This has been interpreted as a simple distinction: direct taxes must be apportioned among the states according to population; indirect taxes must be uniform throughout the states.
What seems simple on its face is not simple at all. It is far from clear what is a direct tax and what is an indirect tax. The Framers provided one example of a direct tax, the head tax, and used several terms for presumed indirect taxes: duties, imposts, and excises. But as we’ll see, that doesn’t tell us whether a given tax is, say, an excise tax or not.
In 1794, during George Washington’s administration, Congress passed a tax on “carriages for the conveyance of persons,” whether for hire or for personal use. This was not a sales tax, but a $16 assessment on every carriage owned, including those possessed at the time the tax was passed. Since the tax was not apportioned among the states, the courts were asked to declare it unconstitutional.
Was that a tax on the ownership of property, making it direct and in need of apportionment? Or was it on the use of property, presumably making it an excise and thus an indirect tax not in need of apportionment (but in need of uniformity)?
No less an authority on the Constitution than Rep. James Madison said it was a direct tax and hence unconstitutional as written. His friend and respected Federalist Rep. Fisher Ames said it was an indirect tax and hence perfectly constitutional because “the duty falls not on the possession, but on the use.” Treasury Secretary Alexander Hamilton filed a brief in the case, in which he said,
If the meaning of the word “excise” is to be sought in a British statute, it will be found to include the duty on carriages, which is there considered as an “excise.”
Although each justice had a different rationale, the Supreme Court, in Hylton v. United States (1796), sided with Hamilton and Ames. The tax was declared indirect and not in need of apportionment.
Here was an early clue that the distinction between direct and indirect was by no means straightforward. If Madison on one hand and Hamilton and Ames on the other couldn’t agree on what seemed to be a simple matter, what lay ahead? In fact, discussions about what’s direct and what’s indirect have something of the feel of a coin toss. Earlier, Hamilton had confessed confusion about the terms: “It is a matter of regret that terms so uncertain and vague in so important a point are to be found in the Constitution.” Indeed, when during the Constitutional Convention a clarification of the term “direct taxation” was requested, Madison recorded in his notes, “No one answered.”
To add to the confusion (and to get a bit ahead of myself), I will point out that while American legal authorities have regarded taxation of income generally as an indirect (excise) tax not requiring apportionment, the British have long regarded it as a direct tax.
This issue as it affects income taxation came to a head in 1894, when Congress passed the first income tax since the war between the states. We’ll turn to that law and its court challenge in the next section.
Beware Income-Tax Casuistry, Part 2
The United States got its first income tax during the war between the states, again demonstrating that war harms ordinary people in more ways than militarily. During any war, government becomes an especially voracious consumer of the people’s resources, and dissent is stifled or suppressed. So it is no surprise that the first income tax came when it did, or that Abraham Lincoln, a devotee of mercantilism, was the father of the tax.
Several successive wartime bills enacting progressive income taxes were passed by Congress, and when the war ended, the income tax did not. Changes to the law got rid of the progressive rate structure, but the tax continued. A flat rate of 5 percent was levied on incomes over $1,000. The tax, however, was set to expire in 1870. Out of a population of 39.5 million, no more than 250,000 people paid it. But it would not end in 1870. The pro-income-tax forces rallied, and Congress passed a 2.5 percent tax with a $2,000 exemption. Then, two years later, that tax was allowed to expire. For the first time since the war, (wealthy) Americans did not see their incomes taxed.
The big budget surplus was a major reason the tax was permitted to die. Meanwhile, the pro-tax lobby kept at work, prompting the introduction of 68 bills from 1874 to 1894. A big selling point for populists was that the income tax would permit large reductions in tariffs, which harmed working people for the benefit of wealthy manufacturers. Their wish to relieve workers of the burden of protectionism was admirable, but their strategy was flawed. Eventually, Americans would have an income tax and high tariffs. There’s a lesson in that for all would-be tax reformers.
Congress next passed an income tax in 1894, during a depression that ate up the budget surplus. President Grover Cleveland, who said he opposed the tax, let it become law without his signature. The law imposed a 2 percent tax on “gains, profits and incomes” over $4,000 during a five-year period. Few people would have paid it — and it had a short life, because it was successfully challenged by a bank stockholder, Charles Pollock, who objected that taxation of dividend income as written in the law was unconstitutional because it was not apportioned among the states. His landmark U.S. Supreme Court case, Pollock v. Farmers’ Loan & Trust Co. (1895), paved the way for the Sixteenth Amendment.
Pollock and the Supreme Court
To cut to the chase, the Supreme Court struck down the unapportioned tax. This has led people to conclude that the Court held income taxation itself unconstitutional. But, as we will see, the Court did not say that.
The case had to be argued twice. In the first instance, the Court declared most of the bill unconstitutional, but split 4-4 on the question of whether a tax on general income was also unconstitutional. (One justice was ill.) On rehearing, the Court voted 5-4 to affirm its earlier decision and to add that income taxation per se was not barred by the Constitution.
