champerty¹⁰⁰ and whether funders can exercise control over settlement decisions.¹⁰¹

Fourth, bar associations and legal ethics committees are increasingly being asked to decide whether litigation funding agreements violate applicable ethics rules. In 2020, the American Bar Association released a set of “Best Practices” for third-party litigation funding, which addressed topics including the handling of confidential information, the rule against fee sharing, and funding contracts.¹⁰² In addition, bar association ethics committees have weighed in on topics including whether agreements between funders and law firms violate the rule against lawyers sharing fees with non-lawyers,¹⁰³ whether litigation counsel should advise clients in the negotiation of litigation funding agreements,¹⁰⁴ how lawyers should approach the sharing of confidential information with litigation funders,¹⁰⁵ and whether lawyers may refer their clients to litigation funders.¹⁰⁶

On all four fronts, the policy debate has tracked the scholarly debate and suffers the same limitations. That is, the policy debate studies litigation finance solely as a litigation phenomenon, with one side arguing that litigation funding promotes a more level litigation playing field and the other side arguing that funding perverts the civil justice system. A simple illustration: litigation finance is discussed by congressional judiciary committees but wholly ignored by financial services committees.¹⁰⁷ One congressional committee debate in June 2024 exemplifies the narrow scope of the debate about funding, with the supporters of funding emphasizing its positive impact on the legal system and the detractors of funding alleging its detrimental effects on civil litigation.¹⁰⁸

The lobbying groups on either side of the debate similarly focus on the litigation effects of funding. As noted, the Chamber of Commerce is probably the most vocal critic of litigation funding and a driving force behind much of the recent state regulation of funding.¹⁰⁹ The Chamber has issued a number of attacks against litigation funding, and they all focus on funding’s impact on the courtroom, not the marketplace or the capital markets.¹¹⁰ Indeed, although the Chamber usually supports deregulating the capital markets and expanding small businesses’ access to capital,¹¹¹ the Chamber has not addressed how litigation finance might impact those goals. Meanwhile, the International Legal Finance Association—the trade association for the litigation finance industry—has likewise articulated the case for litigation funding as fundamentally about access to the courtroom, not access to the capital markets or the business marketplace.¹¹²

* * * * *

Existing scholarship and policy debates discuss funding’s impact on litigation but largely ignore its effect on finance and business strategy. When we reframe the debate about litigation finance around business strategy, we pave new paths to study litigation finance, its use cases, and its impact on society. These are questions that have not simply gone unanswered—they have gone unasked.

II. Nonmarket Strategies: A Primer

We explained in Part I that scholars and policymakers have largely overlooked litigation finance’s implications for corporate finance and business strategy. We believe this has happened in part because legal scholars lack a widely adopted framework for analyzing how companies strategically engage with litigation. In Part II, we provide that framework by drawing on a robust body of literature in business academia concerning “nonmarket strategies.” While business scholars pay great attention to nonmarket strategies, legal scholarship has almost entirely ignored the topic, despite its intimate connection to not only litigation finance specifically but also litigation more generally.¹¹³ In this section, we define and describe nonmarket strategies, identify different forms of nonmarket strategies, and discuss why companies use these nonmarket strategies.¹¹⁴

A. What Are Nonmarket Strategies?

Companies seek to maximize value for their shareholders and other stakeholders. This theme resonates in legal, ethics, and business scholarship¹¹⁵ The actions a company takes to maximize value are called strategies.¹¹⁶

Business research has long focused on how companies use the marketplace in which they operate to extract and maximize value. These behaviors are considered market strategies.¹¹⁷ Market strategies are “a concerted pattern of actions taken in the market environment to create value by improving economic performance.”¹¹⁸ The key element here is the use of the private market environment, which “includes those interactions between the firm and other parties that are intermediated by markets or private agreements. These interactions typically are voluntary and involve economic transactions and the exchange of property.”¹¹⁹ When companies operate with market strategies, they perform business activities like producing goods, hiring workers, contracting with counterparties, and engaging in mergers and acquisitions.

Recall the weather balloon company we discussed earlier. That company surely engaged in a host of market strategies to grow. These market strategies might include offering competitive wages to attract talented employees, conducting research and development into new technologies, entering into joint ventures and other strategic partnerships with other companies, contracting with suppliers, and marketing products. Each of these behaviors relies on private commercial markets, including the markets for labor, supplies, and customers.

The rise of institutional economics has drawn attention to strategic behavior beyond the market environment.¹²⁰ Business scholars have increasingly recognized that, in addition to traditional “market strategies,” companies also engage in strategies that use the “nonmarket.”¹²¹ The nonmarket environment “includes those interactions that are intermediated by the public, stakeholders, government, the media, and public institutions. These institutions differ from those of the market environment because of characteristics such as majority rule, due process, broad enfranchisement, collective action, and publicness.”¹²² The nonmarket environment includes the courts, the lawmaking process, interest group activities, and social and cultural institutions.¹²³

A nonmarket strategy, then, is a set of actions that utilizes the nonmarket environment to drive economic value.¹²⁴ These institutions create the “rules of the game” for competition in the marketplace.¹²⁵ Companies engage in nonmarket strategies when they leverage nonmarket institutions (for example, courts) to compete more effectively in the marketplace.¹²⁶

Our weather balloon company is likely to pursue a host of nonmarket strategies alongside more traditional market strategies. For example, it might lobby lawmakers for subsidies, sue companies engaging in anticompetitive behavior, or challenge government regulations adverse to its business interests.

B. The Types of Nonmarket Strategies

Business scholars have identified three types of nonmarket strategies that firms might pursue: adaptive strategies, transformative strategies, and additive strategies.¹²⁷ We discuss each in turn.

Adaptive Strategies

Adaptive strategies are nonmarket strategies that take the state of existing institutional nonmarkets as a given and attempt to either leverage or circumvent those nonmarket institutions to the actor’s advantage.¹²⁸ One common example is the use of litigation by a company to attack the market position of a direct or indirect competitor.

The Lanham Act is a common locus of adaptive nonmarket strategies, as it provides companies with a cause of action to sue a direct or indirect competitor for false advertising.¹²⁹ One leading Lanham Act case involved Johnson & Johnson’s false advertising suit against Procter & Gamble concerning over-the-counter (“OTC”) heartburn medication.¹³⁰ In 2003, Procter & Gamble launched the OTC heartburn drug Prilosec OTC, which was poised to compete with Johnson & Johnson’s incumbent Pepcid offering.¹³¹ Procter & Gamble’s marketing campaign suggested that one pill of Prilosec OTC would provide twenty-four hours of heartburn relief.¹³² Johnson & Johnson challenged this statement as false advertising, because the pill took up to five hours to start working.¹³³ A federal district court agreed with Johnson & Johnson and granted a preliminary injunction against the advertising campaign, ruling that Procter & Gamble’s advertisements were “literally false and certainly convey[ed] a false message.”¹³⁴

Johnson & Johnson’s litigation may be described as an adaptive nonmarket strategy because, rather than competing through the market system (for example, by using comparative advertising, a well-studied and researched marketing strategy¹³⁵), the company used existing legal institutions—specifically, the court system and liability rules—to gain market share from Procter & Gamble. Lawsuits like these help the plaintiff firm extract economic value from the marketplace, regardless of whether the competitor suit is welfare-enhancing for consumers.¹³⁶

Transformative Strategies

Companies may also engage in transformative nonmarket strategies, which are strategies that seek to alter a nonmarket institution that impacts the company.¹³⁷ In these cases, companies seek to lobby politicians, regulators, and courts to transform the rules of the game.¹³⁸

Lobbying is a classic example of a transformative nonmarket strategy. Ample work has examined the nature of lobbying as it relates to political processes and the law.¹³⁹ When companies lobby, their goal is frequently to have lawmakers (re)write the rules of the game in their favor.¹⁴⁰ For example, when the federal government responds to lobbying efforts by granting tax subsidies that offset the cost of installing electric vehicle chargers, the government effectively reduces the purchase price of electric vehicles. This gives electric vehicle manufacturers, like Tesla, a competitive leg up over manufactures of more traditional gas-powered vehicles.¹⁴¹

Transformative nonmarket strategies may also be directed toward the civil justice system. A company sometimes lobbies lawmakers to change court rules to favor itself. One recent example is illustrative: after Apple lost two prominent patent cases before the U.S. International Trade Commission (“ITC”), the company asked Congress to change the rules governing how the ITC adjudicates complaints and enforces penalties.¹⁴² These rules, if adopted, would make it more difficult for parties to prevail in ITC suits against Apple, giving the company a competitive advantage in the marketplace.¹⁴³

Litigation can also be a form of transformative nonmarket strategy. We discussed above how litigation functions as an adaptive nonmarket strategy when a company uses it to enforce existing rules against competitors. By contrast, litigation is used as a transformative nonmarket strategy when companies bring court challenges to government regulations that impair their business efforts. From one perspective, these litigations simply ask courts to affirm that an inferior law must give way to a supreme law.¹⁴⁴ From another perspective, however, these litigations are nonmarket strategies that ask courts to transform the legal “nonmarket” environment in which firms operate.

For a recent example of litigation as a transformative nonmarket strategy, consider the Chamber of Commerce’s lawsuit challenging the Federal Trade Commission’s rule banning non-compete agreements between employers and employees.¹⁴⁵ Although the Chamber does not disclose its individual donors, the Chamber is financed by corporations and engages in strategic litigation on their behalf.¹⁴⁶ To satisfy standing requirements, the Chamber invokes the associational standing doctrine, which allows the Chamber to vindicate its members’ interests.¹⁴⁷ The Chamber’s challenge to the rule against non-competes is a transformative nonmarket strategy because it seeks to use the nonmarket environment of courts to create a market environment in which companies have greater leverage over their employees, giving them a potential competitive advantage in the marketplace.

Thus, litigation can be used as part of both adaptive and transformative nonmarket strategies. The distinction between the two generally tracks the distinction between the enforcement of “private law” and “public law.”¹⁴⁸ “Private law” refers to litigation that ordinarily occurs between private individuals or companies.¹⁴⁹ As Abram Chayes has explained, private law litigation is typically retrospective—that is, it involves a controversy over an “identified set of completed events” and in which the right and remedy are interdependent. The typical remedy is “that the plaintiff will get compensation”—money damages—“measured by the harm caused by the defendant’s breach of duty.”¹⁵⁰ Adaptive nonmarket strategies typically take this form, with one company litigating a private law claim against another company.

Transformative nonmarket strategies typically involve litigation over the validity of laws and regulations themselves. In such cases, the defendant is usually a governmental body and the primary relief sought is almost always declaratory or injunctive, not retrospective damages. Companies usually engage in public law litigation as part of a transformative strategy to require or prevent the enforcement of laws on issues of public concern—such as civil rights, environmental law, or administrative law.¹⁵¹

Additive Strategies

Additive nonmarket strategies work “by supplementing [existing institutional] structures with new, decentralized ones to which participants commit voluntarily rather than in response to a mandate from the state, thus creating a polycentric institutional structure.”¹⁵² Rather than simply take the institutions as a given, companies seek to augment institutional structures to give themselves a competitive advantage.¹⁵³

In one common additive strategy, companies engage in self-regulation, either acting alone or in concert with competitors. For example, companies may band together into an industry trade association and sign on to certain “standards of conduct,”¹⁵⁴ or they may all agree to certain voluntary business practices.¹⁵⁵ When acting alone, companies may act solely to reduce a perceived negative externality with the hope of setting an industry norm, resulting in benefits to the firm.¹⁵⁶ Traditional corporate social responsibility (“CSR”) behaviors also fall into this nonmarket strategy.¹⁵⁷ CSR strategies include, for example, voluntary environmental and socially-sustainable practices.¹⁵⁸ Companies frequently undertake these behaviors with the hope that stakeholders will reward the company and hence further enhance the firm’s economic value. But additive strategies also seek to anticipate or influence institutional changes. Companies may voluntarily take costly behaviors in anticipation that regulators will eventually enact rules of conduct that the firm has already adopted, leaving the firm better positioned to succeed in the market.¹⁵⁹

C. The Choice Among Nonmarket Strategies

Not all strategies are created equal. Companies consider a range of internal and external factors when deciding whether and how to use nonmarket strategies.

External factors include the nature of both market and nonmarket institutions.¹⁶⁰ Some jurisdictions, including the United States, have clear laws and regulations that allow for relative predictability in outcome.¹⁶¹ Other jurisdictions, including many developing countries, may have no laws, or either unclear or incomplete laws, governing business conduct.¹⁶² Whether an institution is relatively “complete” or “captured” (as in the United States) or relatively “incomplete” (as in many developing countries)¹⁶³ influences which type of nonmarket behavior a company may engage in.

Internal factors also affect which strategies a company may use. For example, some companies may develop a comparative advantage in implementing certain nonmarket strategies over others.¹⁶⁴ These so-called firm-specific capabilities drive which nonmarket strategies firms pursue.¹⁶⁵ Research on firm-specific capabilities analyzes a company’s unique strengths and asks what strategies the company may use to leverage these unique strengths.¹⁶⁶ The goal is to create sustained, long-term competitive advantages in the marketplace.

Consider, for example, a company that can recruit former politicians into its ranks.¹⁶⁷ Relative to its competitors, that company has a comparative advantage in transforming the institutional rules in which it operates. The firm’s political connections provide it with superior insight into how certain regulations will be interpreted and implemented. These capabilities may also

give the firm a comparative advantage in influencing which regulations are made or unmade. Such a firm is more likely to use transformative strategies, as it has unique capabilities to influence regulations.¹⁶⁸

A firm’s capabilities will also help predict whether a company will use a market or a nonmarket strategy in the first place.¹⁶⁹ Certain companies, as we describe using examples below, can more cheaply and efficiently engage in nonmarket strategies in comparison to more traditional market ones. As we argue, SMEs may find it cheaper to engage in capital funding using nonmarket strategies than market ones.

III. Litigation Finance as a Nonmarket Strategy

Litigation finance is an important development not only for the civil justice system but also for the capital markets and marketplace at large. Companies use litigation finance to compete not only in the courthouse but also in the market square. Drawing upon the nonmarket strategy literature discussed above, we illustrate three ways companies engage with litigation finance to help themselves better compete in the marketplace.

The chart below provides a roadmap for our discussion. This chart indicates the types of strategies, the result each strategy seeks to achieve, an example of the strategy, and the business benefit the strategy creates. We also note that some of these strategies involve the use of litigation finance while others involve the regulation of funding.

A. Litigation Finance as Corporate Finance: An Adaptive Strategy

The best things in life may be free, but everything else costs money. Corporate finance is the discipline that studies how companies finance their business pursuits.¹⁷⁰ We first provide a brief overview of the traditional ways companies finance their activities. We then demonstrate how litigation finance operates as an alternative “nonmarket” way to access investment capital and finance business pursuits, including but not limited to the financing of litigation. Using litigation finance in the way we describe below is a type of adaptative nonmarket strategy.

“Market” Methods of Corporate Finance

Companies need money to pursue the waterfront of legitimate corporate activities, including hiring employees, manufacturing products, marketing their goods, investing in research and development, and yes, sometimes pursuing litigation. Firms use one of three broad categories of finance: retained earnings, equity, and debt.¹⁷¹ All three involve the company appealing to traditional market institutions: the marketplace for goods and services to obtain revenue that can then be used to finance future business activities, or the capital markets, in which third parties provide debt or equity capital in exchange for an anticipated return on their investment.¹⁷²

Recall the weather balloon company that needs $15 million in financing, including $5 million to pursue litigation and $10 million for research and development. To come up with the cash, first, the company could use its retained earnings, that is, profits or revenue in excess of expenses.¹⁷³ Second, the company might raise debt from third parties. These loans can be either unsecured or secured.¹⁷⁴ Unsecured loans rely on the borrower’s creditworthiness and future cash flows.¹⁷⁵ Secured loans are backed by company assets.¹⁷⁶ Secured loans may be further categorized: some are secured by all company assets, while others are “asset-based” loans secured by only a specific subset of the company’s assets.¹⁷⁷ Third, the company might raise equity financing, selling ownership interests in the firm in exchange for capital.¹⁷⁸

Several points bear emphasis. First, both debt and equity financing usually involve companies raising capital from third party investors.¹⁷⁹ Creditors remain third parties after the transaction is consummated; that is, they do not become first-party owners of the company.¹⁸⁰ Equity investors, by contrast, are third parties relative to the company before making their investment and come inside the company as first-party owners after the transaction is consummated. Thus, if a firm like our weather balloon company needs capital to fund litigation and research, there is a good chance it would approach the capital markets and raise capital from third-party investors, with those investors expecting their return to come from some or all of the firm’s assets.¹⁸¹

Second, a firm’s choice between using retained earnings, debt, and equity to finance business endeavors is typically driven by questions of corporate finance and business strategy. Classical corporate finance theory teaches that, in perfect markets without transaction costs, firms should be indifferent between using retained earnings, debt, and equity.¹⁸² In reality, markets are not perfect and firms are not indifferent.¹⁸³ There is an entire discipline—corporate finance—devoted to studying firms’ decisions about how to finance their business activities.

A corporate finance literature review is beyond the scope of this Article. It is sufficient for present purposes to identify a few tradeoffs that companies face when deciding whether to finance their business activities through retained earnings, debt, or equity.¹⁸⁴

For example, companies may prefer to use retained earnings because they can act quickly when they see an investment opportunity, avoiding the time-consuming and scrutiny-inducing process of raising money in the capital markets.¹⁸⁵ On the other hand, existing shareholders may prefer to receive those earnings as dividends today and shift the risk of tomorrow’s success onto third-party debt or equity capital.¹⁸⁶ Debt finance frequently has tax advantages,¹⁸⁷ and it usually caps creditors’ upside, ensuring shareholders receive any surplus profits generated when the company invests the loan.¹⁸⁸ On the other hand, debt instruments usually saddle the debtor with relatively inflexible payment obligations, requiring the company to regularly generate cash to pay interest on the debt.¹⁸⁹ An advantage of equity financing is that equity investors have fewer downside protections than lenders, which means equity is usually “riskier capital” than debt.¹⁹⁰ Thus, early-stage companies and other businesses without a proven track record can raise third-party capital in the equity markets even when the debt markets are closed to them.¹⁹¹ On the other hand, raising new equity dilutes existing shareholders, who may prefer not to have their ownership interest and decision-making power reduced.¹⁹²

The upshot for our purposes is that firms select their method of corporate finance for reasons very specific to that firm and the firm’s regulatory environment. Preferences and market access will vary according to a host of factors, including the firm’s size and strength, its industry, its geography, and the regulatory landscape.

