Constitutional Challenge

Repealing the 16th Amendment wouldn't kill the income tax.

Sen. Richard Lugar (R-Ind.), House Ways and Means Committee Chairman Bill Archer (R-Texas), and the Cato Institute's director of fiscal policy studies, Stephen Moore, all want to replace the federal income tax with a national sales tax. They say that repealing the 16th Amendment will eliminate the income tax. They're wrong. Income taxes existed–and were considered constitutional–before the 16th Amendment.

Ratified in 1913, the 16th Amendment states: "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." The amendment gives Congress carte blanche to impose virtually any sort of income tax it desires–including our current labyrinthine system with its multiple rates, surtaxes, alternative taxes, deductions, phase-outs, double taxation of corporate earnings, and tax on phony gains caused by inflation. The current system also includes a combined tax on estates and gifts known as the unified transfer tax.

But contrary to popular belief, repealing the 16th Amendment wouldn't eliminate Congress' power to impose an income tax, because not all income taxes were held unconstitutional by the Supreme Court before the 16th Amendment was ratified. From 1861 to 1872, Congress imposed income taxes without any interference from the high court. In fact, in the 1881 case, Springer v. United States, the Court upheld the 1864 income tax. From 1862 to 1870, Congress imposed inheritance taxes, which applied to certain gifts as well. In 1874 the Supreme Court upheld the Civil War inheritance taxes in Scholey v. Rew, categorizing an inheritance tax as an excise or impost rather than a direct tax.

Embarrassed by large federal budget surpluses and facing re-election in 1872, President Grant and Congress allowed the income tax to lapse. Pressure from voters had already led Congress to repeal the inheritance tax before the 1870 elections.

But budget surpluses then and for the next 30 years didn't prevent supporters of the earlier income tax from clamoring for another one. From 1874 through 1894, members of Congress introduced 68 bills that would have imposed an income tax. Supporters and opponents alike viewed the income tax as "class legislation"–an attempt to redistribute income. Supporters believed that the tax system in use at the time, which relied primarily on tariffs, was regressive, and therefore unfairly distributed income away from the poor to the wealthy. Supporters hoped the income tax would stop or at least reduce regressive redistribution. Opponents saw the income tax as an attempt to set the poor against the wealthy and redistribute income away from those who generated it.

By 1894, a majority in Congress came to support some form of income taxation. It passed a law which imposed a 2 percent flat tax on corporate net income, and on individual incomes in excess of $4,000 ($76,000 in 1998 dollars).

Unlike the current system, however, the 1894 law didn't tax dividends, thus avoiding the current double taxation of corporate income. While the law didn't establish a gift or estate tax, it did include the value of gifts and estates in the income of the recipient for purposes of calculating the income tax.

Opponents of the income tax immediately challenged it in court. In 1895, the Supreme Court, in Pollack v. Farmers Loan and Trust Company, struck down the 1894 income tax as unconstitutional. But the Court didn't rule that every federal income tax would be unconstitutional.

At the core of the Pollack decision is the distinction between direct and indirect taxes. Article I, Section 9, paragraph 4 of the Constitution stipulates that "No Capitation [head], or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken." "Publius" (presumed to be Alexander Hamilton), in Federalist 22, held that taxes "of the direct kind, which principally relate to land and buildings, may admit a rule of apportionment. Either the value of the land, or the number of the people, may serve as a standard." In the 1796 case, Hylton v. U.S., Hamilton, as chief counsel for the government, persuaded the Supreme Court that only head taxes and taxes on real estate should be considered direct taxes. A tax on tangible personal property, such as carriages, was not a direct tax.

So in ruling on the constitutionality of the 1894 income tax in Pollack, the Court faced a century-old precedent holding that the only taxes Congress could not impose without doing so proportionately among the states were head taxes and real property taxes. Opponents of the income tax argued that taxing income from property was the equivalent of taxing the property itself.