The majority opinion, written by Chief Justice Melville Fuller, who has a classical-liberal reputation, is instructive. Recall our discussion from part 1 that the Constitution distinguishes between direct taxes, such as a head, or poll, tax, and “duties, imposts and excises,” presumably indirect taxes. Direct taxes must be apportioned among the states according to the census. Indirect taxes do not have to be apportioned, but must be uniform throughout the country. Recall also that from the beginning, there was no general agreement on precisely which taxes were direct and which were indirect. No less an authority on the Constitution than Fisher Ames said, “It was difficult to define whether a tax is direct or not.” Alexander Hamilton expressed similar uncertainty.
The 1894 tax was comprehensive, which led the Court to consider the nature of the tax as it affected different sources of income. Taking the two rulings together, the Court concluded that a general tax on income, being indirect, was constitutional without apportionment among the states, but that a tax on income from real and personal property, being indistinguishable from a tax on the property itself, was direct taxation and thus required apportionment. Regarding the second point, the Court held,
[Can] it be properly held that the constitution, taken in its plain and obvious sense, and with due regard to the circumstances attending the formation of the government, authorizes a general unapportioned tax on the products of the farm and the rents of real estate, although imposed merely because of ownership, and with no possible means of escape from payment, as belonging to a totally different class from that which includes the property from whence the income proceeds?
Nor can we perceive any ground why the same reasoning does not apply to capital in personalty held for the purpose of income, or ordinarily yielding income, and to the income therefrom.
Thus the Court said that some taxes on income, depending on the source from which it derives, are direct taxes requiring apportionment. This did not mean that all income taxes were in that category. Determining whether a given tax is direct requires an examination of the income’s source.
As to taxation of other income, the Court said it had
not commented on so much of it [the law] as bears on gains or profits
from business, privileges, or employments, in view of the instances in which taxation on business, privileges, or employments has assumed the guise of an excise tax and been sustained as such.
In other words, a general income tax is an excise (indirect) tax and does not require apportionment. “[There] is no question as to the validity of this act except [the sections on real and personal property].” Thus the tax on wages, salaries, and profits was held to be constitutional. But this created a problem. If the provisions that taxed income from real estate and securities were stricken, the Court said,
this would leave the burden of the tax to be borne by professions, trades, employments, or vocations; and in that way what was intended as a tax on capital would remain, in substance, a tax on occupations and labor. We cannot believe that such was the intention of congress.
Thus, concluded the Court, “[The] scheme must be considered as a whole.” The entire act was stricken. This is what leads people to believe that income taxation in general was voided, but as we’ve seen, that is not the case.
The Court stressed that it was not its job to say whether an income tax was desirable. Nevertheless, it reminded the county that “the instrument [Constitution] defines the way for its amendment.”
To summarize, the Pollock Court did not hold general income taxation unconstitutional. Quite the contrary. It acknowledged that in the United States income taxation was regarded as indirect and not subject to the apportionment rule. All that it found unconstitutional was unapportioned taxation of the income from real estate, stocks, and bonds on grounds that to tax such income was to tax the property itself, hence making the tax direct and in need of apportionment.
Was the Court correct? I don’t think so. Surely there is a difference between taxing real-estate holdings and taxing the income from such holdings. If one rents a house to someone, the rent is income that would be covered by an income tax. But if one stops renting the house, the income would cease and thus no tax would apply. The same would hold for stock: no dividends, no tax. Tax would be paid only on the gain at sale. Bonds might be the only exception, since they are held only for the interest income.
So the Court seems to have gotten it mostly wrong. But that’s academic. It has been speculated that the conservative Court ruled the way it did because it was partial to the capitalists and did not want income from capital taxed. Who knows? Its ruling was law, leaving to the proponents of full income taxation only one recourse, a constitutional amendment.
Beware Income-Tax Casuistry, Part 3
In 1895, when the U.S. Supreme Court knocked out an income-tax law in Pollock v. Farmers’ Loan & Trust Co., the champions of income taxation in America suffered a big setback. To reiterate what I said in part 2 of this series, the Court, contrary to what many people think, did not rule income taxation per se unconstitutional. Quite the opposite. All it did was rule that taxation of income from property had to be apportioned among the states. The reason is that it regarded a tax on such income as equivalent to a tax on the property itself. Since a tax on property was regarded as a direct tax, and the Constitution requires direct taxes to be apportioned according to the census, no such tax could stand without an apportionment clause. Since that clause was lacking in the 1894 tax bill passed by Congress, the Court struck it down. It also struck down the provisions taxing wages and salaries, but only because it believed that putting the full tax burden on workers would violate Congress’s intent to have a broad-based tax.