Third, while all companies in principle can use retained earnings or obtain third-party debt or equity, in practice, SMEs usually do not have access to substantial retained earnings or to liquid debt and equity markets.¹⁹³ There is a robust literature explaining how and why SMEs face challenges accessing traditional capital markets.¹⁹⁴

Again, a comprehensive literature review is beyond the scope of this Article. It is sufficient to repeat the oft-made insight that information asymmetries, transaction costs, and other market inefficiencies result in SMEs either being totally cut off from the debt and equity markets or facing much higher costs of capital relative to more established incumbent players.¹⁹⁵ Prospective investors in smaller companies face much larger information asymmetries compared to when they invest in larger companies that are publicly traded and have armies of analysts studying their every move.¹⁹⁶ Increased information asymmetry means increased risk, and increased risk means higher borrowing costs.¹⁹⁷ In short, it is generally much harder for SMEs to find willing investors or lenders, and when they do, they typically face a much higher cost of capital compared to larger companies.¹⁹⁸ Similarly, SMEs almost by definition do not have significant retained earnings to invest in business-critical projects, including research and development, launching new products, or paying lawyers for bet-the-company litigation.

When SMEs can access third-party capital, they tend to gravitate towards bank loans with personal guarantees or towards higher-cost secured credit, in which a third-party investor lends against discrete collateral and has the right to foreclose on that collateral if the debtor fails to repay the loan.¹⁹⁹ With asset-backed transactions, the financier treats the collateral as the primary or, indeed, sole source of repayment and thus does not need to rely on the counterparty’s general creditworthiness, enabling loans to go to companies that cannot qualify for unsecured debt or equity investments.²⁰⁰

We thus have a rough hierarchy of firms’ ability to access the capital markets. Larger, more established firms generally have the best access to equity and debt markets. SMEs often have thin or no access to the capital markets. But SMEs with high-quality assets can frequently obtain secured loans even when unsecured lending or equity investment is not an option.

Litigation Finance as a “Nonmarket” Method of Corporate Finance

Enter litigation finance. We explained earlier that the central insight of the modern litigation finance industry is an insight about corporate finance—namely, that a strong legal claim is a valuable asset that can be used to secure third-party financing. Litigation finance may be characterized as asset-based finance in which the asset is a legal claim, and the financing can be used either to secure financing to pursue the legal claim itself or to secure working capital that can be used for general corporate purposes. Put differently, if a company needs money to invest in litigation, research, or any other legitimate business pursuit, it can use retained earnings, it can raise equity investment, it can raise traditional types of secured or unsecured debt—or it can raise litigation finance.

But we just explained that (a) companies face tradeoffs when deciding whether to use retained earnings, debt, or equity finance, and (b) not all companies have equal access to all of these forms of capital. The same holds true for litigation funding. The latter point is easier to make: litigation finance is only available to companies with strong legal claims that typically involve plaintiff-side litigations with sizable damages potential.²⁰¹ If you do not have a litigation claim, you cannot obtain litigation finance.

As for tradeoffs, there are pros and cons to the use of litigation finance. Many of the drawbacks concern the high transaction costs inherent in litigation funding deals. Because commercial litigation funders perform comprehensive diligence into funded matters, funded deals often take months to close. Companies that need financing quickly—whether because their case has a statute of limitations issue, they urgently need capital to hire new employees, or they have some other reason—may prefer to use readily available retained earnings, or existing access to equity or debt investors, rather than wait months for litigation funders to complete their work.²⁰²

As we explained, litigation funders typically perform more comprehensive diligence on a company’s legal claim compared to other forms of financing.²⁰³ Companies that use retained earnings do not have to subject their decision to pursue a legal claim to the discipline of the market.²⁰⁴ Meanwhile, traditional equity or debt financiers do not usually invest based on the value of legal claims and thus are unlikely to scrutinize the legal claim before providing financing.

The regulatory landscape concerning litigation funding also imposes transaction costs. Litigation funders typically request to see case confidential information before investing in a lawsuit. And defendants typically seek disclosure of litigation finance agreements and communications, in part to gain a strategic advantage in the litigation.²⁰⁵ The early statutes regulating consumer litigation finance deals recognized this fact and reacted by ensuring that communications with funders do not impair the protections of the work product doctrine or attorney-client privilege.²⁰⁶ Ironically, the more recent statutes recognize this fact, too, except that they mandate rather than prohibit litigation finance disclosure.²⁰⁷ Regulations that impede funders’ access to full and transparent communication from prospective funded parties, present lurking regulatory challenges, and limit funders’ ability to control litigation all effectively increase the funder’s risk and thus increase the price funded parties must pay for litigation funding.

Against these drawbacks stand the benefits of using litigation finance. Such funding is typically non-recourse, which means the company can secure financing backed only by a discrete legal asset.²⁰⁸ Litigation finance is thus frequently preferable to debt, since the funder does not have an absolute right to be repaid and the attendant enforcement rights that creditors have. And funding is frequently preferable to equity, as litigation funding does not dilute existing shareholders.²⁰⁹ Funders, like other asset-backed lenders, also have specialized expertise, which can help the company maximize the value of its legal assets. Moreover, because traditional debt and equity financiers are not trained in valuing legal claims, they are likely to undervalue legal claims relative to litigation funders.

But perhaps the most important reason many companies—especially SMEs—use litigation finance is simply that these businesses have no other choice. Most companies do not have millions of dollars in retained earnings to invest in litigation or research and development. Most companies are not publicly traded and do not have investment bankers who help them access liquid pools of debt and equity capital. Traditional equity and debt financing is either prohibitively expensive or effectively unavailable to these many enterprises. And most companies do not have substantial assets like inventory, machinery, or real property that can serve as the basis for asset-backed loans.²¹⁰

For these reasons, SMEs are leading consumers of litigation finance.²¹¹ They use litigation finance not only to finance their cases but also to obtain lower-cost capital than they could access in the traditional capital markets.²¹² Simply put, companies most likely to use litigation finance are SMEs that have difficulty accessing capital in the more traditional capital markets.

The implications for the scholarly and political debate about funding are significant. Companies use litigation finance not simply because it gives them better access to the courts. They use litigation finance because it gives them better access to the capital markets. Companies use litigation finance as an adaptive nonmarket strategy, leveraging their legal claims to secure financing that allows them to grow their businesses and better compete in the marketplace. This is especially true when a company secures litigation finance to obtain general working capital, for in that sense, litigation finance companies serve an identical function to financiers in other corners of the capital markets: they are third parties who provide investments secured by company assets. This insight holds true when they secure funding to pay the fees and costs of litigation: money is fungible, and by obtaining financing for their litigation, they free up other cash to invest in their core business.

B. Litigation Finance to Pursue Litigation: Adaptive and Transformative Strategies

We explained earlier that businesses frequently seek a competitive market advantage by engaging in litigation, including by bringing suit against competitors, customers, suppliers, or regulators. Companies use the court system to gain a strategic advantage in the marketplace and drive economic value to themselves.²¹³ Winning the litigation is a secondary consideration, or more precisely, a necessary antecedent to the ultimate goal of winning in the marketplace. Companies use litigation as an additive nonmarket strategy when they use litigation to enforce existing rules and regulations against other market participants in the hope of achieving an advantage in the marketplace.²¹⁴ These litigations are typically “private law” disputes seeking money damages. By contrast, companies use litigation as a transformative nonmarket strategy when they use the court system to transform the rules and regulations that affect their business, typically by challenging the legality of laws and regulations.²¹⁵ These litigations are typically “public law” disputes seeking declaratory and injunctive relief.

If a company wants to use litigation as a nonmarket strategy, it needs money to pursue that claim. Litigation is expensive, and some firms (generally, SMEs) are at a comparative disadvantage in terms of their ability to use retained earnings to file suit or to access traditional capital markets to raise debt or equity capital that can be used to finance litigation.

A firm’s relative inability to use litigation as a nonmarket strategy puts the firm at a comparative disadvantage in its ability to compete in the marketplace. Compared to larger players, the firm is relatively unable to pursue private law claims against other market participants to bolster its position in the market, and it is also comparatively less able to pursue public law claims that attack unfavorable government regulations. Thus, litigation finance helps level the playing field in the marketplace by enabling SMEs to have greater ability to use litigation as a nonmarket strategy. The battle over litigation finance must then be understood at least in part as a battle over which companies have access to litigation as a nonmarket strategy.

Our argument here does not presume that any and every nonmarket strategy is necessarily welfare-enhancing. Indeed, scholars have questioned the value of litigation through a host of normative lenses. For example, some have argued that private law litigation between two parties does not maximize welfare for either the parties to the litigation or society as a whole.²¹⁶ Likewise, the use of lobbying—a transformative strategy—has been challenged as inefficient rent-seeking.²¹⁷ While resolution of these underlying questions is beyond the scope of this Article, we offer three relevant comments.

First, the question for purposes of this Article is not whether litigation (or lobbying for that matter) should be used as a nonmarket strategy. Litigation has been used for strategic business reasons since long before the rise of the modern litigation finance industry, and well-resourced companies will continue to use litigation as a nonmarket strategy even if third-party litigation finance is stamped out of existence. The question instead is whether the ability to use litigation for strategic purposes should primarily be the domain of companies more likely to rely on retained earnings or traditional capital markets to pursue litigation or whether it should also be the domain of smaller firms more likely to use third-party litigation finance.²¹⁸ Put differently, even if one believes the “first-best” policy would be for no one to use litigation as a nonmarket strategy, the second-best solution is not necessarily to allow well-resourced incumbents to use nonmarket strategies while stripping smaller competitors of the means to do so too.²¹⁹

Second, there are good reasons to believe that cases funded by litigation funders are less likely to exacerbate broader concerns about the use of litigation as a nonmarket strategy. We previously discussed funders’ rigorous due diligence process, which tests a case’s merits in the courtroom, not its impact on the plaintiff’s market position.²²⁰ Because funders need their return to come from a court settlement, they generally do not benefit if a funded case results in a small monetary settlement but a significant market advantage for the funded party. Put differently, litigation funders are less likely to back cases that help companies win in the marketplace unless the company is also likely to win in the courtroom. Thus, although some critics of litigation finance argue that funders may promote frivolous litigation, the opposite is more likely to be true: cases funded by litigation funders are probably less likely to be weak, competitor-bullying cases than are most other cases, because funded cases are subject to more pre-filing scrutiny than other cases.

Third, litigation finance is more likely to be used in contexts where litigation is used as an adaptive rather than a transformative strategy. Because litigation funders invest on a non-recourse basis, receiving their recovery only from case proceeds, they typically only invest in cases where the plaintiff seeks money damages, not injunctive relief.²²¹ Thus, litigation funders frequently finance competitor suits like patent suits, false advertising cases, unfair competition suits, and so on, all of which are within the domain of adaptive nonmarket strategies. But litigation funders are highly unlikely to finance cases that pursue transformative strategies, as those suits are more likely to be cases brought against governmental entities seeking declaratory and injunctive relief, usually in the form of a court order finding a particular regulation unenforceable.

Larger firms that do not need litigation finance (for example, the Apples and Intels of the world) are more likely to pursue litigation as a transformative strategy rather than an adaptive strategy. In a related context, scholars have studied the different litigation preferences of repeat players compared to “one shotters.”²²² Larger corporations tend to be repeat players, whereas smaller firms and individuals tend to be one-shotters.²²³ And larger companies are more likely to be sued than to sue for violations of patent, antitrust, unfair competition, trademark, and copyright laws. For this reason, they are less likely to pursue meritorious plaintiff-side cases involving those underlying legal theories because they do not want to establish precedent that expands liability in those domains. For example, a victory in a specific patent case for Apple may be Pyrrhic if it expanded Apple’s liability for patent infringement in dozens of other cases.

Litigation used as a transformative strategy—that is, as a strategy to invalidate rules and regulations—presents a different story. In general, larger firms will be more comfortable with plaintiff-side litigation that develops precedent in ways that restrict the power of regulatory bodies, such as precedent overruling the Chevron doctrine or invalidating agency regulations. This insight helps explain why the Chamber of Commerce strongly opposes modern commercial litigation finance even as it actively pursues public law litigation to benefit its own financiers.²²⁴

In sum, (a) large and small companies can use litigation as a nonmarket strategy, (b) litigation finance is primarily used by smaller companies to implement adaptive nonmarket strategies, and (c) larger companies that have less of a need for litigation finance are more likely to pursue transformative strategies and disfavor litigation involving adaptive strategies. From these points emerges an important implication for the policy debate about litigation finance: regulations of litigation finance, with their focus on third-party funders’ receipt of money damages rather than injunctive relief, target the use of litigation as an adaptive strategy, primarily as employed by SMEs. If the battle over litigation finance is partly a battle over which companies can use litigation as a strategy to better compete in the marketplace, then the regulation of litigation finance will generally tend to give larger companies a comparative advantage over smaller companies.

C. Lobbying and Trade Associations: Transformative and Additive Strategies

Litigation finance has become a contentious policy issue, with regulations being considered by state and federal lawmakers and judges alike. The opponents of litigation finance are lobbying lawmakers and judges, asking them to impose regulations that range from mandatory disclosure rules and registration requirements to rate caps and even bans on funding.²²⁵ These efforts are led by the United States Chamber of Commerce, a business lobby, and by major corporations that have found themselves as defendants in funded cases.²²⁶ The supporters of funding have launched their own counter-offensive, trying to stave off the regulations they believe will hinder the industry’s growth.²²⁷ The funding community’s efforts are led by the International Legal Finance Association (“ILFA”), a nonprofit organization whose mission is to promote litigation finance and represent funders’ interests before lawmaking bodies like the United States Congress.²²⁸

As we have demonstrated, participants in the policy debate focus on funding’s impact on the civil justice system.²²⁹ Our analysis suggests a different interpretation: the policy fight itself must be understood at least in part as a nonmarket strategy where the stakes are success in the market. Many companies stand to either win or lose in the marketplace when litigation finance becomes widely available. Efforts by groups like the Chamber of Commerce and businesses to impose burdensome regulations on the litigation finance industry represent a classic example of that common transformative nonmarket strategy: lobbying.²³⁰ These enterprises are trying to transform the laws and regulations governing funding to essentially increase the transaction costs associated with third-party litigation finance, with the goal of ultimately giving larger firms a comparative advantage in the marketplace.

Litigation funders have also responded by forming ILFA, a trade association. ILFA engages in lobbying as its own transformative strategy in response to efforts to regulate litigation funding. ILFA has also promulgated a set of best practices for funders, which includes an emphasis on clarity, avoidance of conflicts of interest, confidentiality, respect for court rules, and capital adequacy.²³¹ ILFA’s members voluntarily commit to these standards.²³² Trade associations that set standards for an industry present prime examples of additive nonmarket strategies.²³³ Companies voluntarily sign onto these trade associations, they fund them, and ultimately, they follow the advice of these trade associations.²³⁴ The goal is frequently to insulate an industry from further external regulation through self-regulation.²³⁵

By voluntarily committing to the standards set by ILFA, financiers can accomplish several strategic goals. By self-regulating, they may avoid “being subject to government rules which may be more onerous or less efficient than the rules defined locally by the actors themselves.”²³⁶ The legal profession itself is largely self-regulating through the code of legal ethics, allowing lawyers primarily to regulate themselves rather than being subject to external government regulation.²³⁷ Moreover, by organizing behind a group like ILFA, funders can signal to stakeholders that they take seriously their obligations to justice and the legal system. The goal here is to create a system where financiers are “rewarded for establishing a norm of better behavior, either by those who benefit from their actions directly, or from those who value responsible behavior more generally.”²³⁸

IV. Policy Implications of Litigation Finance as Nonmarket Strategy

We have demonstrated that litigation finance has powerful implications not only for the legal system, but also for finance and business competition. The primary contribution of this Article is thus to identify a new dimension of study for scholars and policymakers who wish to understand the welfare effects of litigation finance. We provide a nonmarket strategy framework for understanding how litigation funding impacts finance and business.

We now provide some initial observations for how our insights affect debates about funding. First, we identify implications related to funding’s impact on the marketplace. Second, we draw implications for the existing debate about funding’s impact on the civil justice system.

A. A New Dimension to the Policy Debate

Companies use litigation finance to compete not only in the courtroom but also in the marketplace. Scholars and policymakers cannot fully understand and effectively regulate litigation finance unless they account for these overlooked welfare impacts.

A Regulation of the Capital Markets

Recent efforts to regulate “third party litigation finance” cannot be understood as efforts to broadly regulate the practice of third parties funding lawsuits in the civil justice system. Rather, the proposed regulations are targeted at a particular corner of the capital markets—and a corner more likely to be used by SMEs.

Consider two enacted regulations: a federal court’s local rule requiring disclosure of certain third-party financing agreements, and an exemplary state law regulating certain third-party financing arrangements. These regulations do not target third-party funding writ large. Rather, they target very specific types of corporate transactions.

We begin with the District of New Jersey’s Local Rule requiring mandatory disclosure of certain litigation funding arrangements, which has been copied verbatim by Judge Colm Connolly in the District of Delaware. The rule requires disclosure of any

person or entity that is not a party and is providing funding for some or all of the attorneys’ fees and expenses for the litigation on a non-recourse basis in exchange for (1) a contingent financial interest based upon the results of the litigation or (2) a non-monetary result that is not in the nature of a personal or bank loan, or insurance.²³⁹

Subtle nuances in the Rule’s language work to require disclosure only of certain forms of third-party finance. The rule covers entities that are “not a party” to the litigation and provide finance “on a non-recourse basis.” These limitations carve out traditional equity and debt financing. If a company raises equity financing from third parties with the goal of using that money to pursue litigation, disclosure is not required because the third-party investor essentially becomes a first-party owner. This new equity holder could very well hold voting rights to control the company’s activities, including its litigation. Meanwhile, the reference to “non-recourse” financing carves out traditional forms of unsecured or secured credit, which typically rely on the firm’s general creditworthiness (unsecured loans) or discrete assets like receivables or machinery (secured loans).

The Rule also excludes from disclosure instances where a company finances a third party seeking injunctive relief, as when companies provide financing to entities like the Chamber of Commerce so that the Chamber can seek declaratory and injunctive relief in public law cases. Companies that finance third parties seeking injunctive relief do not retain “a contingent financial interest” in the litigation, nor do they finance in exchange for “a non-monetary result that is not in the nature of a personal or bank loan, or insurance.” They simply finance the pursuit of injunctive relief that will necessarily benefit their business.

A similar analysis may be applied to a recent law enacted in Louisiana, SB355, which requires disclosure of litigation financing agreements and prohibits funders from controlling litigation.²⁴⁰ The statute has a lengthy definition of “third-party litigation funder” that excludes from its coverage many entities that are in fact third-party litigation funders. The statute’s 300-plus word definition of “litigation financing” provides:

“Third-party litigation funder” means any person or entity that provides funding intended to defray litigation expenses or the financial impact of a negative judgment related to a civil action and has the contractual right to receive or make any payment that is contingent on the outcome of an identified civil action by settlement, judgment, or otherwise or on the outcome of any matter within a portfolio that includes the action and involves the same counsel or affiliated counsel. This term does not apply to:

(a) The named parties, counsel of record, or law firm of record providing funding intended to defray litigation expenses related to the civil action.

(b) A person or entity providing funding solely intended to pay costs of living or other personal or familial expenses during the pendency of such civil action where such funds are not used to defray litigation expenses.

(c) Counsel of record, or law firm of record, or any referring counsel providing legal services on a contingency fee basis or to advance his or her client’s legal costs where the services or costs are provided by counsel of record or law firm of record in accordance with the Rules of Professional Conduct.