Determined to stop what they (correctly, it seems) saw as an entering wedge for wide-scale income redistribution, a majority of the eight justices who initially heard the case accepted the argument and expanded the list of direct taxes to include taxes on the income from real property. The Court also ruled unanimously (on this issue) that a federal tax on income from state and local bonds infringed the right of states and their subdivisions to borrow money.

And after the ninth justice returned from illness, upon rehearing the case the majority expanded the definition of a direct tax even further, to include taxes on income from tangible personal property. With such a large portion of the law disabled, the majority decided to toss it out entirely.

But the Supreme Court did not say that the remaining provisions of the law, had they passed independently, would have been unconstitutional. To the contrary, the Court made clear that Congress could impose a tax on income from wages, salaries, and other compensation for personal services, as well as on income from intangible property such as stocks, bonds, patents, and copyrights. The Court ruled the law unconstitutional because it taxed income from tangible property without apportionment.

So even without the 16th Amendment, Pollack would allow Congress to impose a tax on a broad range of income. The Supreme Court clarified the point in a series of cases, including Brushaber v. Union Pacific Railroad (1915), Stanton v. Baltic Mining Company (1916), and Eisner v. Macomber (1920). In these cases, the Court ruled that the 16th Amendment granted Congress no new power to tax; the 16th Amendment simply reclassified an income tax on tangible property as an indirect tax. Demonstrating that the 16th Amendment granted no new power, the Court held that Congress still couldn't tax interest earned on state and local bonds–much to the chagrin of not only Progressives but also of Secretary of the Treasury Andrew Mellon and other tax cutters, who believed that the tax-exempt status of state and local bonds was redirecting capital from efficient allocation in the private marketplace into bloated state and local government bureaucracies.

Three years after Pollack, Congress passed the War Revenue Act to fund the Spanish-American War. The act imposed a tax of 0.25 percent on the gross receipts over $200,000 of companies in the sugar and oil refining businesses and a progressive estate tax ranging from 0.75 percent to 15 percent. (An estate tax is imposed on the estate, while an inheritance tax is imposed on the recipients of the estate.) In Spreckles Sugar Refining Company v. McClain (1902), the Supreme Court upheld the gross receipts tax as an excise tax. Two years earlier, in Knowlton v. Moore, the Court had decided that Pollack hadn't overturned Scholey, so that an inheritance or estate tax still constituted an indirect excise rather than a direct tax.

Fourteen years after Pollack, Congress imposed a 1 percent flat tax on corporate net income in excess of $5,000 ($95,000 in 1998 dollars). By taxing corporations on dividends from other corporations, the 1909 act began the practice of double taxing corporate income. Opponents challenged the 1909 act in court, too. In 1911–two years before the adoption of the 16th Amendment–the Supreme Court ruled in Flint v. Stone Tracy Company that the tax on corporations was constitutional as "an excise upon the particular privilege of doing business in a corporate capacity." In other words, according to the Court's reasoning in 1911, just because the corporation tax was a tax on income didn't mean it was an income tax.

So even before the 16th Amendment, the Pollack, Spreckles, and Flint decisions gave a clear signal to Congress that it could impose a tax on wages, salaries, professional service fees, interest, dividends, royalties from intellectual property, estates, gifts, gross receipts, and any income earned by corporations. Congress could even double tax corporate income.

Eliminating Congress' power to tax income, as many supporters of a national sales tax propose, would require more than merely repealing the 16th Amendment. We would have to ratify an amendment prohibiting Congress from imposing any income tax as well as estate, gift, and gross receipts taxes. Otherwise, Congress could rely on the earlier Supreme Court decisions to continue collecting these and other related taxes. And as the residents of Canada and Western Europe could tell us, we'd probably end up with the worst of both tax worlds: paying both a national sales tax and an income tax.

David B. Levenstam was the Louis Pelzer Fellow in American History at the University of Iowa and a Salvatori Fellow at the Heritage Foundation. A tax practitioner since 1982, he is working on his Ph.D. dissertation, titled The Triumph of Competition: The American Political Economy, 1887-1933.