This left the income-tax advocates only one route: a constitutional amendment. In 1913 the Sixteenth Amendment was added to the U.S. Constitution. (I leave aside the claims that the amendment was ratified improperly by the states. No court accepts this argument, which is based on trivialities. Besides, the case against the procedural integrity of the original Constitution’s ratification is far stronger.)
The Sixteenth Amendment is worded thus: The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
In light of Pollock one can see the significance of the key phrase in the amendment, “from whatever source derived.” What the amendment did was remove a restriction, one of the few, from Congress’s power to tax, namely, by relieving it of the need to apportion a tax on income from property. As we shall see, it did not grant Congress the general power to tax incomes because Congress needed no amendment to exercise a power it already had.
The Brushaber Decision
The same year that the Sixteenth Amendment was ratified Congress passed a graduated income tax during a special session called by President Woodrow Wilson. As usual, the income tax began as a tax on the wealthy. (World War II turned it into a truly mass tax. That’s war for you.) Shortly after passage, the tax law was challenged in federal court. The case culminated in a revealing Supreme Court decision, Brushaber v. Union Pacific Railroad, which was handed down in 1916. Frank Brushaber, a stockholder in the railroad, contended that the tax on the company violated due process. The Court rejected Brushaber’s claims, arguing that it is “well settled” that the due-process provision is not a limit on the power to tax: “in other words, that the Constitution does not conflict with itself by conferring, upon the one hand, a taxing power, and taking the same power away, on the other, by the limitations of the due process clause.”
For anyone looking for protection from taxation this is an ominous statement. The tax-protest movement attaches great weight to this opinion — for reasons that mystify me. The language of Brushaber should make them cringe.
The Court laid the groundwork for its opinion by rehearsing the ruling in Pollock. It noted that the Pollock Court did not rule that income taxes in general were direct taxes requiring apportionment — only certain income taxes, namely, those on land and securities. The Brushaber Court commented,
Nothing could serve to make this clearer than to recall that in the Pollock Case, in so far as the law taxed incomes from other classes of property than real estate and invested personal property, that is, income from “professions, trades, employments, or vocations,” its validity was recognized; indeed, it was expressly declared that no dispute was made upon that subject, and attention was called to the fact that taxes on such income had been sustained as excise taxes in the past. [Emphasis added.]
In other words, Congress always had the constitutional power to tax incomes, which were regarded as indirect taxes not requiring apportionment. (Tax-protest activists make much of the fact that the income tax is held to be an excise tax, but it’s not clear what this gets them.)
The Court then went on to say that the purpose of the Sixteenth Amendment was to relieve the government of what the Pollock Court had to engage in, namely, an examination of the sources of income. In other words, future courts would no longer have to inquire whether a tax on a particular kind of income was in effect a direct tax. Contrary to Frank Brushaber’s argument, it said, no limitations on the power to tax incomes can be divined in the Sixteenth Amendment. Indeed, all such contentions are “in irreconcilable conflict with the very purpose which the Amendment was adopted to accomplish.”
If the opinion had stopped there, it would have been enough to depress opponents of income taxation. But the Court did not stop there. It went on to describe Congress’s power to tax in the most sweeping terms possible, stressing that this power predated the Sixteenth Amendment and was present from the beginning of the government. For example, the Court said that “the authority conferred upon Congress by 8 of article 1 ‘to lay and collect taxes, duties, imposts and excises’ is exhaustive and embraces every conceivable power of taxation.” (Emphasis added.) This is followed by: “[There] was authority given, as the part was included in the whole, to lay and collect income taxes”; “the conceded complete and all-embracing taxing power”; “the complete and perfect delegation of the power to tax”; “the complete and all-embracing authority to tax”; and the “plenary power [to tax].
”
This is all in one paragraph!
In case someone missed the point, the Court later referred to “the all-embracing taxing authority possessed by Congress, including necessarily therein the power to impose income taxes.”
The Legacy of Brushaber
No Court has contradicted the holding in Brushaber. One can quibble with the Court’s opinion that the amendment did not create a new class of taxation, namely, a direct tax that needed no apportionment. It seems to me that is what the amendment did. But that is a side issue. The undeniable upshot of Brushaber is that Congress always had the power to tax anything, including incomes, and that the former necessity to examine the source of income was removed by the Sixteenth Amendment.
Thus the income tax is and has always been constitutional. The manufactured argument that the income tax was intended to, and constitutionally could, tax only incomes derived from some federal privilege is entirely lacking in foundation. If you ask proponents of this position to prove their case, they become evasive, or they make ludicrous arguments, along the lines that the word “includes” is a term of limitation rather than “a term of enlargement,” as a court put it. (One writer argues that only government employees are subject to withholding because the code says, “[The] term ‘employee’ includes an officer, employee, or elected official of the United States, a State, or any political subdivision thereof, or the District of Columbia….”)
Libertarians have to understand that they will not invalidate the tax in court by legal legerdemain. Some tax resisters have managed to have money refunded, but the IRS usually catches up with them. Some land in jail.
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