(d) A health insurer, medical provider, or assignee that has paid, is obligated to pay, or is owed any sums for health care for an injured person under the terms of a health insurance plan or other agreement.

(e) A financial institution providing loans made directly to a party, counsel of record, or a law firm of record when repayment of the loan is not contingent upon the outcome of such civil action or on the outcome of any matter within a portfolio that includes such civil action and involves the same counsel or affiliated counsel.

(f) A nonprofit legal organization exempt from federal income tax under 28 Section 501(c)(3) of the Internal Revenue Code, or any person providing funding to a nonprofit legal organization that represents clients on a pro bono basis. This Subparagraph does not affect the award of costs or attorney fees to a nonprofit legal organization or related attorney.²⁴¹

Each of the exclusions in subsections (a) through (f) is in fact an instance of third parties to the litigation that provide financing to support the litigation. Subsection (b) exempts third-party funding provided for a particular use of funds. Ignoring that money is fungible, the statute permits funders to provide capital that is specifically used for “costs of living or other personal or familial expenses,” so long as that money is not diverted “to defray litigation expenses.” Subsection (b) does not permit funders to provide capital used for corporate working capital, thus ensuring that the statute regulates discretionary financing to companies but not to individuals.

The remainder of the exclusions carve out various entities that provide third-party funding. Subsections (a) and (c) exempt lawyers (third parties to the litigation) who finance the litigation on a contingent fee basis, while subsection (a) also allows one party to the litigation to finance the litigation of their co-plaintiffs. Subsection (d) exempts insurers. Subsection (e) carves out all third-party investments that are non-recourse and limited only to the legal claim. In other words, subsection (e) recognizes that many companies use general-recourse third-party debt and equity financing to back their litigation, but it excludes those entities from having to disclose their funding. Meanwhile, subsection (f) excludes nonprofit entities organized under section 501(c)(3).

The definition of “third-party litigation funder” also only covers entities with a “contractual right to receive or make any payment” from the funded case.²⁴² This definition therefore excludes all funders that seek declaratory or injunctive relief in public law matters (as opposed to money damages relief in private law matters). This exclusion applies, for example, to organizations like the Chamber of Commerce’s Litigation Center, a 501(c)(6) organization that raises money from donors to pursue injunctive relief against government entities (pursuing transformative nonmarket strategies on behalf of its backers). The Chamber’s proposed regulations of third-party funding carve out the form of third-party funding that the Chamber uses.

In sum, the New Jersey disclosure rule and Louisiana statute, which are emblematic of other proposed and enacted regulations,²⁴³ do not broadly regulate the practice of third parties financing the pursuit of legal claims. Rather, they target specific forms of third-party funding, with a definition based on the corporate form of the transaction and the parties thereto. The regulations turn primarily on the financier’s corporate status (e.g., whether it is a law firm, nonprofit, or profit-seeking funder), the collateral for the financier’s investment (e.g., whether it is broad-recourse equity or debt, or recourse only to the litigation), and whether the financier’s expected return is tied directly to a monetary result in a case. Certain types of companies are more likely to prefer the narrow category of third-party funding regulated by these rules and statutes. Specifically, SMEs are more likely to structure their third-party capital raises using modern commercial litigation finance, regardless of whether they use the litigation funder’s investment to pursue litigation or as general corporate working capital.

Implications for Business Competition

Efforts to regulate or deregulate litigation finance must be viewed as a battle for an edge not just in the courthouse but also in the marketplace. When companies lobby for regulations of litigation funding, they are pursuing transformative nonmarket strategies to give themselves a market edge by discouraging litigation funding. And when the funding industry forms its own lobbying and standard-setting body, it is pursuing transformative and additive nonmarket strategies to combat the anti-funding transformative strategy.

This Article has also shown that companies use litigation finance to pursue nonmarket strategies in both adaptive and transformative ways. Regulations that promote or discourage litigation finance will impact firms’ ability to avail themselves of these nonmarket strategies. This insight raises important but overlooked welfare concerns that scholars and policymakers must consider when evaluating litigation finance.

First, consider the use of litigation finance to pursue litigation as an adaptive strategy (e.g., to pursue an antitrust suit against a competitor) or as a transformative strategy (e.g., to challenge a regulation that targets the company’s business model). If policymakers curtail access to funding, then companies that rely on litigation funding to pursue litigations with adaptive or transformative purposes will be less likely to pursue those litigations, or they will have fewer resources to effectively prosecute those litigations.²⁴⁴

In the first instance, the normative impact of litigation finance regulations will likely depend on whether one views the pursuit of these nonmarket strategies as a good or bad thing. For example, if one thinks the patent laws are under-enforced and the antitrust laws promote a healthier market, then diminished access to litigation finance may be a bad thing because it means fewer firms will be able to pursue patent and antitrust suits as an adaptive nonmarket strategy. If one takes a different view—that litigation involving the existing patent and antitrust laws diminishes welfare—then one might view the regulation of litigation finance as a good thing.

But the analysis is more complicated than this. Many companies do not need modern litigation finance to pursue litigation as an adaptive or transformative nonmarket strategy. Ban litigation funding, and they still have access to retained earnings and traditional debt or equity capital to pursue litigation designed to give them an edge in the courthouse. Regulating litigation finance thus only prohibits some players from deploying these nonmarket strategies. Put differently, if one prohibits some (mostly smaller) firms from accessing litigation finance, other (mostly larger) firms that do not need litigation finance can still pursue litigation for adaptive and transformative purposes, putting them at a comparative advantage in the marketplace. Policymakers must consider the welfare implications that flow from firms’ unequal ability to pursue litigation as a nonmarket strategy.²⁴⁵

Second, in addition to the use of litigation for adaptive and transformative purposes, this Article also demonstrated that companies can use litigation finance as an adaptive strategy by leveraging their legal claims to raise capital. Many companies use third-party financing writ large not simply to pay their lawyers on legal cases, but also to raise general working capital to fund their business activities.²⁴⁶ Larger companies often structure these transactions as third-party equity investments, or third-party debt investments that are either unsecured or secured by assets other than litigation claims. Smaller companies have more difficulty accessing these traditional markets, so they often turn to litigation finance instead.²⁴⁷

Put differently, large companies are more likely to finance their litigation and other business activities through third-party capital that falls within the safe harbors provided by the nascent regulations of litigation funding such as the New Jersey disclosure rule and Louisiana statute discussed above. They are more likely to raise general recourse debt or equity capital, and they are more likely to have the financial wherewithal to finance transformative litigation through a third party like the Chamber of Commerce.

To see the patchwork results, recall the weather balloon company that needs $15 million to finance litigation and develop new products. If the company has retained earnings or is able to raise traditional third-party debt or equity financing, it need not disclose its financing in litigation. Yet if the most efficient fundraise for the company is a commercial litigation finance fundraise, then the litigation finance regulatory structure kicks in. Meanwhile, if the company’s interests lie not in enforcing a claim against a competitor for money damages, but rather in invalidating a government regulation via declaratory and injunctive relief, then the company is not subject to the litigation finance disclosure regime either. This is so regardless of whether the company sues in its own name or if it finances a third party like the Chamber of Commerce to pursue the litigation.

One’s perspective on these insights may depend on the normative lens applied. As an example, consider the impact of limiting companies’ ability to raise capital via litigation funding. Assuming one values marketplace efficiency, current calls for regulation of litigation finance likely move the marketplace away from efficiency.²⁴⁸ This is because current litigation finance regulations hamper small businesses’ ability to access the litigation finance capital markets to fund various strategic business endeavors. These regimes thus favor larger companies, who have ample access to other capital markets and have less need for litigation funding.

And assuming one believes that it is better when most industries have many firms competing against each other, then the use of litigation finance as an adaptive strategy to raise capital likely improves societal outcomes. Litigation finance allows more companies to raise capital to produce, market, and sell their goods. Increased competition usually reduces prices for consumers and moves the market towards a more competitive equilibrium.²⁴⁹

B. Implications for the Civil Justice System

In addition to identifying a new dimension in the debate about litigation funding—how funding affects parties’ ability to compete in the marketplace—our study also brings a fresh perspective to the existing debate about how funding affects the civil justice system.

First, one significant question in the existing policy debate is whether litigation funders spur frivolous litigation. Opponents of litigation funding argue that funders will seek high-value claims even if they are frivolous, with the hopes of forcing settlements. Proponents of funding respond that financiers who invest in bad cases will soon be out of business.²⁵⁰

Our analysis sheds new light on that question by inviting a comparison of the scrutiny applied to cases that are funded via third-party litigation finance, as compared to funding via retained earnings or traditional third-party debt and equity financing. Before commercial litigation finance companies invest in cases, they apply extensive, months-long due diligence that is characteristic of asset-based lenders in general.²⁵¹ By contrast, funding litigation with retained earnings does not result in rigorous third-party scrutiny of the value of the litigation. Indeed, corporate finance scholarship has identified the agency problem inherent when managers use retained earnings to pursue new investments. Retained earnings avoid investor accountability because, by not raising external funds, “managers avoid a capital markets inspection of their past performance and the need to persuade the capital markets of the soundness of their proposed projects.”²⁵² By contrast, the use of project finance—and litigation finance is project finance for law—can “discipline management” because it “allows the investors, not the managers, to decide where the free cash flow will be invested. If the managers want to make new investments, they must raise the capital from outside investor.”²⁵³ Meanwhile, while raising more traditional equity or debt capital does invite investor scrutiny, it is not usually scrutiny specifically focused on the value of the legal claim. It follows that if companies want to pursue frivolous litigation, third-party litigation funding is probably least likely to result in approval to pursue the case.

Second, another important question in the existing debate about funding is whether third-party funders should be able to control litigation strategy and settlement decisions. Third-party funders state that they generally do not exercise control rights over litigation decisions, and many publicly-disclosed financing agreements bear this out, but there is one notable exception: after Burford Capital provided $140 million in working capital to Sysco, secured against several antitrust suits the food company had brought against suppliers, Burford attempted to veto Sysco’s decision to settle those cases for an amount below Burford’s liking.²⁵⁴ Meanwhile, litigation finance regulations have targeted control, with recent regulatory efforts trying to prohibit funders from controlling litigation, and court rules promulgated by the District of New Jersey and the Chief Judge of the District of Delaware requiring parties to disclose if they have provided a third-party funder with litigation control rights.²⁵⁵

If policymakers are concerned about control, there are many ways that financiers can accomplish control, and indeed standing as a third-party funder may be a uniquely inferior way to obtain control. For example, a third-party financier could become a controlling equity investor in the company and thus take over control of all the company’s operations, including the litigation.²⁵⁶ This approach might be particularly feasible for smaller claimholders in financial distress whose value is tied primarily or entirely to the value of litigation. Similarly, traditional creditors usually have powerful levers of control, including the power to force the company into bankruptcy or sue for payment on a loan.²⁵⁷ Creditors may use these rights to influence litigation. Yet the proposed regulations of litigation funding capture none of these instances of control via equity or traditional debt investment.

Third, a more recent issue in the litigation finance debate is whether litigation finance might present a national security risk. Opponents of litigation finance argue that funding can provide a conduit for foreign adversaries like China and Russia to impair the competitiveness of American companies by forcing them to defend against costly litigation and by gaining access to sensitive trade secrets during discovery.²⁵⁸ Supporters of litigation finance argue that there is little evidence of such foreign interference, and that China and Russia have much more effective ways of hurting America than corrupting the judicial system from the position of a third-party funder.²⁵⁹

Our analysis offers a different perspective. If foreign adversaries want to gain a competitive edge by accessing secrets through litigation, they can do so much more effectively by simply taking control of the plaintiff company, or by pursuing any of the other third-party financial methods that are not captured by the proposed regulations. In those circumstances, none of the onerous proposed regulations of litigation finance would capture their participation. The enacted and proposed regulations are highly underinclusive relative to the stated goal of ferreting out foreign influence.

Fourth, the disclosure of litigation finance agreements has emerged as a leading regulatory proposal in the existing debate. Proposed regulations of funding almost universally include a requirement that plaintiffs disclose the presence of litigation funding to the court and defendants.²⁶⁰ Proponents of disclosure argue that it is necessary to unearth whether the funder is violating any applicable ethical or legal rules, and to avoid judicial conflicts of interest.²⁶¹ Opponents of disclosure argue that it invites discovery side-shows and gives defendants a strategic advantage by disclosing whether the plaintiff has funding (and potentially disclosing much more, too).²⁶²

But again, there are myriad ways in which third parties finance another company’s litigation, and these financing methods are not commonly disclosed to courts or litigation opponents. Indeed, the federal rules provide very thin corporate disclosure, mandating that private companies need only disclose the identity of a parent corporation and of any publicly held corporation that owns ten percent or more of its stock.²⁶³ These limited disclosures were no mere oversight but a deliberate choice. The Rules Committee acknowledged that “[f]raming a rule that calls for more detailed disclosure will be difficult” and could create “[u]nnecessary disclosure requirements” that “place a burden on the parties and on courts.”²⁶⁴ The new regulations of litigation finance thus impose burdensome disclosure requirements on only one form of corporate finance, with the inquiry turning not on the type of litigation or the intent of the financier, but rather simply on the type of corporate form that makes most sense for the regulated party.²⁶⁵

In sum, almost all companies raise third-party capital to finance litigation and other business pursuits. Sometimes they raise equity from third-party investors. Sometimes they raise traditional third-party debt on a secured or unsecured basis. And sometimes—if it makes sense for the company given its size, strength, and regulatory environment, among other factors—they raise modern “litigation finance.” Efforts to regulate only a subset of the many ways claimholders raise third-party capital to finance litigation suggest that many proposed regulations of funding are underinclusive relative to their stated goal. Our nonmarket strategy framework suggests strategic business motivations for these proposed regulations.

V. Scholarly Benefits of the Nonmarket Strategy Framework

In addition to reframing how scholars and policymakers should approach litigation finance, our framework also holds value for both the law and business academies. First, our analysis answers recent calls by legal scholars for work that combines the scholarly disciplines of law and strategy. Second, our framework creates new insights for business scholars, especially concerning the types of strategic endeavors that firms engage in.

A. Legal Scholars

Legal scholarship does not usually focus on strategic business decision-making.²⁶⁶ “The notion that law may be a source of competitive advantage remains largely unexplored.”²⁶⁷ This is so even though law has a tremendous impact on business strategy, and even though many of the most contentious contemporary legal questions have high stakes for business interests.²⁶⁸

Scholars have recently called for a change. “If scholars can better understand the characteristics of firms and the attitudes of managers that promote legal strategy,” Robert Bird has argued, “both scholars and managers can devise ways to capture value from the legal environment that have never been previously considered.”²⁶⁹ He concludes that “law and strategy research can contribute much to both disciplines and can produce beneficial insights for scholars, practitioners, and managers alike.”²⁷⁰ For example, a full picture of the interaction between corporate counsel and regulators must account for business strategy decisions.²⁷¹ Fortunately, a law-and-strategy line of legal scholarship is emerging.²⁷² Other scholars (including one of us) similarly contend that laws and legal principles are important for marketing and product developers to understand so that they may better drive consumer demand to their products.²⁷³ Still others have argued that litigation can be a type of bullying to capture market power.²⁷⁴

This Article responds to the call of various legal scholars to engage with strategic decision-making in addition to legal decision-making.²⁷⁵ We provide a new lens for legal scholars to study how laws impact business strategy. This framework can help scholars address business litigation writ large, including private law disputes (such as the antitrust, patent, and Lanham Act disputes we have discussed) as well as high-profile public law disputes that grab headlines at the Supreme Court.²⁷⁶

B. Business Scholars and Businesses

Just as legal scholars have mostly ignored business scholars’ insights about law and strategy, the business and finance academy has mostly overlooked litigation finance.²⁷⁷ This Article contends that litigation finance is ripe for business scholarship, too.

A few avenues of research are likely to be fruitful. First, litigation finance is relatively unique in the nonmarket strategy context as it implicates adaptive, transformative, and additive strategies. Most business scholarship focuses on corporate strategies that are one-dimensional. Litigation finance is also unique because it is the subject of a push-and-pull of nonmarket strategies: some companies are using litigation finance as a nonmarket strategy to improve their market position, while others are pushing back against funding to preserve their own position.

Second, there is a dearth of empirical scholarship on litigation finance.²⁷⁸ The literature that has explored the instrument empirically has, unsurprisingly, focused on dependent variables relevant to the legal system, including the number, type, and outcome of funded cases.²⁷⁹ The framework presented in this Article suggests business scholars should also explore various business-focused dependent variables, including investment returns, weighted cost of capital, market power, and so on. Our framework can be a foundation on which scholars can evaluate the efficacy of these nonmarket strategies.

In addition to business scholarship, our framework here should provide businesses themselves with new strategies to create economic value. We have identified for firms the types of nonmarket strategies they can leverage. While we have identified several ways companies leverage litigation finance to drive economic value, we suspect that there are many unexplored strategies. By retooling litigation finance as a strategic endeavor and not just a legal one, companies may improve their ability to compete not only in the courtroom but in the market too.

Conclusion

This Article shifts the vantage point for analyzing litigation finance from the courthouse to the market square. The extensive scholarship on litigation finance has focused only on funding’s impact on the civil justice system. We argue that scholars and policymakers must also grapple with funding’s impact on capital markets and the business marketplace. To make this point, we use an interdisciplinary approach, drawing on business strategy literature about nonmarket strategies that has been largely ignored by legal scholars. Our framework identifies an entire set of funding’s policy implications in the market. It also offers new insights for the existing debate about how litigation finance affects the civil justice system. This approach provides a new lens for scholars and regulators struggling with how to study and regulate funding.

98 S. Cal. L. Rev. 1379

Download

Suneal Bedi* & William C. Marra†

*Associate Professor of Business Law & Ethics, Jerome Bess Faculty Fellow, Indiana University Kelley School of Business.

†Lecturer in Law, University of Pennsylvania Carey Law School. For helpful comments, we are grateful to Tom Baker, Mathew Caulfield, Brian Fitzpatrick, Todd Haugh, Donald Kochan, Samir Parikh, Tony Sebok, Maya Steinitz, and Maria Glover. The authors would also like to thank the law review editors for their helpful edits and comments.

A New Look at Old Money

October 2025October 2025Miranda Perry Fleischer*

Taxing wealth—including inherited wealth—is a hot topic, making headlines and generating heated debate. Should millionaires and billionaires face an annual wealth tax, as championed by Senators and former presidential candidates Elizabeth Warren and Bernie Sanders? Should we strengthen the existing estate tax, as former presidential candidate Kamala Harris urged? Or, as opponents argue, are both annual wealth and once-a-generation wealth transfer taxes unfair and impractical? What makes this debate so intractable is not only that the public as a whole is divided on these issues, but that also many individual Americans hold simultaneous beliefs about wealth, opportunity, fairness, desert, and family that seemingly contradict each other. This Article cuts through that debate by proposing a novel solution for inheritance taxation that reconciles these deeply held beliefs with the benefits of wealth transfer taxation.

