Most of us have heard of Murphy’s Law, which says that if something can go wrong, it will. Now, the U.S. Court of Appeals in Washington has given the axiom a literal meaning with a wrong decision called Murphy.

This Murphy starts with an essential fact: Americans are litigious. American courts have long awarded compensation for physical injury. But many plaintiffs and their lawyers are really in court to convince judges and juries they need damages for something vaguer — emotional pain. Dollar awards for the latter often run in the millions, multiples of the physical damages.

The compensation for physical injury is not taxed, on the cool actuarial theory that cash for an arm offsets a quantifiable loss. Yet the money won for emotional pain has been taxed in recent years. And this doesn’t seem wrong because many plaintiffs who are suing for emotional damages are also performers: Their lawyers are the jesters who believe that, if they work hard enough, the jury will toss down someone else’s fortune.

While the cash that plaintiffs do win may well be about loss, it is also a payment for theater well done. The Taxman’s arrival on the scene for his share has been society’s acknowledgment of that reality.

Until the case of Marrita Murphy, a former employee of the New York Air National Guard. Ms. Murphy blew the whistle about environmental violations at an airbase. Her ex-bosses retaliated by giving her bad references. She won $70,000 for emotional pain and loss of reputation and duly paid some $20,000 in taxes. It is that tax money that the appellate judges said must go back to Ms. Murphy. They ruled that the award wasn’t taxable “because compensation for a non-physical personal injury is not income under the 16th Amendment” to the Constitution.

Tax protesters on the far right will love this one. If you have ever listened to their radio tax talk, you know they are constantly trying to narrow or annihilate the 16th Amendment. On the legal side, too, there is a basis for this opinion — maybe.The 16th Amendment, ratified in 1913, says Congress may “lay and collect taxes on incomes, from whatever source derived.” Ever since then, economists have been fighting about the definition of the concept of income.

In Ms. Murphy’s case, the judges decided that the award was given to her “to make Murphy emotionally and reputationally ‘whole.'” The judges are saying that all Ms. Murphy got back was what she had had before she tangled with her employers.

This reasoning will appeal to legal experts across the political spectrum. We can speculate that Judge Douglas Ginsburg, the conservative who wrote the opinion, may have wanted to attack the income tax from the right, and found his vehicle in Ms. Murphy. Judge Judith Rogers, who signed off on the opinion, is an appointee of President Clinton’s. She may approve of the redistributive aspect of the opinion — Democrats tend to believe redistribution is highly constitutional.

When you try applying Murphy to other areas, as the tax bloggers have been doing nonstop in the week or so since the Murphy finding, you run into trouble. Take the argument to its humorous extreme: Both windfall wealth and gambling proceeds are currently taxable. The Murphy principle suggests that they shouldn’t be. Plaintiffs could argue that their casino winnings were only restoring to them the luck they were born with.

There are also potential consequences for financial markets. As Paul Caron of the University of Cincinnati College of Law points out, “The buyer of a zero-coupon bond that does not pay interest currently is nevertheless taxed each year on the increased value of the bond as it nears maturity.Yet because such imputed interest was not considered income back in 1913, the Murphy court’s approach could impose a constitutional barrier to taxing such items.”

“Almost anything is up for grabs here,” concludes Mr. Caron.

Also important is the signal Murphy sends to potential litigants. From obstetricians who retire early to avoid malpractice challenges to company chairmen announcing initial public offerings overseas, Americans routinely withhold their talents from the rest of the economy because of the current legal crisis.

Part of that crisis comes from the fact that “non-economic damages of any sort are a sort of tragedy bonus,” as Philip Howard, cofounder of a legal reform group, Common Good, puts it. By lifting taxes on such damages, the federal court is upping that bonus substantially. Insurers will eventually get wise to this, but at first they would take some hits. The new incentive to sue may yield results that make the current legal weather seem mild.

There is another signal from Murphy, subtler but equally distressing. Americans tend to believe that activity that is taxed is somehow suspect, whereas untaxed activity is more virtuous. Now the court is confirming to citizens what their lawyers already tell them — litigation is virtuous. More virtuous than buying a lottery ticket, for lottery winnings are taxable.

The hope is that the Supreme Court, which is likely to hear the case, will lay Murphy to rest. Then Congress can alter the law if it likes. But as it stands, Murphy is dangerous. It confirms what Americans already believe: The world owes them.

Miss Shlaes is a columnist for Bloomberg News.