Our current estate tax treats the self-made millionaire the same as an heiress who has not earned a cent when they pass their fortunes on to their heirs. But this is misguided. Drawing on recent work on the psychology of taxation, this Article makes the case for an innovative inheritance tax system that taxes old money more heavily than new. This approach would allow individuals to bequeath wealth that they have earned—but not wealth that they have inherited—free of tax. Known as a Rignano tax, this proposal harnesses the finding that many Americans “silo” beliefs about wealth, holding seemingly contradictory beliefs that differ in part based on whether wealth is earned or inherited. By leveraging these findings and building on experience with the existing transfer tax system, this Article elaborates and advances a set of specific and concrete design recommendations for a Rignano tax.

This comprehensive analysis of a Rignano tax—the first in the law review literature—complements philosophical work that advocates for such a tax but does not address key design and policy questions. Further, it contributes to tax scholarship by advancing our understanding of the relationship between a tax’s normative goals and structural design choices. And for both advocates and opponents of the estate tax, it offers a nuanced and fair exploration of the debate surrounding inheritance taxation as well as a potential resolution of the enduring stalemate over taxing wealth.

Her voice is full of money.

—F. Scott Fitzgerald, The Great Gatsby¹

They were new money, without a doubt: so new it shrieked. Their clothes looked as if they’d covered themselves in glue, then rolled around in hundred-dollar bills.

—Margaret Atwood, The Blind Assassin²

Introduction

Compare Tom, who builds a multi-million-dollar business from the ground up, with Mary, an heiress who inherits millions and never earns a cent. Both want to leave their fortunes to their children. Although our current estate tax treats Tom and Mary the same, this approach is misguided. It ignores that not only is the public as a whole divided on the issue of taxing wealth transfers,³ but many individual Americans hold simultaneous beliefs about wealth, opportunity, desert, fairness, and family that seemingly contradict each other. Many believe, for example, both that working hard and saving in order to help one’s children is as American as apple pie and that it is unfair for some children to begin life with a substantial head start.⁴

As a result, the debate over taxing wealth—including inherited wealth—is at a longstanding impasse.⁵ Influential legislators including Senators and former presidential candidates Elizabeth Warren and Bernie Sanders champion annual wealth taxes on ultra-millionaires, while opponents passionately contend that even once-a-generation taxes on wealth transfers are unfair and impractical, calling them “expropriation” and “an especially cruel injury.”⁶ This Article cuts through that debate and reconciles those competing beliefs by proposing a novel inheritance tax system that taxes old money more heavily than new. This innovative approach—known as a Rignano tax⁷—would allow Tom to bequeath wealth that he has created free of tax, while taxing Mary, who simply inherited her wealth.

Drawing on recent work on the psychology of taxation, this innovation harnesses the finding that many Americans “silo” beliefs about wealth, holding seemingly contradictory beliefs that differ in part based on whether wealth is earned or inherited. A Rignano tax thus reconciles the benefits of wealth transfer taxation with deeply held beliefs about fairness, desert, private property, and family. Because these beliefs—which legal philosophers Liam Murphy and Thomas Nagel call “everyday libertarianism”⁸ and which economist Steven Sheffrin terms “folk justice”⁹—generally differ from those of policymakers and academics, they are often ignored. Recent work on the psychology of taxation suggests that this is a mistake.¹⁰ Policymakers who ignore these beliefs do so at their own peril, often undermining their own normative aims.

But taking these beliefs into account does not mean abandoning wealth transfer taxation altogether. People frequently hold views about fairness and morality in different domains that appear to contradict each other, a concept that Zachary Liscow terms “policy silos.”¹¹ A pro-life advocate, for example, may also support the death penalty; someone who opposes redistributive taxation may favor transportation policy that helps the poor. Crucially, evidence indicates that many Americans “silo” beliefs about wealth, holding seemingly contradictory beliefs that depend in part on whether wealth is earned or inherited.

These insights suggest a way out of the morass bogging down the debate over inherited wealth. Supporters of inheritance taxes should not dismiss out-of-hand public attitudes about hard work, thrift, and family, but instead harness the concept of policy silos. By allowing individuals to make tax-free transfers of wealth that they themselves have earned—but not wealth that they have merely inherited—a Rignano tax acknowledges the very real, deeply held value that the public places on hard work, entrepreneurship, and notions of desert while also addressing concerns about inherited wealth.¹²

Although the idea of taxing old money more heavily than new has long fascinated philosophers of all stripes,¹³ philosophical literature leaves key design and policy questions unanswered. This Article answers those questions, offering the only comprehensive analysis in the law review literature of a Rignao tax. It first justifies a Rignano tax as a normative matter, delving more deeply into both expert and lay arguments for and against taxing wealth and recent work on the psychology of taxation. Its key normative insight is that a Rignano tax balances the goals of wealth transfer advocates (such as enhancing equality of opportunity and minimizing dynastic transfers of unearned power) with those of opponents of such taxes (such as rewarding desert, hard work, and family). By acknowledging both the pros and cons of taxing wealth transfers, a Rignano tax can succeed politically where other proposals fail.

What remains to be resolved are important questions of design and administration. Charting new ground in the literature on Rignano taxes, this Article builds on experience with the existing transfer tax system to elaborate and advance a set of specific and concrete design recommendations for a Rignano tax. These are:

Base: Imposing a tax on gifts and bequests received by an individual when that wealth is the subject of a second transfer;

Rate: Levying a rate of 0% on first-generation transfers and 40% on other transfers;

Valuation: Using the risk-free rate of return to determine what portion of a gift or bequest is second-generation wealth;

Frequency: Taxing generation-skipping transfers;

Tracing: Using a first-in-time approach to allocate second-generation wealth;

Trusts: Treating distribution as the relevant date for both imposing the tax and “starting the clock” for determining future growth; and

Transition Rules: Treating one-sixth to one-third of existing wealth as inherited.

Together, these recommendations build upon the insights of the psychology literature to craft an inheritance tax system that balances how the public actually thinks about taxation with the goals of inheritance tax supporters. Taxing heirs instead of transferors harnesses the insight that people silo beliefs about wealth, distinguishing between inherited and earned wealth. It also lessens the pull of moral mandates about double taxation and hard work. At the same time, it reflects the moral intuitions shared by most supporters of inheritance taxation. For example, many of the concerns raised by inherited wealth—such as equality of opportunity—are best measured by how much wealth a given person inherits, not how much total wealth an individual bequeaths without regard to how that wealth is divided among beneficiaries.

Imposing a zero rate on initial transfers of earned wealth likewise diminishes the attraction of the double taxation and hard work arguments. It also minimizes the threat that people often feel when systems of which they are a part—such as the family or an economy that rewards hard work and entrepreneurship—are undermined. By suggesting a rate of forty percent for later transfers, it acknowledges that repeated wealth transfers raise normative

concerns without breaching the fifty percent threshold that is especially salient in tax debates.

Other recommendations address valuation and liquidity concerns to increase administrability and decrease opposition triggered by those difficulties. For example, even though most normative considerations suggest taxing trust beneficiaries when their interests vest, this Article proposes taxing them at distribution. At that point, accurate valuations—and not just estimates—can be made, and liquidity concerns disappear. This acknowledges the instinct many people have that taxing “paper gains” is unfair. And using the risk-free rate of return to determine what portion of an inheritance’s growth is earned versus unearned provides a simple, easy to administer method for distinguishing what portion of a second transfer is old money versus new.

A Rignano tax thus charts a course through the competing beliefs held by both supporters and opponents of inheritance taxation. Although implementing one will require some additional complexity and recordkeeping, these burdens are not insurmountable. Several European countries tax some bequests more heavily than others depending on the relationship between the transferor and transferee.¹⁴ And for the last decade or so, our current system has successfully allowed one spouse’s estate tax consequences to turn on the value of the other spouse’s property as well as actions taken by the predeceased spouse’s executor at his or her prior death. This suggests that tying a recipient’s tax burden to the actions of the transferor is feasible. Administrative concerns therefore do not derail a Rignano tax’s carefully charted course. What remains is a workable inheritance tax system that can gain traction with the public where other proposals fail.

This Article proceeds as follows. Section I offers an overview of the current estate and gift tax system and common alternatives. Section II explores the arguments for and against taxing wealth transfers. Section III describes the justifications for a Rignano tax, and Section IV details what implementing a Rignano tax would entail. Section V concludes by assessing how well a Rignano tax balances competing intuitions concerning inherited wealth and concludes that the Rignano tax is worth pursuing notwithstanding the potential complexities that attach to its design and implementation.

I. An Overview of Wealth Transfer Taxation

Taxing wealth transfers is a longstanding feature of our federal tax system. Our current estate tax dates from 1916, when Congress imposed a tax ranging from one percent on estates over $50,000 to ten percent on estates over $5,000,000.¹⁵ To prevent individuals from avoiding the tax by making lifetime gifts instead of bequests, Congress permanently added a gift tax a few years later.¹⁶ This system is “unified,” meaning that it taxes an individual’s gratuitous transfers once they cumulatively exceed a per-transferor exemption amount, whether those transfers are gifts or bequests.¹⁷ For simplicity, this Article refers to this unified structure as the “estate tax.”

Due to changes in the exemption and rates, the tax’s bite has fluctuated dramatically over the past two decades.¹⁸ As recently as the year 2000, the top rate was 55 percent; by 2013, it had dropped to 40 percent, where it remains.¹⁹ As rates were dropping, the exemption was increasing. Between 2000 and 2017, it grew from a comparatively small $675,000 to over $5,000,000,²⁰ and in 2017, the Tax Cuts and Jobs Act temporarily doubled the exemption to $10,000,000²¹ (adjusted for inflation to $13,990,000 in 2025²²). Although the exemption was scheduled to return to a benchmark of $5,000,000 in 2026, legislation in the summer of 2025 permanently increased it to $15,000,000, adjusted for inflation, starting in 2026.²³ Given the exemption’s size, the estate tax affects only a tiny sliver of the population. In 2020, roughly 4,100 estates were required to file an estate tax return,²⁴ and of those, only about 1,900 actually owed any estate tax—less than 0.1 percent of the estimated 2,800,000 decedents that year.²⁵ Despite the small number of taxable returns, the tax raises a non-trivial amount of revenue—roughly $16 billion in 2020.²⁶ Interestingly, the amount of revenue has not decreased as fast as the number of taxable estates has decreased, which suggests that exempting additional transfers from tax (as a Rignano tax would) would not necessarily eviscerate the tax’s revenue-raising capacity.²⁷

A few features of the estate tax merit mention. First, it focuses on the transferor. This contrasts with recipient-focused taxes, such as the inheritance or accessions tax schemes that are more common abroad.²⁸ Other than the marital and charitable deductions, the estate tax does not distinguish among recipients. Consider Anna, whose wealth totals $15,000,000. She is taxed the same whether she transfers her fortune to one child or splits it among ten cousins.

Second, individuals may make a number of tax-free transfers. Most importantly, each individual has a single lifetime exemption amount—currently $13.99 million—which applies to her cumulative wealth transfers.²⁹ Assume that Anna gifts her daughter $10 million during life and later dies with an estate of $5 million. The lifetime gift uses up most of her exemption amount, leaving only $3.99 million of it left for later transfers. At her death, $3.99 million of her estate will be shielded from tax by the rest of her exemption amount, and the remaining $1.1 million of her estate will be taxed. She does not get a new exemption for her bequests. In addition, the annual exclusion allows each individual to exclude the first $19,000 transferred to each recipient each year from the above calculations.³⁰ Anna can give as many people as she likes—her whole Tax I class, perhaps—$19,000, and the gifts are simply ignored. Anna can do this year after year, and the gifts do not use up any of her exemption amount. Further, there are unlimited deductions for marital³¹ and charitable transfers.³² If Anna bequeaths her entire estate to her spouse, her taxable estate is zero. She does not need to use her exemption amount, and it rolls over to her spouse for later use. Likewise, if Anna bequeaths her $15,000,000 to charity, her taxable estate is zero. In this case, however, her unused exemption simply disappears.

Third, the generation-skipping transfer tax precludes families from minimizing their total tax burden by “skipping” generations. If Anna bequeaths her estate to her daughter Bonnie, who in turn bequeaths the wealth to Anna’s granddaughter Chloe, the estate tax is imposed twice. But if Anna skips Bonnie and bequeaths her wealth directly to Chloe, the estate tax is imposed only once. To equalize the tax burden in these situations, the generation-skipping tax imposes a tax on transfers that “skip” generations.

Finally, this system is separate from the income tax. Gifts and bequests received are not included in a recipient’s income, regardless of size.³³ Later income tax consequences to the transferee depend on whether the transfer is a gift or bequest.³⁴ Assume that Anna buys stock for $100 and transfers it to Bonnie when it is worth $1,000. If the transfer is a gift, Bonnie takes Anna’s basis for income tax purposes and will pay tax on the $900 unrealized gain upon disposition.³⁵ If Anna bequeaths the stock to Bonnie, Bonnie takes a fair market value basis of $1,000.³⁶ The $900 gain that accrued in Anna’s hands disappears.

A transferor-focused estate tax is just one possible way of taxing wealth transfers. Numerous OECD countries, including Belgium, France, Germany, Japan, Spain, and Switzerland, impose either accessions or inheritance taxes that focus on beneficiaries.³⁷ Although the two terms are often used interchangeably, they are technically distinct.³⁸ The former taxes the recipient based on the total amount of gifts and bequests received during her lifetime, while the latter taxes the beneficiary on such receipts annually.³⁹ Inheritance tax rates often vary based on the relationship between the donor and beneficiary, with transfers between close relatives taxed more lightly than transfers between more distant relatives and unrelated individuals. Finally, both accessions and inheritance tax systems generally exempt transfers between spouses.

An alternative to taxing gifts and bequests through a separate estate, inheritance, or accessions tax system is to change their income tax treatment. Most obviously, gifts and bequests could be included in income, just like salary or lottery winnings.⁴⁰Although this is fairly rare, Latvia and Lithuania do this, and Lily Batchelder’s “comprehensive inheritance tax” is essentially an income inclusion scheme.⁴¹

Another option is to use carry-over basis for bequests as well as gifts so that when transferees sell, they will pay tax on any gain that accrued to the donor regardless of whether the transfer is a gift or bequest (returning to Anna and Bonnie, Bonnie would pay tax on the $900 gain that accrued in Anna’s hands in both circumstances). The U.S. has briefly experimented with carry-over basis twice before—once in 1976 (although it was repealed before going into effect) and again in 2010 (that year, estates could choose between the regular estate tax or a system without an estate tax but with carry-over basis).⁴²And finally, gifts and bequests could be treated as realization events to the donor that trigger tax on unrealized appreciation at the time of transfer.⁴³ The United Kingdom⁴⁴ and Australia⁴⁵ treat gifts as realization events. Canada takes this approach at death, and former President Biden and numerous Senators have proposed that the U.S. follow suit.⁴⁶ In theory, one could both change the income tax treatment of gifts and bequests and impose a separate wealth transfer tax, but in the real world, they tend to be treated as either/or propositions due to political concerns.

II. The State of The Debate over Estate Taxes

Taxing wealth transfers is extremely controversial. As the foregoing history demonstrates, opponents have successfully pursued legislation that has drastically weakened the estate tax over the past two decades. In spite (or perhaps because) of this political history, taxing wealth transfers (as well as wealth itself) remains popular with a substantial portion of the public.⁴⁷ Supporters of wealth transfer taxation focus on egalitarian and welfarist justifications, while opponents generally rely on libertarian arguments. This Article’s goal is not to evaluate the strengths and weaknesses of those arguments in depth, which an extensive body of work does elsewhere. Instead, it is to provide an overview of this debate so that readers can better understand how people think about the estate tax so that they can evaluate the attractions of a Rignano tax.

A. Arguments in Favor of Wealth Transfer Taxation

Equality of Opportunity

Perhaps the most popular argument for taxing wealth transfers stems from the principle of equality of opportunity.⁴⁸ This ideal holds that each individual—regardless of arbitrary characteristics such as race or gender—should have an equal shot at pursuing her vision of the good life, while still bearing responsibility for her decisions.⁴⁹ In tax and legal scholarship, the most common instantiations require “redistribution from those with greater means and opportunities to those with less.”⁵⁰

These “liberal egalitarian” theories⁵¹ rest on two arguments. First, the financial circumstances of birth impact one’s ability to develop one’s talents. An intelligent child born to poor parents generally does not have the same educational opportunities as one born to wealthy parents.⁵² Well-off parents can afford private school tuition or a house in a high-quality school district,⁵³ tutors, and challenging after-school programs. Parents of athletes pay for private coaches, travel teams, and expensive summer camps. Well-off children do not have to work to help pay the rent but can instead spend time on their studies and resume-building activities like internships. And once a child is grown, wealthy parents can provide seed money for a business, pay for graduate school, or cover the down payment on a house. Second, these circumstances are arbitrary. A child does not choose to be born into a rich or poor family, just as she does not choose her race.

Equal opportunity therefore requires some ex ante equalization of resources so that a poor child with an IQ of 150, Mozart’s musical genius, or a keen business sense has the same shot at success as a richer child. In theory, taxing wealth transfers both reduces their size (in turn diminishing the advantages of being born into a rich family) and creates revenue to fund redistribution to those with fewer opportunities.⁵⁴

Dynastic Power

A related justification is to minimize the intergenerational transmission of power.⁵⁵ As our founders recognized, rejecting hereditable power is one of our fundamental values.⁵⁶ Yet great wealth often brings economic and political power over others.⁵⁷ Those favoring wealth transfer taxes on these grounds point to the following.

First, money enables one to make substantial political donations. Donors become de facto gatekeepers and agenda setters, influencing who more easily stays in the race and which issues gain prominence.⁵⁸ Substantial contributions plausibly increase access to elected officials⁵⁹ as well as influencing legislative behavior.⁶⁰ Large contributors often obtain influential positions such as ambassadorships or bureaucratic posts.⁶¹ Having a lot of money also makes it easier to run for office. Consider recent presidential candidates Tom Steyer⁶² and Michael Bloomberg⁶³ as well as President Donald Trump.⁶⁴ Closer to home, numerous candidates in U.S. Senate and House races⁶⁵ and state and local elections⁶⁶ have also spent plentiful sums of their own.

Money also allows one to influence public opinion,⁶⁷ most directly through unlimited, anonymous contributions to Section 501(c)(4) social welfare organizations that can advocate for and against candidates, lobby, and conduct issue advocacy. The wealthy can shape the media’s news and editorial coverage through advertising purchases⁶⁸ or from owning media companies directly.⁶⁹ And finally, the ability to influence policy (both directly and indirectly) also accompanies wealth.⁷⁰ Threats to relocate businesses, cancel events, or abandon planned openings or expansions can influence elected officials eager to protect local economies, even when the policies in question are not directly business-related.⁷¹ Business leaders are often consulted for advice by policymakers,⁷² be it through informal conversations or official advisory councils.⁷³ And more directly, such leaders are often named to policy-making positions that require special knowledge precisely because of the skills and expertise that made them successful. Lastly, the traits that bring business success often enable business leaders to naturally become civic leaders.⁷⁴

Wealth can also mean having economic power over others, especially in areas where a few families dominate economic life. Although the days of official company towns are long-gone, some influential families still control much of the employment opportunities in certain communities—for example, the Kohler family in Wisconsin.⁷⁵Elsewhere, residents might depend on a small set of firms for groceries, housing or other needs, such as cars. Decisions about what food to stock and at what prices, whether to raise rents or wages, expand or close a firm, and the like directly impact residents’ lives.⁷⁶ Handing the family business (or controlling chunks of publicly traded companies) down to one’s heirs is therefore tantamount to handing them economic power over others.

Inheritances and Ability to Pay

A third justification for taxing wealth transfers proceeds from the principle that political institutions should maximize welfare.⁷⁷ This argument equates welfare with utility and assumes that individuals have identical utility functions that decline as wealth and income increase.⁷⁸ Redistribution from an individual with more income or wealth to an individual with less thus increases overall utility. The catch is that taxing higher-income (or higher-wealth) individuals may lead to reduced labor and investment, decreasing overall welfare. The optimal tax literature thus argues that the ideal solution would be to tax ability, which cannot be minimized the way one can choose to work less.⁷⁹ But since ability cannot be directly observed, the next best is to tax income as a proxy.⁸⁰

Starting from this premise, some theorists argue that gifts and bequests received also reflect well-being and ability and should be taxed as proxies therefore.⁸¹ The reasoning is two-fold. If you are comparing two individuals with identical labor income, ignoring the fact that one receives a large inheritance is nonsensical—just as ignoring any other inflow, such as winning the lottery, would be. Second, the receipt of gifts and bequests is linked to a variety of “nonfinancial inherited assets and traits that powerfully affect earning ability.”⁸² These theorists generally reject the standard optimal tax account that taxing capital (which an estate tax does) creates too many economic distortions on three grounds.⁸³ First, they argue that this account overestimates the share of bequests made for reasons that are responsive to tax versus those that are not responsive. For example, someone who is saving to fund a comfortable retirement or for medical and long-term care as they age, and who “accidentally” leaves whatever is left to their heirs, will not really be influenced by taxation. Second, they contend that observed declines in wealth accumulation that correlate to transfer taxes are plausibly attributable to tax avoidance or increased lifetime gifting rather than reduced savings.⁸⁴ Lastly, these theorists note that most studies ignore recipients, who often work less after receiving an inheritance.

A Wealth Transfer Tax as a Periodic Wealth Tax

The foregoing arguments focus on the significance of transferring wealth. In contrast, a second set of justifications focuses on its very existence. But because political and administrative hurdles render taxing wealth itself difficult (if not impossible), taxing wealth transfers is an indirect solution.⁸⁵

Wealth Inequality and Democratic Concerns. A first justification for taxing wealth is to protect our democratic institutions.⁸⁶ There is a strong link between money and political influence, and people have different amounts of money.⁸⁷ As a result, many argue that money muddles the ideal that “the political system should . . . treat[] all citizens as free and equal participants.”⁸⁸ One concern is that the preferences of constituents with money will be prioritized over those without.⁸⁹ A growing body of evidence suggests that policymakers are more responsive to the views of the former;⁹⁰ this phenomenon has been observed at both the state⁹¹ and federal level,⁹² across a range of policies,⁹³ and especially when the two sets of views diverge.⁹⁴ This is both fundamentally at odds with a core tenet of democracy,⁹⁵ and creates a second harm by distorting the deliberative process.⁹⁶ If the system ignores information about the preferences of a large chunk of society, policymakers may lack all the information necessary to make fully-informed decisions. This vacuum also prevents the deliberative system from benefiting from a diversity of viewpoints.⁹⁷ A similar yet distinct harm from overweighting the preferences of the affluent is inefficiency. Here, the concern is that neither the harms to the non-affluent from policies favored by the wealthy nor the benefits from policies favoring the non-affluent will be taken into account. As a result, the true costs of a

variety of policies are obscured, potentially resulting in indirect redistribution to the affluent.⁹⁸

Economic Externalities from Wealth Concentrations. A similar justification for taxing wealth is that large wealth concentrations harm the economy.⁹⁹ Although short-run studies are mixed, several long-run studies suggest that highly unequal concentrations of wealth are negatively correlated with economic growth.¹⁰⁰ Several plausible explanations exist, but two appear most likely.

First, high levels of inequality might lead to underinvestment in education and health. Poorer families often face borrowing constraints that encourage young adults to enter the workforce rather than continue with schooling that increases skills and later income. In turn, fewer resources will be available to pass on to the next generation, compounding the cycle.¹⁰¹ A complex link between wealth, fertility, and education may also exist. Wealthier families tend to have fewer children, leading to greater investment in each one; the opposite is generally true for less-wealthy families.¹⁰² At the societal level, societies with higher levels of inequality may invest less in educational opportunities for the less well-off.¹⁰³

Somewhat similarly, high levels of inequality might decrease societal investment in health care.¹⁰⁴ And on the micro-level, having a relatively low income or social status might negatively impact an individual’s health, which imposes costs in terms of lost human capital and diverted financial resources.¹⁰⁵ Second, unequal concentrations of wealth are linked to social unrest and diminishing social cohesion, both of which can also contribute to slower economic growth in a number of ways.¹⁰⁶ It is plausible that in highly unequal societies, individuals engage in more rent-seeking, which misallocates resources. Inequality also contributes to sociopolitical instability, which both disrupts normal market and economic activities (think

of labor strikes) and creates an environment of political and legal uncertainty.¹⁰⁷

Owning Wealth and Ability to Pay. A final justification for taxing wealth is that simply holding it reflects ability to pay. Consider two people who each have $75,000 of labor income. If one also has several million dollars in the bank, shouldn’t that change our assessment of whether the two have an equal ability to pay tax?¹⁰⁸ After all, the mere existence of wealth enhances one’s financial capacity.¹⁰⁹ It also brings comfort, security, and status, all of which are intrinsically valuable and plausibly make it easier to generate even more wealth.¹¹⁰ Second, recall the welfarist ideal that tax burdens should track ability or endowment, and that income is the best proxy. Due to the realization requirement, our income tax system does not tax all economic income as it accrues. Some therefore propose taxing wealth periodically to capture the same measure more fully.

B. Arguments Against Wealth Transfer Taxation

While advocates of wealth transfer taxes tend to rely on arguments that reflect egalitarian and welfarist ideals, opponents generally ground their criticisms in libertarian and libertarian-adjacent arguments about efficiency, property rights, and the appropriate role of government. These can be a bit hard to categorize because scholarly opposition to wealth transfer taxes is scant in comparison to scholarly support. Most of the arguments made by everyday estate tax supporters are also fleshed out with care by academics. This is less true, however, for many of the opinions held by everyday estate tax opponents. Nonetheless, we can sort these critiques into roughly two groups.¹¹¹ The first set opposes wealth transfer taxes because they have differing normative visions of the role of government, a just distribution of resources, and fairness. The last set focuses on the efficiency of wealth transfer taxes to argue that they are themselves harmful.

Equality of Opportunity Revisited

The argument that equality of opportunity requires redistributing resources from rich to poor is contested.¹¹² Another interpretation of equal opportunity, known as “careers open to talents” or “the merit principle,” instead focuses on open competition.¹¹³ On this view, resources are irrelevant to one’s ability to compete for jobs, school admissions and scholarships, and the like; what counts is whether all individuals have a chance as a formal matter to compete.¹¹⁴ This ensures that positions are awarded based on merit to the most talented, instead of to the less talented due to arbitrary and unrelated characteristics like race or sex. Advocates of the merit principle often point to rags-to-riches stories such as media personality Oprah Winfrey, clothing designer Ralph Lauren, and Starbucks CEO Howard Schultz as proof that formal nondiscrimination sufficiently ensures a level playing field. If one interprets equal opportunity in this manner—as many Americans do—then one would naturally oppose any tax designed to redistribute wealth or income on equality of opportunity grounds, including a wealth transfer tax.

Rejecting Declining Marginal Utility and Progressivity

Many similarly contest the various arguments relating to the declining marginal utility of wealth and income. Some oppose the estate tax because they believe that redistribution to maximize welfare is beyond the proper scope of government, even if they accept the premise of declining marginal utility.¹¹⁵ Others question the assumption itself.¹¹⁶ Richard Epstein emphasizes, for example, that dollars are not ends unto themselves, but rather means. As he writes, “The decline in the marginal utility of an additional steak after you have already eaten one may be very high. But wealth is convertible into any number of different goods, so in each case the decline in utility has to be measured by referring to the utility of the most desired good as yet unpurchased.”¹¹⁷ And there’s some evidence supporting this view,¹¹⁸ including work suggesting that although utility likely declines as income rises in the lower range, it then increases with income in the middle range before declining again, creating an S-shaped curve.¹¹⁹

A related set of critiques reflects the normative dispute over whether the overall tax system should impose progressive or proportionate tax burdens.¹²⁰ Supporters of progressivity favor taxes that target the wealthy—such as estate taxes—as a way to increase the progressivity of the overall tax system.¹²¹ Opponents of progressivity naturally oppose such taxes, favoring proportionate taxes for several reasons.¹²² Some accept the ideal that tax burdens should track one’s ability to pay but reject the assumption that declining marginal utility requires imposing higher tax rates on the wealthy—the “equal sacrifice” argument. If utility does not decline, then taxing everyone at the same rate imposes an equal sacrifice, negating the need for progressive rates.¹²³

Others reject the ability-to-pay principle, instead arguing that taxes should reflect how much one benefits from the societal infrastructure (the “benefit” theory). As Friedrich Hayek explains, “since almost all economic activity benefits from the basic services of government, these services form a more or less constant ingredient of all we consume and enjoy and that, therefore, a person who commands more of the resources of society will also gain proportionately more from what the government has contributed.”¹²⁴ Richard Epstein analogizes the state to a partnership, highlighting that partnerships default to the “pro rata division of gains and losses derived from any common venture,” which ensures that “every individual [is] made better off to the same degree, that is, receive the same rate of return on his proportionate investment in social infrastructure.”¹²⁵

Private Property Rights

A third normative objection is that estate and inheritance taxes unjustly interfere with private property rights.¹²⁶ Supporters of strong private property rights, ranging from John Locke¹²⁷ and John Stuart Mill¹²⁸ to Robert Nozick¹²⁹ and Richard Epstein, overwhelmingly argue that if someone justly acquires property, she has the right to transfer that property however she likes, including by making gifts and bequests.¹³⁰ Because estate and inheritance taxes interfere with this right, they are not simply unjust, but uniquely unjust. As philosopher Loren Lomasky argues, they are “an especially cruel injury because [they] deprive[] the dead of one of their last opportunities for securing the goods that they value.”¹³¹ On this account, choosing to make a gift or bequest expresses the identity of the donor in a way that selling property does not. It is a sign of her affection for the recipient, as well as her values.¹³² Just as other intimate family matters relating to the expression of values—such as which holidays to celebrate and whether to go to church—should be immune from state interference, so too should gratuitous transfers. Moreover, gifts and bequests take place in the private realm of the home and neither avail themselves of the market infrastructure nor represent a voluntary entrance into the public sphere. In contrast, most taxable activity—like selling labor or property—represents a voluntary entry into the public sphere whereby one willingly consents to the burdens of taxation in exchange for using the market infrastructure. Perhaps, then, the intrusive burden of taxing gifts and bequests (e.g., tracking, valuing, and reporting) in the private sphere should be given more weight than the burden from taxing transactions in the public marketplace.

Double Taxation

Many also view the estate tax as double taxation.¹³³ Although this critique is extremely common among members of the public, policymakers and scholars tend to be dismissive of it as betraying a misunderstanding of the broader tax system. They first note that because of the realization requirement,¹³⁴ many wealthy individuals have never paid income tax on the increase in value of their investments.¹³⁵Studies suggest that untaxed appreciation comprises an average of 32% of smaller estates (a few million dollars) to 55% of large estates (those in the $100 million range).¹³⁶ To some extent, then, estate tax supporters are correct that opponents wielding the double taxation argument either misunderstand this point or overstate their case.

But what about wealth that has already been taxed, such as labor income invested in assets such as taxable savings accounts? Estate tax opponents are correct that an estate tax taxes this twice.¹³⁷ And to many, that just seems unfair on a gut level, despite various counterarguments. One counter is that the same income is often taxed multiple times to the same person; think of income, payroll, and sales taxes. Another counter is that recipients of gifts and bequests do not include them in income. Therefore, taxing gifts and bequests simply matches up the number of people that benefit from the property with the number of times it is taxed. If Hannah gives Iris a gift of $1,000, many argue that taxing both of them makes sense since each benefits from the funds. Hannah could have spent that $1,000 on fancy cheese, but instead chose to give the money to Iris, and she enjoys the warm glow that comes with making a gift. And Iris has $1,000 to spend as she sees fit.¹³⁸

But many transfer tax opponents contest that Hannah benefits when she makes a gift to Iris the same way that she benefits when, for example, she pays Iris to paint her house. In their view, Hannah has transferred the ability to benefit from the funds to Iris. Since only one person—Iris—ends up benefitting, only one person should be taxed. Since Hannah was already taxed via the income tax, it makes no sense either to impose a separate transfer tax or require Iris to include the transfer in income.¹³⁹ Setting aside the issue of appreciated property, we can see that the double taxation argument comes down to a normative view about the definition of income. If Hannah benefits from making a gift just as she benefits from having her house painted, there is no double taxation. But if one believes that Hannah gives up her ability to benefit and passes it to Iris, then taxing gifts and bequests is double taxation. As with arguments about equality of opportunity and progressivity, this simply comes down to reasonable disagreements about normative priors.

Efficiency and Administrative Concerns

A final set of arguments highlight efficiency and administrative concerns. For some, these concerns alone are sufficient to oppose the estate tax, even if they otherwise sympathize with its goals; for others, these concerns buttress normative critiques.

Economic Incentives. At heart, transfer taxes are taxes on savings by donors.¹⁴⁰ As such, opponents contend that they punish savers and reward spenders by raising the price of saving relative to spending.¹⁴¹ This reaction seems intuitive to many laypeople, and is arguably backed up by two recent economic analyses finding a correlation between higher estate taxes and lower wealth accumulations at death—a reduction in wealth at death of roughly 10% for the very wealthiest taxpayers.¹⁴² Some theorists–such as economists who deploy optimal tax analysis—thus argue that transfer taxes decrease overall welfare by shrinking the size of the pie available for redistribution.¹⁴³ Professor Ed McCaffery offers a twist on this argument, arguing that the estate tax exacerbates inequalities of opportunity by encouraging lifetime consumption and early spending.¹⁴⁴ And many everyday people simply recoil at the idea of a tax that seems to single out behavior (working hard, saving, and frugality) that our society deems virtuous.

Harm to Small Businesses and Family Farms. A related critique—one that strongly resonates with the public—is that the estate tax harms small businesses and family farms. To that end, estate tax opponents frequently recount stories of families who allegedly have been or will be forced to sell farms and small businesses to pay the tax.¹⁴⁵ (The story of Lester Thigpen, an African-American tree farmer from Mississippi who was the grandson of slaves, is a prime example.)¹⁴⁶ Opponents also emphasize the costs that families must incur to plan for the tax, such as purchasing insurance to provide liquidity and paying advisors to help minimize potential taxes.

To the ire of estate tax supporters, however, many (if not all) of these stories are unproven. Namely, many of the individuals profiled by estate tax opponents would not have been subject to the tax, even at its pre-EGTRRA levels. And according to Michael Graetz, neither the American Farm Bureau nor New York Times reporter David Cay Johnston could find any farms that had actually been sold to the pay tax after a search in the late 90s.¹⁴⁷ Nevertheless, the possibility (however remote) that a family farm or small business could be harmed troubles many Americans. Moreover, many estate tax opponents overlook that this possibility becomes more likely were exemption levels to drop, and rates to increase, as they advocate.

Avoidance Costs. Another efficiency-related concern is that the tax raises little revenue while encouraging wasteful tax planning that renders the tax essentially voluntary.¹⁴⁸ In 2020, for example, the estate and gift taxes together raised only $17.6 billion—roughly 0.1% of gross domestic product.¹⁴⁹ Meanwhile, millions—possibly billions—of dollars¹⁵⁰ are spent each year on avoidance activities that involve complicated legal structures.¹⁵¹ Because of the availability of these structures to well-advised families, many view the estate tax as a “voluntary” tax that only the less-sophisticated, semi-wealthy pay, while the truly wealthy avoid it.¹⁵² Here, opponents of the estate tax see another reason to reject it, while supporters see a reason to strengthen it.

Administrative Costs. A related critique is the cost and difficulty involved in administering the estate tax. Some opponents estimate that taxpayers spend almost $20 billion annually complying with the tax,¹⁵³ although supporters of the tax dispute this figure. One contributor to high compliance costs is valuation difficulties.¹⁵⁴ While the assets of many middle- and upper-middle class individuals such as lawyers and doctors are fairly easy to value–cash, brokerage and retirement accounts, publicly-traded stock, and straightforward real estate like suburban houses—the same is not true for the wealthy. One estimate suggests that roughly half the assets owned by the wealthiest 1% of American families are hard to value, including unique real estate, closely held stock, noncorporate business assets, farm assets, private equity and hedge funds, art, limited partnership interests, and other miscellaneous assets.¹⁵⁵ Moreover, taxpayers can engage in a number of complicated transactions to artificially minimize the value of normally easy-to-value assets like stock.¹⁵⁶ To opponents, the fact that valuation is costly, time consuming, and imprecise is another reason its limited revenue is not worth the cost.

III. Settling the Debate with a Rignano Tax

As Section II shows, the debate over estate taxation is complex, implicating both normative values and empirical questions. The recent weakening of the tax suggests that opponents are winning this debate, to the great frustration of estate tax supporters who repeat the following laments: If only the public understood that the tax affects a mere sliver of the population and how few family farms and small businesses are impacted by it. If only the public knew that the tax’s burden likely falls on heirs, who have not in fact done anything to earn the wealth in question. If only opponents could see that the estate tax is not double taxation, due to the realization requirement and the step-up in basis. If only the public appreciated the harms of inequality.¹⁵⁷

Estate tax advocates thus keep recycling the same tactics. One approach is to try to correct the public’s factual misperceptions about double taxation, the impact on family farms and small businesses, and how many estates are hit by the tax.¹⁵⁸ Another is to argue that taxing the recipient instead of the transferor (via an accessions tax or income inclusion) would better display the tax’s goals and burdens to the public, thereby convincing them of the value of taxing wealth transfers.¹⁵⁹

But these approaches miss the mark by failing to adequately account for deeply held beliefs shared by a large portion of the population about fairness, desert, private property, and family. This Section first explores these beliefs, as well as seemingly contradictory views on equal opportunity and democratic participation that are also widely held. It then argues that a Rignano tax is the best way to reconcile the competing moral intuitions held by many Americans.

A. Attitudes Toward Taxation, Fairness, Redistribution, and Equality

Crucially, these beliefs about fairness, desert, and property rights—which Liam Murphy and Thomas Nagel call “everyday libertarianism” and which economist Steven Sheffrin terms “folk justice”¹⁶⁰—often do not overlap with the philosophical and economic frameworks favored by policymakers and academics. Sheffrin explains:

Ordinary individuals hold a set of psychological principles about fairness in taxation that are considerably broader and that differ in systematic and fundamental ways from the ideas of fairness that dominate our public debate today. . . . [T]he emphasis on tax fairness as redistribution comes from academic work in philosophy and economics that, in many ways, stands apart from the concerns that motivate everyday people. . . . [T]ax fairness is important, but it is not synonymous with redistribution. To the average person, tax fairness means something else, primarily receiving benefits commensurate with the taxes one pays, being treated with basic respect by the law and the tax authorities, and respecting legitimate efforts to earn income. The average person is not totally indifferent to inequality, but concerns for redistribution are moderated by the extent to which income and wealth have been perceived to be earned through honest effort.¹⁶¹

Because the public takes these views so seriously, policymakers who simply try to convince the public to change its views face an uphill battle. For example, Murphy and Nagel acknowledge that their argument that pre-tax income is meaningless is “counterintuitive” and that “[c]hanging this [belief] would require a kind of gestalt shift, and it may be unrealistic to hope that such a shift in perception could easily become widespread.”¹⁶² Sheffrin terms this “resonance,” arguing that “[a]ny ethical or social theory that does not resonate with folk ideas will be doomed to eventual failure as a vehicle for social change. Understanding folk ideas of justice is then essential to building effective social structures.”¹⁶³

Going further, many theorists argue that when policymakers fail to take these views seriously, they end up undermining their own normative aims.¹⁶⁴ Zachary Liscow illustrates with the common law and economics wisdom that redistribution should take place solely in the tax and transfer system. He argues that this approach makes sense in theory but fails in the real world because it “ignores how ordinary Americans think about [taxes] and thus ends up exacerbating inequality rather than mitigating it.” As a result, “tax policy runs up against political constraints—driven by ordinary people’s

attitudes about taxation” that prevent tax policy from accomplishing policymakers’ goals.¹⁶⁵

Taxation and Folk Justice

What are these attitudes? One key belief relates to what moral philosophers call “desert” and what Steven Sheffrin terms “equity theory.” To everyday people, there should be a roughly proportional relationship between effort and results.¹⁶⁶ People believe that the money they earn belongs to them,¹⁶⁷ and that if they “earn more money, they deserve to keep a decent share of it.”¹⁶⁸ Even those who critique this belief acknowledge that the “idea that people deserve to be rewarded for thrift and industry” is natural to many and that “it can seem preposterous” that hard-working individuals who are willing to take risks do not deserve more than the lazy and unadventurous.¹⁶⁹ Although scholars debate the merits of these views,¹⁷⁰ numerous studies suggest that substantial portions of the public subscribe to them.¹⁷¹ As Murphy and Nagel recognize, to many, these views are “instinctive[],”¹⁷² “ingrained,”¹⁷³ and “hard to banish from [] everyday thinking.”¹⁷⁴

These beliefs lead to a distaste for redistributive taxation generally, and to some extent, opposition to the estate tax simply reflects these general principles of folk justice. But Sheffrin identifies two further aspects of folk justice that supercharge these attitudes as applied to the estate tax. In his view, the fact that estate tax opponents have successfully capitalized on these folk justice beliefs—while estate tax supporters have ignored them—explains a large part of the tax’s deep unpopularity.¹⁷⁵ (Polls consistently suggest that roughly fifty percent of the population supports repealing it entirely).¹⁷⁶

Moral Mandates. One concept is that of moral mandates, which are deeply held, non-negotiable subjective beliefs about right and wrong. These beliefs are resistant to logical argument, and can be seemingly inconsistent, such as when a pro-life advocate also favors the death penalty.¹⁷⁷ When something contravenes a moral mandate, it generates a level of outrage that might seem excessive. An act becomes “wrong” and not merely “disagreeable.”

According to Sheffrin, several of the arguments discussed in Section II.B. rise to the level of moral mandates. One is that imposing a tax when someone dies is simply immoral. On this account, the estate tax “comes at the worst possible time for families – the death of their family’s breadwinner.”¹⁷⁸ People are simultaneously grieving their loved ones and worried about providing for the family that’s left behind. Telling people that it’s not death per se that triggers the tax but instead the transfer of wealth; or that grieving families have to deal with all kinds of logistical and business arrangements, such as funerals and the probate process; or that the families affected by the tax are wealthy and well-provided for, will not make any headway. The tax is associated with death, and that simply seems immoral to many.

Another moral mandate—one which polling data suggests has been extremely influential—is that double taxation is unfair.¹⁷⁹ People have deeply-held beliefs that if someone works hard and saves their whole life, paying taxes as she goes along, she should be able to leave her wealth to her family at her death without the government swooping in a second time.¹⁸⁰ And again, telling people that double taxation is not unique to the estate tax, or that much wealth subject to the estate tax has not already been taxed, is pointless.

And finally, people value entrepreneurship.¹⁸¹ They view the tax as disincentivizing hard work and wealth accumulation, thus undermining another deeply held value. Demonstrating that very few small businesses or family farms owe the tax, let alone need be liquidated to pay the tax, is largely fruitless.

System Justification. In addition to touching on moral mandates, Sheffrin argues that the tax also implicates “system justification theory.” This theory—somewhat like cognitive dissonance—posits that individuals adapt their beliefs to defend existing systems and the status quo, even when they do not appear to benefit from those systems. They thus react strongly to threats to that system, even when people other than themselves—such as the wealthy—will be the ones harmed by those threats.¹⁸²

Specifically, the estate tax appears to threaten two key systems: the family and our meritocratic system that rewards talent and effort. Even if the estate tax will not affect the majority of Americans, many view wealthy businesspeople as “valuable members of society who deserve their wealth and support the American economy.”¹⁸³ As such, a tax that affects them undermines an entire system of which they are a part. Likewise, even if the families affected by the tax are rich families, taxing them when they engage in a familial act of generosity threatens the family system that we are all a part of.¹⁸⁴

Policy Silos

At the same time that the public opposes estate taxes, however, it also shares many of the values highlighted by its supporters. Economist Stefanie Stantcheva’s recent empirical work on how people reason about income and estate taxes illustrates this seeming contradiction. In a large-scale representative survey, Stantcheva finds that 58% of respondents believe that parents should be able to pass along whatever they wish to their children, even if that creates unequal opportunities at a societal level, and that 61% of respondents believe that it is unfair to tax the estates of hard workers. Yet in this same group,

68% say that it is unfair that children from wealthy families have access to better amenities such as schools;

64% believe that the wealth distribution is unfair; and

46% view inequality as a serious issue.¹⁸⁵

Stantcheva is not the first to note that many people hold a variety of conflicting beliefs simultaneously. In fact, her findings illustrate another aspect of moral mandates—people form them on an issue-by-issue basis. They do not represent an overarching world view, and they may contradict each other, as when a pro-life advocate also favors the death penalty.¹⁸⁶

Zachary Liscow calls this phenomenon “policy silos,” meaning that “ordinary people hold category-by-category views about what is just for a given policy and apply those views partly in isolation.”¹⁸⁷ For example, people view taxation and transportation separately, such that they may oppose redistributive taxation but favor redistributive transportation policy. The former is “giving” money to the poor, while the latter is helping them get to work.¹⁸⁸ Stantcheva’s findings echoed this observation, as respondents’ views differed based on whether the questions focused on parents/transferors or children/transferees. To put it in Liscow’s terms, people appear to view estate taxes in a different silo than equal opportunity concerns.

As a result of siloing, public support for two economically identical but superficially different programs can vary based on framing.¹⁸⁹ This has two implications. First, Liscow argues that lawmakers should not rely on the tax system as the sole means of redistribution but should also implement redistributive policies elsewhere. A second implication is that when policymakers do use the tax system for redistributive or similar reasons, they should take advantage of siloing, as the public’s dislike of one tax might not necessarily translate into a dislike of a different tax. Joseph Thorndike has observed, for example, that even though the public hates the estate tax, it favors wealth taxes.¹⁹⁰

A Rignano Tax Reconciles These Competing Intuitions

What does all this mean for wealth transfer taxes? One common suggestion is to replace the estate tax with a recipient-focused accessions or inheritance tax.¹⁹¹ The hope is that focusing attention on recipients will shift the debate more firmly into the equal opportunity silo instead of the tax silo, as well as lessening the intensity of some of the moral mandates around double taxation, entrepreneurship, hard work, and thrift.

This Article takes that suggestion one step further. A Rignano-style accessions tax that exempts first-generation transfers does an even better job of incorporating folk justice and people’s everyday psychological intuitions about the estate tax. Imagine the following structure (which Section IV fleshes out in more detail): Grandfather builds a business from the ground up and bequeaths $10,000,000 to Mother. No tax is imposed, but if Mother does not create any wealth of her own and simply retransfers $10,000,000 to Daughter, all of Mother’s estate is taxed. In contrast, if Mother creates new wealth, different portions of her estate are treated differently. The inherited $10,000,000 that Mother re-transfers is taxed, while any newly earned wealth is not.

By allowing individuals to make tax-free transfers of wealth that they themselves have earned—but not wealth that they have merely inherited—a Rignano tax acknowledges the very real, deeply-held value that the public places on hard work, entrepreneurship, and notions of desert while also addressing the concerns people hold about the prevalence of inherited wealth.¹⁹²

IV. A Rignano Tax

The idea of taxing second- or third-generation wealth more heavily than newly earned wealth has a long history. Roughly 100 years ago, Eugenio Rignano offered the first sustained treatment of it, arguing that such a tax is the best way to move gradually toward socialism.¹⁹³ Rignano believed that the means of production should eventually be owned by the government, but that individuals, not the government, are better wealth-creators. He thus proposed a tax that would exempt transfers by wealth-creators, tax second transfers at 50%, and tax third transfers at 100%. This, he believed, would be the most efficient way to implement socialism.¹⁹⁴

Libertarian Robert Nozick later picked up this idea, albeit for decidedly non-socialist reasons. In The Examined Life, Nozick suggests that a Rignano-type structure is the best means of balancing competing intuitions about family ties, wealth and inheritance, and fairness. He first defends the right of individuals to bequeath what they have created themselves as an act of love: “Bequeathing something to others is an expression of caring about them, and it intensifies those bonds. . . . [T]he donor . . . has earned the right to mark and serve her relational bonds by bequeathal.”¹⁹⁵ But he does not view second-generation inheritances as a similar act of love, due to the lack

of connection between the person who created the wealth and the second recipient.

He also acknowledges, moreover, that when wealth is “passed on for generations to persons unknown to the original earner and donor, [it] produc[es] continuing inequalities of wealth and position” and that the “[t]he resulting inequalities seem unfair.”¹⁹⁶ Unfortunately, Nozick’s discussion of this tension is rather sparse. He does not explain, for example, why he believes the resulting inequalities are unfair. Nor do we know whether first-generation bequests are inherently fair, or whether they are unfair, but whose unfairness is outweighed by the value of the donor’s ability to express affection and love.¹⁹⁷

And most recently, philosopher Daniel Halliday argues that a Rignano tax furthers equality of opportunity ideals better than traditional estate and inheritance taxes. In his view, context matters—that is, whether someone is born into a family that has not just wealth, but long-standing wealth and the social and cultural capital that accompanies it (let’s call these “wealth norms”). Imagine that Grandfather starts with nothing, builds a successful business, and leaves all his wealth to Mother at his death. Halliday believes that this bequest does not give Mother a head start in life. Her life prospects were largely shaped long before receiving her inheritance, when she was young and Grandfather was still building his business. He had not yet amassed enough wealth to pay for private school and expensive tutors for Mother, to give her seed money to start her own business or to launch her own career. Moreover, Grandfather’s self-made status suggests that the family did not have wealth norms when Mother was growing up. Instead of golfing at a country club, Grandfather likely bowled in the neighborhood bowling league and did not have the same cultural norms and social and professional networks as families with older wealth.

But now consider Mother and Daughter. Halliday argues that “parental conferral of advantage compounds over successive generations. . . . Families that have been wealthy for longer possess a greater range of powers that keep their children privileged.”¹⁹⁸ Grandfather’s bequest allows Mother to provide advantages to Daughter that she herself did not have, such as high-quality schools, tutors and after-school lessons, and expensive camps. It also means that Daughter—unlike Mother—grows up in a family with wealth norms. The family belongs to a country club, not a bowling league. Mother’s contacts can give Daughter internships, and Daughter knows which fork to use during the interview lunch and how to dress for it. For these reasons, Halliday views the transmission of wealth across three generations as a contributor to and a tag for economic segregation, which he argues undergirds unequal opportunities. As such, these inheritances should be taxed.

In contrast, Halliday contends that first-generation inheritances should not be taxed. Not only are they not problematic, but they might even reduce economic segregation by serving as a safety net keeping middle-class families afloat in a stagnating or contracting economy. Halliday observes that in many areas, the costs of housing and other necessities have skyrocketed while middle-class wages have stayed flat, rendering home-ownership unaffordable to many such families. But if Grandfather leaves the family home to Mother, or enough money for a down payment, this helps minimize economic segregation in such areas. First-generation inheritances thus counteract inequality of opportunity and therefore should not be taxed.

Implementing a tax that exempts the first transfer but taxes the second might sound simple to those unfamiliar with tax policy. Yet the devil is in the details. Implementing a Rignano tax requires resolving seven design decisions, explored below: the (1) base; (2) rates; (3) valuation; (4) frequency; (5) tracing; (6) transfers in trust; and (7) transition rules. Although a Rignano tax is complex, crafting one is possible.¹⁹⁹ As we shall see, in many instances one solution is superior regardless of why one wants to tax old money more heavily than new. With other decisions, however, differing justifications for taxing repeated wealth transfers point in different directions.

A. The Base

This section addresses three base-related decisions: Should the tax focus on transfers or receipts? Should it treat gifts and bequests equally? And should it contain any exclusions or exemptions?

Transfers or Receipts?

The first base-related question is whether to tax receipts or transfers. If Grandfather earns a fortune, leaves it to Mother, and Mother in turn passes it along to Daughter, who does the tax focus on? Does it look at Grandfather and Mother in turn, and tax Mother because she’s the one who re-transfers wealth while exempting Grandfather because he’s the one who earned the wealth? This model is akin to a traditional estate tax, which focuses on the total amount of wealth transferred by an individual over the course of her lifetime.²⁰⁰ Or does it look at each and ask who among them received re-transferred wealth (here, Daughter)? This is similar to traditional accessions or inheritance taxes, which apply to transferees based on gifts and bequests received.²⁰¹

In either case, the tax is imposed once, at transfer.²⁰² But the distinction matters, both psychologically and normatively. At first glance, one might think an estate tax model makes the most sense. If Grandfather creates the wealth, and the goal is to allow him to transfer it tax-free, then the focus should be on him. Yet this ignores many of the normative aims of those who wish to tax wealth transfers in the first instance.²⁰³

Start with dynastic wealth and equality of opportunity concerns. Looking at the sum of gratuitous transfers received by a given individual tracks ex ante differences in opportunity better than looking at aggregate transfers made by an individual. Imagine a decedent with an estate of $5,000,000. An estate tax treats her the same whether she leaves it all to one child or splits it up among ten recipients. Yet receiving $5,000,000 impacts life opportunities much more dramatically than receiving $500,000. The same is true for dynastic wealth: what matters is how much wealth someone receives. An inheritance of $50,000,000 bestows political and economic power in a way that an inheritance of $500,000 does not. As numerous commentators have acknowledged, a recipient-focused accessions or inheritance tax better reflects these concerns.²⁰⁴

Next consider the welfarist argument that gratuitous transfers received should count toward an individual’s ability to pay, just like salary, business profits, and gains from property sales. This concern also suggests a recipient-focused tax. How much wealth a transferor has does not necessarily correspond to the ability to pay of the transferee. For example, Lily Batchelder and Surachai Khitatrakun estimate that “22% of heirs burdened by the estate tax have inherited less than $500,000, while about 21% inheriting more than $2,500,000 bear no estate tax burden.”²⁰⁵

An accessions-tax framework also better addresses the concern that wealth concentrations are in and of themselves harmful by encouraging donors to split their fortunes up. An estate tax would treat Warren the same whether he leaves his fortune in one big bundle to one lucky heir, or whether he splits it up among multiple recipients. But an accessions tax treats these two situations differently, since it focuses on cumulative gifts and bequests received in excess of an exemption amount. Since each recipient has their own exemption amount, splitting a large fortune up generates a lower overall tax bill.

Finally, the psychological insights discussed in Section III.B. also point to the superiority of an accessions tax. Recall, for example, Stantcheva’s findings that support for transfer taxes rises when people focus on recipients instead of transferors.²⁰⁶ This is likely due in part to framing and siloing, but perhaps also to the fact that focusing on recipients weakens the pull of moral mandates about double taxation and hard work.²⁰⁷

Gifts

A second decision is whether the tax should apply not only to bequests but also to gifts. Although Rignano clearly suggests taxing both, Halliday is more equivocal. Halliday’s equivocation is misplaced; the tax should apply to both equally.

a. Gifts in General

Consider the various reasons for taxing wealth transfers, starting with equality of opportunity. As Halliday notes, gifts are usually received earlier in life than bequests. This creates advantages sooner rather than later for the donee and her family, thus magnifying those advantages.²⁰⁸ For this reason, Anne Alstott has suggested varying inheritance tax burdens based on the recipient’s age.²⁰⁹ Further, the act of making a gift suggests that the donor feels financially secure enough to dispose of some of her wealth while alive, which makes it more likely that her heirs grew up in a family with wealth norms.

The ability-to-pay and dynastic wealth concerns also suggest taxing both gifts and bequests. Both gifts and bequests enable recipients to spend money for political purposes as well as influence the economic lives of others. Both gifts and bequests provide utility to recipients. In fact, declining marginal utility suggests that gifts might even provide more utility than bequests of comparable size, as individuals tend to have less money earlier in their lives. And both serve as a tag for one’s nonfinancial endowment. Again, gifts may signal greater nonfinancial advantages than comparably sized bequests, as families that engage in lifetime gifting are often wealthier than families who do not.

Moreover, Halliday’s arguments for excluding gifts from a Rignano tax do not withstand scrutiny. One argument is that transferors have such a strong preference for bequests that excluding gifts would not encourage them to make gifts instead.²¹⁰ Halliday correctly observes that many transferors do not maximize opportunities to make tax-free gifts under current law and that many people save more than enough to cover the expenses of old age. He also acknowledges, however, that these statistics reflect decisions made during periods with relatively low rates and that they likely underestimate the extent to which wealthier families will change their behavior. A key part of estate planning for such families is maximizing the tax advantages of lifetime gifts, and minimizing the ability of transferors to characterize bequests as gifts creates a great deal of complexity in the current estate tax system.

Halliday also argues that taxing gifts is essentially pointless.²¹¹ He believes that most gifts can be easily concealed—unlike bequests, which are documented during probate and hard to hide. But many large gifts are similarly hard to conceal. Stock transfers are recorded; large cash transfers are tracked. And even gifts of jewelry and other family heirlooms generate records when donees insure them. Of course, under-the-table gifts will always occur, but not at a level that makes attempting to tax gifts pointless. Because this Article advocates for treating gifts similarly to bequests, later references to “bequests” or “inheritances” refer to gifts and vice versa.

b. Gifts and Timing Complications

Taxing gifts does raise a complication related to timing. Return to Grandfather, Mother, and Daughter. We do not know exactly how much Mother will inherit—which affects the accessions tax imposed on Daughter—until Grandfather is dead. If the tax only applied to bequests, this would not be a problem. But what if the tax also applies to gifts and Mother makes a gift to Daughter while Grandfather is still alive, before he bequeaths any wealth to Mother?

To illustrate, imagine that Mother gives Daughter $1,000,000 and five years later, receives $10,000,000 from Grandfather. If we look just at the first gift of $1,000,000, it initially appears to be newly created wealth that should not be taxed. But money is fungible; if Mother knows she’s about to receive an inheritance, this frees her up to make a lifetime gift to Daughter, whether from her own or borrowed funds. The tax would be easy to avoid if we simply cast any transfer from Mother’s generation to Daughter’s generation as a first transfer of wealth if it comes before Grandfather transfers anything to Mother. Yet whether Mother inherits before or after the gift to Daughter seems irrelevant if the point is to tax the second generation in a family that inherits wealth. This is especially true if one views second-generation wealth transfers as more of a welfarist or equal opportunity concern than first-generation transfers.

A “catch-up tax” that applies to transferees who have themselves made prior transfers can account for this scenario. When Daughter receives $1,000,000 from Mother, the tax—as applied to Daughter—would treat it as a first-generation transfer because at that point, Mother has not yet inherited anything. When Mother later inherits $10,000,000 from Grandfather, the tax—as applied to Mother—would treat different parts of that bequest differently. It would treat $9,000,000 as first-generation wealth and any amounts previously transferred by Mother to Daughter—here $1,000,000—as second-generation wealth.

Now consider what might happen later. One possibility is that Mother consumes the $10,000,000 she inherits from Grandfather, making no more gifts to Daughter. Because Daughter receives nothing more, no more tax is imposed upon the family. In total, $11,000,000 has been transferred within the family ($10,000,000 to Mother, and $1,000,000 to Daughter.) Overall, the tax will have treated $10,000,000 as first-generation wealth (Daughter is taxed as receiving $1,000,000 of first-generation wealth and Mother is taxed as receiving $9,000,000) and $1,000,000 as second-generation wealth (imposed on Mother via the catch-up tax at Grandfather’s death).²¹² In essence, the price Mother pays for making a lifetime gift before receiving her own inheritance is that she, not Daughter, is treated as having received a second-generation transfer.

Another possibility is that Mother later passes her $10,000,000 inheritance down to Daughter. In that case, a total of $21,000,000 has been transferred within the family ($10,000,000 to Mother, and $11,000,000 to Daughter). Of this, $10,000,000 represents a second transfer, and $11,000,000 represents newly created wealth (Grandfather created $10,000,000 and Mother created $1,000,000). When Daughter receives Mother’s $10,000,000 inheritance, the tax should therefore treat only $9,000,000 as second-generation wealth. This accurately taxes $10,000,000 of the family’s total transfers as second-generation wealth (recall that when Mother received her inheritance, $1,000,000 was treated as second-generation due to the catch-up tax), and $11,000,000 as first-generation wealth ($1,000,000 when Daughter received Mother’s lifetime gift, $9,000,000 of Mother’s receipt from Grandfather, and another $1,000,000 when Mother dies).

Exclusions and Exemptions

The last set of base-related decisions concerns exclusions and exemptions. As both Rignano and Halliday suggest, each individual should have a relatively small lifetime exclusion amount.²¹³ Assume that after Grandfather bequeaths his $10,000,000 to Mother, she has several runs of bad luck and passes along only $1,000,000 to Daughter. Even though that $1,000,000 is second-generation wealth, it seems plausible to allow Daughter to inherit something free of tax for the same reasons that most (if not all) systems have such exemptions. In addition to administrative concerns, allowing small inheritances tax-free recognizes that bequests are a natural part of most families’ lives, and that they can provide a needed cushion for many less-wealthy individuals. Any amount chosen would be arbitrary, but something like $500,000 or $1,000,000 seems reasonable.

For similar reasons, the tax should have something similar to the annual exclusion described in Section I, but on a smaller scale. The annual exclusion’s purpose is to simplify record-keeping and to recognize that intra-family gift giving for birthdays, weddings, and holidays is a normal, everyday occurrence in almost all families that does not trigger any normative concerns. These same concerns are relevant in a Rignano tax. That said, the current $19,000 per recipient exclusion is far larger than necessary to cover regular birthday and holiday gifts, and in fact, allows for much tax-free giving that exacerbates unequal opportunities.²¹⁴ As with the lifetime exemption amount, any chosen number would be arbitrary, but something like $5,000 seems reasonable.

Most transfer tax systems also exempt marital and charitable transfers. Intra-spousal transfers should not be taxed, as they do not transmit wealth down to a lower generation.²¹⁵ Charitable transfers are a bit trickier from a normative perspective. In theory, their treatment should depend on what kind of charity receives the gift or bequest. If one’s concern is equality of opportunity, for example, a gift to an inner-city tutoring program furthers equality of opportunity while other gifts may undermine it (imagine gifts to private foundations that employ family members or to a private school that provides few scholarships).²¹⁶ But if one goal of a Rignano tax is to gain public traction where other transfer taxes flounder, charitable transfers should be exempted. Charities benefit from a “halo effect,” and the point that some charities exacerbate social ills is nuanced and hard for the public to understand. Further, giving to charity is seen as virtuous, and may invoke reactions similar to the moral mandates and systems justification theories discussed earlier.

A final question is whether the relationship between the wealth creator and the second recipient should matter in determining whether a gift or bequest received is second-generation. Specifically, should second-time-around transfers that originate in a different family be exempted if the recipient is the first in her family to inherit? Halliday, for example, suggests the tax should apply to anyone whose parents or grandparents have inherited, but not to individuals who are the first in their families to inherit. That makes sense if one’s concern is equal opportunity and if one agrees with Halliday that repeated wealth transfers are the real culprit in that context due to the creation of wealth norms and economic segregation.²¹⁷

Imagine two scenarios in which Grandfather starts with nothing, earns a fortune, and leaves it to Mother. In Childless, Mother has no children and leaves her wealth to Friend’s child. Mother’s Friend neither inherits from Friend’s parents nor bequeaths any wealth to Friend’s child. In Helping Hand Family, Mother has a daughter, to whom she leaves her wealth. In both cases, Mother inherited wealth and then passed it along a second time. In that sense, both Daughter and Friend’s child have received second-generation wealth. But if the concern is that repeated wealth transfers create or signal economic segregation and wealth norms, then Daughter and Friend’s child are not similarly situated. Friend’s child is the first in Friend’s family to inherit, and in that sense, what she receives is not second-generation wealth.²¹⁸ Daughter, by contrast, belongs to the second generation of Mother’s family to inherit. This suggests looking not only at the recipient, but also at the pattern of prior transfers in the recipient’s family—if one shares Halliday’s concerns.²¹⁹

However, other normative justifications for taxing wealth transfers point in other directions. If one’s focus is dynastic wealth and traditional equality of opportunity concerns, or welfarist concerns, then the source of the gratuitous transfer should be irrelevant. Receiving unearned advantage, power, or welfare is the main concern, more than whether that receipt followed an intra-familial chain of transmission. The same is true if one’s concern is the mere existence of wealth.

Likewise, the psychological insights of folk justice suggest that treating intra-family transfers worse than other transfers would not fare well. First, system justification theory indicates that a large factor in hostility to the existing estate tax is its perceived threat to the family.²²⁰Second, it is plausible that people hold moral mandates about family businesses and family farms that would be triggered if intra-family transfers were treated worse. Thus, any softening of the public’s opposition to inheritance taxes that comes from exempting first transfers would likely be undone if familial transfers were treated worse than other second transfers.

B. The Rate

After choosing a base, one must also choose a rate. Halliday and Rignano both use examples in which first-generation transfers are not taxed, second-generation transfers are taxed at 50%, and third-generation transfers are taxed at 100%.²²¹ This Article proposes completely exempting first-generation inheritances and taxing subsequent ones at a rate of 40%, although it acknowledges that any rate will be somewhat arbitrary. Although this Article’s normative arguments point to taxing later transfers more heavily than initial transfers, they do not point to specific rates the way they signal, for example, that gifts and bequests should both be taxed. Nor does past experience illuminate the perfect rate as a technical matter. Perhaps

more than any other design question, choosing a rate reflects balancing numerous political considerations.

Initial Transfers

The rate on initial transfers should be a simple, easy to understand zero. Work on cognitive psychology and tax suggests that individuals focus on “highly visible” and “easily recallable” aspects of a tax; this is known as “prominence” or “saliency.” When thinking about income taxes, for example, the public tends to focus on the highest marginal rate.²²² Completely exempting initial transfers of wealth provides a sharp and clear distinction between initial and successive transfers in a way that merely using a lower rate does not. “You are not taxed at all when you pass along wealth that you have earned” has a salience that “you are taxed less” lacks.

The former also harnesses the power of folk justice better than the latter. Start with systems justification theory and the notion that taxing wealth transfers threatens a system that people are a part of and value. Here, it is the act of taxation in and of itself which is harmful. Taxing transfers of earned wealth at a low rate is still taxing them. Telling people that a system they care about is damaged only “a little bit” will do little to assuage the concerns of those who value the family. Damaging something valuable a little bit still damages it.

Completely exempting initial transfers also better counters the double taxation argument. Once again, it is the act of taxation—not the level of taxation—that gives this argument weight with the public. The public believes (rightly or wrongly) that the wealth-earner has already been taxed on the wealth. Educating the public about untaxed appreciation and the step-up in basis has not countered that. Nor has emphasizing that what should matter is the total tax burden, not the number of times something is taxed. Telling the public that you are taxing earned wealth less than inherited wealth will be similarly fruitless. From a folk justice perspective, the best way to address concerns that earned wealth is being double taxed is to be crystal clear that transferring it does not trigger tax. Only completing exempting such transfers does this.

Subsequent Transfers

If first-generation transfers are completely exempted, how should later transfers be treated? Rignano suggested taxing second-generation transfers at 50% and third-generation transfers at 100%; although Halliday rejects the latter suggestion, he does not address whether second- and third-generation transfers should be taxed differently.²²³ This Article proposes treating them alike by taxing all later transfers at a flat rate of forty percent.

As an initial matter, second- and later-generation transfers should be treated similarly to each other. While the insights of folk justice strongly point to distinguishing first-generation wealth, they do not justify treating later transfers differently from each other. Nor do most of the justifications for taxing wealth transfers. Gifts and bequests received increase well-being and enhance ability to pay, regardless of whether the transferor earned or inherited the wealth in question. Money is money when it comes to political spending. Similarly, under traditional equality of opportunity concerns, money is money when it comes to paying for private school tuition or houses in top school districts, tutors, or fancy camps.

That said, other justifications are plausibly consistent with distinguishing among second-generation and later transfers, even if they do not necessarily mandate such an approach. Take Halliday’s linkage of wealth norms and equality of opportunity; it is likely that the older the family’s money, the stronger the wealth norms. Likewise, it is plausible that the longer a family has been politically or economically powerful in a given town, the more powerful they are. Knowing that another family has had power over yours for decades is probably more demoralizing the longer that has been the case.

In these cases, however, any difference in power or opportunity between second- and later-generation wealth diminishes over time. Let’s illustrate with wealth norms and equal opportunity: Grandfather creates wealth, which he passes along to Mother, who in turn passes her inheritance along to Daughter. Under Halliday’s reasoning, Mother enjoys substantially fewer advantages than Daughter, since Mother grows up in a family with first-generation wealth and Daughter grows up in a family with second-generation wealth. Yet it is unlikely that Daughter has substantially fewer advantages than Daughter’s children. The marginal advantage of growing up with third-generation wealth as opposed to second is likely much smaller than the marginal advantage of growing up with second- versus first-generation wealth. The case for distinguishing between second- and later-generation inheritances is therefore much weaker than for distinguishing first transfers.

And on a practical level, treating second and third inheritances alike minimizes the valuation, tracing, and record-keeping concerns addressed below. All that need be determined is how much an individual’s parents inherited. Given the weak theoretical case for distinguishing among later transfers, and the strong practical case against doing so, treating second and later transfers similarly to each other is preferable.

This Article thus proposes a rate of 40% on subsequent transfers, which is the current estate tax rate in the U.S. This number is admittedly arbitrary, and none of the theoretical considerations discussed above mandate any given rate. That said, something about tax rates that exceed 50% seem to hit a nerve with people. And given the prominence bias discussed above, it is likely that a Rignano tax that is seen as “raising rates” above current levels would face more opposition than one that does not raise rates.

Adjusting for Age

A final rate-related issue is whether gifts and bequests received earlier in life should be taxed more heavily than those received later in life. Here, practical and theoretical considerations are in tension. Several justifications for taxing wealth transfers point in the direction of adjusting for age, such as equal opportunity theory.²²⁴As theorists recognize, receiving an inheritance early in life alters one’s life prospects more than receiving one later in life. A $1,000,000 bequest at age twenty-five provides seed money for a start-up, while such a bequest at age sixty-five likely does no more than enable one to enjoy a more comfortable retirement. Other justifications, however, do not support adjusting for age. A large bequest increases one’s ability to pay regardless of one’s age, for example. And although such adjustments could be made,²²⁵ doing so adds another layer of complexity and is probably not worth that additional complexity.

C. Frequency: Determining the Number of Transfers

A further issue is determining how many times wealth has been transferred. Revisit Grandfather, Mother, and Daughter. Two questions arise. First, if Grandfather leaves his wealth directly to Daughter in a “generation-skipping transfer” that skips over Mother, is that a first- or second-generation transfer? Put another way, should that be treated the same or differently than if he leaves it to Mother, who in turn re-bequeaths it to Daughter? Second, what if Grandfather leaves his wealth to Mother, who

dies soon thereafter? Should adjustments be made for deaths in rapid succession?

Generation-Skipping Transfers

Let’s start with generation-skipping transfers. Current law imposes an additional tax on such transfers to ensure that families face an equivalent level of tax whether their wealth proceeds directly from one generation to the next or skips over one generation. This prevents ultra-wealthy families in which Mother’s generation may not need Grandfather’s wealth from minimizing their tax burden by having Grandfather pass his wealth directly to Daughter.

Although counterarguments exist, a Rignano tax should contain similar rules that treat a transfer by Grandfather directly to Daughter as a second transfer instead of a first. This would prevent families from avoiding one level of tax by skipping generations. As under current law, however, exceptions should apply if Mother pre-deceases Grandfather, such that Grandfather’s transfer to Daughter does not skip over a living person.²²⁶

To be sure, this design decision runs counter to folk justice principles. It renders transfers directly to grandchildren vulnerable to the double taxation argument and to system justification concerns about harming families. But the Rignano tax is not a tax designed to further folk justice principles; rather, it is a tax designed to take such principles into account when designing a wealth transfer tax that achieves other goals. Here, treating such transfers as first transfers would allow for too much game-playing, thus undermining the goals of taxing second-generation wealth. Moreover, it is plausible that the treatment of such transfers will be less salient to the public than the fact that the default for first transfers is complete exemption.²²⁷ For these reasons, the better approach is to treat generation-skipping transfers as two transfers, not one.

Transfers in Rapid Succession

A related issue is how to treat transfers in rapid succession. Imagine that Grandfather bequeaths his fortune to Mother, who dies unexpectedly a few months later, re-transferring his wealth to Daughter. Should this be considered a second transfer? Halliday argues that it should not be: “A short interval between bequests may mean that a donor has had less opportunity to save and accumulate due to an early death. It is harder to say, in that case, that this person’s bequests should still be taxed as if he or she had remained idle.”²²⁸

Halliday’s approach is misguided; transfers in rapid succession are still transfers. Halliday is correct that Mother has had less time to build upon Grandfather’s inheritance after receiving it. Yet he ignores that she had time before either her or Grandfather’s death to earn her own wealth, and that wealth will be taxed as first-generation wealth. Counting each transfer treats Mother and Daughter the same as other families.

D. Valuation

Perhaps the most difficult issue is how to value re-transferred wealth. Revisit Grandfather, who starts with nothing and builds a $10,000,000 fortune. He bequeaths his wealth to Mother, who later dies with a $50,000,000 fortune which she leaves to Daughter. How much of Mother’s $50,000,000 should be considered a second transfer of Grandfather’s wealth? Rignano and Halliday, without discussion, use a simple but flawed approach in their examples: they would treat $10,000,000 as a second transfer and $40,000,000 as newly created wealth.

The Problem

This approach erroneously overlooks the fact that asset values fluctuate over time due to a variety of causes—inflation, the time value of money, changing market conditions, and the owner’s efforts. Take inflation. Imagine that Mother invests her inheritance in an asset that keeps exact pace with inflation. $10,000,000 inherited in 1993 has an inflation-adjusted value of roughly $22,700,000 in 2025.²²⁹ The Rignano/Halliday default wrongly treats the $12,700,000 increase that is due to inflation as instead stemming from Mother’s efforts. But Mother has added no value. The asset has simply kept up with inflation.

Risk-Free Rate of Return as the Default Solution

A more accurate approach would impute the risk-free rate of return to Grandfather’s fortune. This better distinguishes between earned and inherited wealth by recognizing the dual roles of risk and choice. To illustrate, imagine that Grandfather leaves Mother a building worth $10,000,000 that is worth $30,000,000 when she re-bequeaths it to Daughter. As explained above, attributing only $10,000,000 of the building’s value to Grandfather overstates Mother’s contribution and understates Grandfather’s. Yet attributing all $30,000,000 to Grandfather does exactly the opposite. It overstates Grandfather’s contribution and understates Mother’s.

What is key is that when Mother inherited the building, she had a choice. At that point, she held $10,000,000 of wealth that she could invest however she liked. She could continue to hold that particular building, swap it for other real estate, or cash out and invest in stocks, bonds, or a risky start-up. If she keeps the building itself, some—but only some—of any later increase in value is due to her choice to do so.

More specifically, a later increase in value has three possible components: the risk-free rate of return, a return to risk, and (occasionally) inframarginal returns.²³⁰ The risk-free rate of return is the return one would receive by investing in a zero-risk project with a guaranteed return, such as a U.S. Treasury bond. This return is simply compensation for using the invested funds—a pure time-value-of-money return sometimes referred to as the “return to waiting.”²³¹

To illustrate, imagine a stock investor. Unlike a bond investor, the stock investor does not know ex ante whether she will recoup her investment. Because the company’s value could either increase or decrease, she will insist on a higher return to compensate her for taking on that risk. Most investment returns are comprised solely of these two elements, which means that the return to risk is the excess over the risk-free return.

Occasionally, an investment also yields an inframarginal return, which is a return above and beyond the market rate for risky investments. These arise from “special opportunit[ies] not generally available in the market” and are usually associated with “rents to ideas, managerial skill, or market power.” They can include unique returns to capital due to information asymmetries or imperfect markets, as well as returns to some combination of a person’s labor, ingenuity, and/or luck.²³²

Although distinguishing between inframarginal and market-rate returns is difficult, we need not do so. Mother—not Grandfather—should be credited for both whenever Mother has a choice about investing her inherited wealth. Any investment of Grandfather’s $10,000,000 would have triggered, at minimum, the risk-free rate of return and should be traced back to Grandfather’s bequest. Returns above and beyond the risk-free-rate of return, however, should be attributed to Mother.

The default rule should therefore be to attribute the risk-free rate of return—as measured by the average U.S. Treasury bond yield—to Grandfather’s investment. The best measure of this is the average yield on a U.S. Treasury Bond of comparable length. Imagine that Mother outlives Grandfather by 30 years. If so, the average rate of return for a 30-year bond should be imputed to Mother’s inheritance from Grandfather. Any “extra” wealth should be credited to Mother and treated as new, first-generation wealth.

Complications

The foregoing analysis assumes both that Mother has a choice about what to invest in, and that her investments are successful. But what if those assumptions are incorrect? Start with choice. Imagine that Grandfather bequeaths stock that skyrockets in value to a trust with an independent trustee over whom Mother has no control. Given that Mother has no say in how to invest the asset and assumes no risk herself, none of the stock’s value is attributable to her choices. The stock’s full value at her death should be credited to Grandfather. Moreover, we already have rules that identify when one has control over a trust; the Rignano tax could simply import the grantor trust rules.

Next let’s upend the assumption that Mother’s investments are uniformly successful. Imagine that Mother quickly squanders Grandfather’s fortune by investing his $10,000,000 in Blockbuster Video stock. She later, however, invests in a relatively unknown start-up called “Google,” parlaying a few thousand dollars into $10,000,000. How should Mother’s fortune be treated at her death?

Mother’s fortune should still be treated as inherited and traced back to Grandfather for three reasons (an approach favored by Rignano).²³³ First, Mother is able to leave Daughter $10,000,000 more than without Grandfather’s wealth. His bequest enables Mother to start at $10,000,000; lose $10,000,000; and nevertheless end at $10,000,000. Without the bequest, if Mother loses and re-earns $10,000,000, she ends at zero. Second, if we assume that Mother would have earned the risk-free rate of return when successfully investing Grandfather’s bequest, parity requires us to make the

same assumption even when the outcome is different. Either we assume that return or we do not.

Finally, ignoring Grandfather’s bequest ignores that money is fungible and creates incentives that undermine the goals of wealth taxation by essentially encouraging Mother to squander Grandfather’s bequest. Let’s say that Mother has an idea for a successful business that will earn her $15,000,000, and Mother also wants to spend $10,000,000 on a year-long first-class trip around the world. Compare two scenarios, Early Trip and Late Trip. In Late Trip, Mother saves Grandfather’s money and starts a business that earns $15,000,000 before taking the trip. The trip reduces her bank account from $25,000,000 to $15,000,000. Under the default rule established above, we’d use the risk-free rate of return to see what Grandfather’s wealth would have grown to. For the sake of illustration, let’s assume it would have grown to $14,000,000. If so, only $1,000,000 of Mother’s bequest to Daughter is treated as earned by Mother.

In contrast, imagine what happens if we use a rule that ignores Grandfather’s bequest if she spends it or invests it poorly. Mother can reduce her tax burden by travelling before earning her own money. In Early Trip, Mother spends Grandfather’s money on the trip and zeroes out her account. She then starts a business and earns $15,000,000, which she passes along to Daughter. If we ignore Grandfather’s bequest on the grounds that she spent it or wasted it, all her $15,000,000 wealth is treated as self-made.

Mother should not be treated differently depending on what she does with Grandfather’s money. Whether she spends it, invests it poorly, or invests it wisely, she had power over $10,000,000, and at her death, $10,000,000 (plus the risk-free-rate-of-return) should be credited back to Grandfather.

E. Tracing

A fifth issue—flagged by neither Rignano nor Halliday—is determining who receives inherited wealth as it moves downstream. This has two components, one normative and one administrative.

The Normative Question

Let’s start with the normative question. We’ve been using an example with one member in each generation for simplicity. Again, assume that Grandfather leaves Mother $10,000,000, but now imagine that Mother has not one but two children, Daughter and Son.

In applying the tax to Daughter and Son, how should we decide as a normative matter who receives Grandfather’s wealth, and who receives the wealth created by Mother? Ideally, we’d somehow allocate Grandfather’s wealth to each of them in proportion to how much wealth they actually receive from Mother. This would be possible if Mother does not make any lifetime gifts, instead re-transferring all of Grandfather’s wealth at her death. Lifetime gifts, however, render this impossible.

One option is to allocate Grandfather’s bequest pro rata among Daughter and Son by giving them each a $5,000,000 “taxable amount” that is essentially a mirror-image of existing exemptions (this represents the total amount of Grandfather’s wealth that should be taxed as a second transfer when Mother passes it along, divided by two since Mother has two children). Under this approach, transfers to each of them would be taxed until they reached $5,000,000; later transfers would be untaxed. This solution, however, has two problems. First, it undertaxes the family if Mother favors one child. Imagine that Mother does not earn her own wealth, and transfers all of Grandfather’s $10,000,000 to Daughter and none to Son. Under the pro rata apportionment approach, only $5,000,000 would be treated as second-generation. Second, assigning a per-capita amount at Grandfather’s death requires knowing who Grandfather’s bequest should be apportioned among—that is, who Mother is going to leave her wealth too—which may be unknowable at his death.

A better solution is a first-in-time approach that treats the first $10,000,000 received by either Daughter or Son as second-generation, regardless of how Mother splits $10,000,000 between them. This is essentially how the current system treats a donor’s lifetime exemption amount and allows Mother to allocate the tax burden via the timing of her transfers.

Administration

The next question is how one determines as an administrative matter, that a recipient of a gift or bequest has received wealth that has been inherited by the transferor. This requires more record-keeping than a traditional estate or inheritance tax, but not an insurmountable amount. And in fact, certain elements of this Article’s proposal exist in current estate and inheritance taxes in the U.S. and internationally.

Revisit Grandfather, Mother, and Daughter. As under current law, Grandfather’s executor will file a tax return at his death that shows the total amount of gratuitous transfers that Grandfather has made. To implement a Rignano tax, his executor would also make an election on that return to treat some or all of Grandfather’s wealth as first-generation, as well as recording to whom Grandfather left his wealth. Any wealth not elected by the executor will be treated entirely as a second-generation transfer. Absent malpractice, Grandfather’s executor will make the election. Mother, who receives Grandfather’s bequest, will also file a tax return upon receipt showing the bequest’s source and value, as well as indicating whether any assets are not under her investment control. Assuming Grandfather’s executor make the proper election, however, Mother will pay no tax.

These records enable us later to determine how much of any wealth that Mother later passes along should ultimately be traced back to Grandfather. When Mother makes a gift or bequest later, we need to know three things to calculate Daughter’s tax liability: the imputed value of Grandfather’s bequest to Mother at the time of Mother’s later transfer, the amount of that later transfer, and the value of any assets transferred from Grandfather to Mother over which Mother had no control.

We know the imputed value of Grandfather’s bequest by applying the risk-free rate of return to its value, as recorded on his and Mother’s tax return. This, of course, assumes Mother had investment control over the assets. If Grandfather also bequeathed assets to Mother over which she had no control, we’d determine both the imputed value of assets over which she control, and the current value of any assets over which she lacked control. This determines what dollar value of any transfers from Mother should be taxed to the recipients. Any excess will be treated as wealth created by Mother and not taxed.

This approach requires more record-keeping than under current law—namely, it requires both transferors and recipients to file returns, instead of just the transferor (in an estate tax) or just the recipient (in an inheritance tax). But the valuations required present no more difficulties than under current law. Transferors must already value assets at the time of a gift or bequest, and at times, formulas are used to impute such values based on current interest rates.

Two additional aspects of this approach are similarly used both in the U.S. and abroad. First, many inheritance tax systems tax recipients differently depending on from whom they inherit. (Generally, heirs who inherit from close relatives such as parents are treated more leniently than those who inherit from more distant relatives like cousins.). There is thus precedent for looking at the source of a gift or bequest when taxing the recipient.

Second, current law in the U.S. provides that in some circumstances, the tax consequences to a decedent turn on actions taken at the prior death of a spouse.²³⁴More specifically, the second spouse to die can use any of the first spouse’s unused exemption amount, so long as the first spouse’s executor made the proper election. The success of portability, as these rules are known, suggest that tying one person’s tax consequences to the actions of prior transferors is workable.

F. Transfers in Trust

The foregoing illustrations have used outright gifts and bequests. But many wealthy families transfer most of their wealth in trusts that last for several generations. For example, Grandfather may choose to create a trust that pays the income to Mother for her life, and at her death, distributes the corpus to Daughter. Applying a Rignano tax to transfers in trust raises additional questions. The first, which arises in any accessions tax proposal, is to determine when the taxable events occur. Note that for each trust beneficiary, there are potentially two important events—the date the tax is actually imposed, and the date the clock starts for valuation purposes for later transfers.

Remainder Interests

Let’s start with Daughter and her remainder interest. Should she be taxed at vesting, or at distribution?²³⁵ Most accessions tax proposals suggest distribution for administrative and valuation reasons.²³⁶ First, we do not know until distribution exactly how much Daughter receives. While we can often estimate the value of her remainder interest when Grandfather creates the trust based on current interest rates and Mother’s life expectancy, any figure is just that—an estimate. And for some trusts, additional valuation difficulties appear. Imagine that Grandfather’s trust was to Mother for life, and then to her children equally. Perhaps Daughter is the only living child at Grandfather’s death. But whether Mother has more children affects the share of the remainder Daughter will receive. Finally, many interests are subject to trustee discretion, as would be the case if the remainder interest in Grandfather’s trust passed to “Mother’s children in such proportions as the trustee determines to be in their best interests.” Second, until distribution, Daughter may not have liquid funds with which to pay the tax. Although some trust interests can be sold or borrowed against, many cannot.

These concerns apply with equal force to a Rignano tax. But where do normative considerations point, vesting or distribution? With a traditional accessions tax, one could argue that most (but not all) normative justifications suggest treating vesting as the taxable event. For example, if an accessions tax is designed to further welfarist principles, then vesting seems logical, as one’s welfare (from security, reputation, and the fungibility of money) increases upon vesting. Political influence likely starts accumulating at vesting, when politicians and PACs start courting the remainder beneficiary. And since money is fungible, a vested interest frees up other funds that can provide a head start when it comes to educational and economic opportunities. That said, Anne Alstott has argued that the choice/chance distinction counsels in favor of distribution if an accessions tax is designed to reflect equal opportunity concerns.

But a Rignano tax is not designed to further any single normative goal such as equality of opportunity or welfarism in isolation. Instead, it is designed to find a compromise among competing intuitions about wealth transfer taxation—even when those intuitions may seem “wrong” to tax theorists. To that end, some of the administrative considerations discussed above take on normative weight. Consider valuation. In theory, one could tax at vesting based on estimated values and then adjust at distribution to account for divergences from the estimate. But it is quite likely the public would react negatively to the taxation of undistributed yet vested interests, for the same reason the public reacts negatively to the possible taxation of unrealized gains. To many, it simply seems unfair to impose a tax when there has not yet been an event that provides liquidity, or when valuation is unclear. Given that one purpose of a Rignano tax is to make political headway where other inheritance taxes fail, the better course is to wait until distribution of remainder interests to impose the tax—that is, until we know exactly who gets exactly how much.

The same rule, with two exceptions, should apply when determining when Daughter’s clock starts ticking for purposes of valuing later growth for subsequent transfers. Daughter generally does not have control of the funds until distribution, and therefore none of their prior growth (or lack thereof) should be attributed to her to determine what part of subsequent transfers by Daughter stems from her own initiative or Grandfather’s wealth. The first exception would be if Daughter somehow had discretionary investment control of the assets during Mother’s income interest, in which case investment decisions could plausibly be attributed to her. The second is if Daughter could sell her remainder interest at vesting, in which case the decision to leave it invested in the trust should be attributed to her and any later distribution of wealth beyond the risk-free-rate of return should be deemed self-made.

Income Interests

What about income interests? Assume that Mother’s income interest has an estimated FMV of $1,000,000 at vesting based on the present value of its payment stream and is predicted to pay out $100,000 a year for the rest of Mother’s life. Or imagine that Daughter receives a secondary life estate instead of the corpus outright at Mother’s death. Should she be treated as receiving the inheritance all at once at vesting, or over time when she receives her annual income distribution? In theory, these are economically equivalent, assuming perfect information about interest rates and lifespans (just as the difference between taxing a remainder interest at vesting and distribution is).

The same considerations that apply to remainder interests should apply here as well. The normative considerations that justify a traditional accessions tax do not point clearly in one direction, while weighty valuation and liquidity concerns remain. The default should be that the taxable event, be it imposing tax or starting the clock for later valuation purposes, happens at distribution. Exceptions would be made where the beneficiary has control over investment assets or the ability to sell her income interest.

G. Transition Rules

A Rignano tax contains a unique transition issue. In the illustrations used throughout this Article, we have assumed that Grandfather was self-made. And in the example above, we know how much of Mother’s wealth to tax because Grandfather’s estate would have filed an election to treat his estate as first-generation wealth.

But what if Grandfather himself inherited some money, and was not completely self-made? How do we treat the first generation after a transition to a Rignano tax? Treating all existing wealth at the time of the tax’s imposition as self-made is unsatisfactory, for it essentially delays implementation of the tax for a generation and does not reflect reality. Instead, some existing wealth should be treated as self-made, and some should be considered second-generation wealth. Halliday and Rignano both acknowledge the need for a transition rule to determine that portion, with Rignano suggesting that one-third to one-half of current wealth should be treated as inherited.²³⁷ Fairly recent studies suggest that anywhere from 15% to 46% of current wealth is inherited. Although any number will be admittedly arbitrary, treating one-sixth to one-third of existing wealth as second-generation wealth seems reasonable.²³⁸

CONCLUSION

This Article has made the case for an inheritance tax system that—unlike our own—taxes old money more heavily than new. Specifically, it proposes completely exempting gifts and bequests of self-made wealth, but taxing heirs who receive re-transferred wealth. Although such a tax is more complex than our current system, the challenges are manageable and are well worth it.

Crucially, this proposal provides a way out of the enduring stalemate over taxing wealth. The estate tax has been the subject of passionate debate for decades, resulting in an ongoing state of political uncertainty. Rates and exemption levels have ping ponged back and forth for two decades, including a single year—2010—that had no estate tax at all. And although recent legislation ostensibly made the exemption’s expansion “permanent,” there is no reason a future Congress could not “permanently” shrink it again. Given the current political polarization, there is no doubt that questions about whether and how to tax wealth will continue to generate heated debate.

What makes this debate so intractable is not only that the public as a whole is divided on the issue of inheritance taxation, but that many individual Americans hold simultaneous beliefs about wealth, opportunity, desert, fairness, and family that seemingly contradict each other. Many of us, for example, have at least a sliver of sympathy for some of the claims of both supporters and opponents of the tax.

Yet our current system treats taxing wealth transfers as an all or nothing proposition, without acknowledging a key source of our seemingly contradictory beliefs: the finding that many of us silo beliefs about wealth, distinguishing among earned and inherited wealth. By harnessing this finding, as well as the insights of other recent psychological work on taxation, a Rignano tax thus reconciles the benefits of wealth transfer taxation with deeply held beliefs about fairness, desert, private property, and family. And by so doing, it offers an opportunity for a stable and lasting resolution to the debate over taxing inherited wealth.

98 S. Cal. L. Rev. 1439

Download

Miranda Perry Fleischer*

*Richard and Kaye Woltman Professor in Finance, The University of San Diego School of Law. For helpful feedback and suggestions, the author thanks Anne Alstott, Jordan Barry, Lily Batchelder, Heather Field, Dov Fox, David Gamage, Ari Glogower, Daniel Halliday, Shelly Layser, Ray Madoff, Shu-Yi Oie, Caley Petrucci, Jim Repetti, Diane Ring, Darien Shanske, and Mila Sohoni, as well as participants at the University of Virginia Tax Policy Workshop, the Boston College Law School/Tulane Law School Tax Roundtable, the Association of Mid-Level Tax Scholars Conference, the University of San Diego Colloquium Series, and the staff of the Southern California Law Review. Thanks to the University of San Diego Law Library and Carlisle Olson for invaluable research assistance.

Introduction

I. Today’s Debate About Litigation Finance

A. What is Litigation Finance?

B. The Scholarly Debate

C. The Policy Debate

II. Nonmarket Strategies: A Primer

A. What Are Nonmarket Strategies?

B. The Types of Nonmarket Strategies

Adaptive Strategies

Transformative Strategies

Additive Strategies

C. The Choice Among Nonmarket Strategies

III. Litigation Finance as a Nonmarket Strategy

A. Litigation Finance as Corporate Finance: An Adaptive Strategy

“Market” Methods of Corporate Finance

Litigation Finance as a “Nonmarket” Method of Corporate Finance

B. Litigation Finance to Pursue Litigation: Adaptive and Transformative Strategies

C. Lobbying and Trade Associations: Transformative and Additive Strategies

IV. Policy Implications of Litigation Finance as Nonmarket Strategy

A. A New Dimension to the Policy Debate

A Regulation of the Capital Markets

Implications for Business Competition

B. Implications for the Civil Justice System

V. Scholarly Benefits of the Nonmarket Strategy Framework

A. Legal Scholars

B. Business Scholars and Businesses

Conclusion

98 S. Cal. L. Rev. 1379

Introduction

I. An Overview of Wealth Transfer Taxation

II. The State of The Debate over Estate Taxes

A. Arguments in Favor of Wealth Transfer Taxation

Equality of Opportunity

Dynastic Power

Inheritances and Ability to Pay

A Wealth Transfer Tax as a Periodic Wealth Tax

B. Arguments Against Wealth Transfer Taxation

Equality of Opportunity Revisited

Rejecting Declining Marginal Utility and Progressivity

Private Property Rights

Double Taxation

Efficiency and Administrative Concerns

III. Settling the Debate with a Rignano Tax

A. Attitudes Toward Taxation, Fairness, Redistribution, and Equality

Taxation and Folk Justice

Policy Silos

A Rignano Tax Reconciles These Competing Intuitions

IV. A Rignano Tax

A. The Base

Transfers or Receipts?

Gifts

a. Gifts in General

b. Gifts and Timing Complications

Exclusions and Exemptions

B. The Rate

Initial Transfers

Subsequent Transfers

Adjusting for Age

C. Frequency: Determining the Number of Transfers

Generation-Skipping Transfers

Transfers in Rapid Succession

D. Valuation

The Problem

Risk-Free Rate of Return as the Default Solution

Complications

E. Tracing

The Normative Question

Administration

F. Transfers in Trust

Remainder Interests

Income Interests

G. Transition Rules

CONCLUSION

98 S. Cal. L. Rev. 1439

Table of Contents