The Unconstitutionality of a Wealth Tax

In a post today, Jim Pethokoukis refers to an op-ed in the New York Times from November arguing that wealth, not income, should be taxed.  He cuts out this snippet:

American household wealth totaled more than $58 trillion in 2010. A flat wealth tax of just 1.5 percent on financial assets and other wealth like housing, cars and business ownership would have been more than enough to replace all the revenue of the income, estate and gift taxes, which amounted to about $833 billion after refunds. Brackets of, say, zero percent up to $500,000 in wealth, 1 percent for wealth between $500,000 and $1 million, and 2 percent for wealth above $1 million would probably have done the trick as well.

 

I'd like to address the idea of a wealth tax - and, yes, I'm going to operate on the naive assumption that the Supreme Court adheres to the Constitution and its own precedent...

A wealth tax is unconstitutional. The Sixteenth Amendment permits taxation only on income and the Supreme Court has ruled on numerous occasions that there must be a “liquidity event” or “transaction” before the Federal government can tax assets.

‘Income may be defined as the gain derived from capital, from labor, or from both combined,’ Stratton’s Independence v Howbert, 231 U.S. 399, (1913).

‘Income within the meaning of the 16th Amendment and the Revenue Act means, gain … and, in such connection, gain means profit… proceeding from property severed from capital, however invested or employed and coming in, received or drawn by the taxpayer for his separate use, benefit and disposal.’ – Staples v United States, (1918).

While it acknowledged the power of the Federal government to tax income under the Sixteenth Amendment in Eisner v Macomber, 252 U.S. 189 (1920, the Court said this did not give Congress the power to tax — as income — anything other than income, i.e., that Congress did not have the power to re-define the term income as it appeared in the Constitution:

“Throughout the argument of the Government, in a variety of forms, runs the fundamental error already mentioned—a failure to appraise correctly the force of the term “income” as used in the Sixteenth Amendment, or at least to give practical effect to it. Thus, the Government contends that the tax “is levied on income derived from corporate earnings,” when in truth the stockholder has “derived” nothing except paper certificates which, so far as they have any effect, deny him [or "her" — in this case, Mrs. Macomber] present participation in such earnings. It [the government] contends that the tax may be laid when earnings “are received by the stockholder,” whereas [s]he has received none; that the profits are “distributed by means of a stock dividend,” although a stock dividend distributes no profits; that under the Act of 1916 “the tax is on the stockholder’s share in corporate earnings,” when in truth a stockholder has no such share, and receives none in a stock dividend; that “the profits are segregated from his [her] former capital, and [s]he has a separate certificate representing his [her] invested profits or gains,” whereas there has been no segregation of profits, nor has [s]he any separate certificate representing a personal gain, since the certificates, new and old, are alike in what they represent—a capital interest in the entire concerns of the corporation.”

Holding:

 

“A pro rata stock dividend where a shareholder received no actual cash or other property, and retained the same proportionate share of ownership of the corporation as was held prior to the dividend, was not taxable income to the shareholder within the meaning of the Sixteenth Amendment, and that an income tax imposed by the Revenue Act of 1916 on such dividend was unconstitutional, even where the dividend indirectly represented accrued earnings of the corporation.”

Instead, income is realised whenever there are “instances of:

1) undeniable accessions to wealth that is

2) clearly realised, and

3) over which the taxpayers have complete dominion.”

‘Congress has taxed INCOME, not compensation or property.’ – Conner v United States, 303 F Supp. 1187 (1969). Notice that the Court took special pains to emphasize only INCOME IS TAXABLE.

“… whatever may constitute income, therefore, must have the essential feature of gain to the recipient. This was true when the 16th Amendment became effective, it was true at the time of Eisner v Macomber, it was true under Section 22(a) of the Internal Revenue Code of 1938, and it is likewise true under Section 61(a) of the I.R.S. Code of 1954. If there is not gain, there is not income … Congress has taxed income not compensation.” – Conner v United States, 303 F Supp. 1187 (1969).

“Before the 1921 Act this Court had indicated (see Eisner v Macomber, 252 U.S. 189 (1920)), what it later held, that ‘income,’ as used in the revenue acts taxing income, adopted since the 16th Amendment, has the same meaning that it had in the Act of 1909, Merchants; Loan & T. Co. v Smietanka, 255 U.S. 509, (1921); Southern Pacific Co. v Lowe, 247 U.S. 330, (1918).” – Burnet v Harmel, 287 U.S. 103 (1932).

Pursuant to 26 CFR 1.861-8(a)(3), gross income is generated from any of the enumerations in Sec 61:

 

    (i) Compensation for services, including fees, commissions, and similar items;

    (ii) Gross income derived from business;

    (iii) Gains derived from dealings in property;

    (iv) Interest;

    (v) Rents;

    (vi) Royalties;

    (vii) Dividends;

    (viii) Alimony and separate maintenance payments;

    (ix) Annuities;

    (x) Income from life insurance and endowment contracts;

    (xi) Pensions;

    (xii) Income from discharge of indebtedness;

    (xiii) Distributive share of partnership gross income;

    (xiv) Income in respect of a decedent;

    (xv) Income from an interest in an estate or trust. 1.861-8(a)(4):

"(4) Statutory grouping of gross income and residual grouping of gross income. For purposes of this section, the term "statutory grouping of gross income" or "statutory grouping" means the gross income from a specific source or activity which must first be determined in order to arrive at "taxable income" from which specific source or activity under an operative section. (Paragraph (f)(1).  All income from whatever source derived including but not limited to: ("The source of income. Place where, or circumstance from which, income at issue is produced, Union Electric Co. v Coale, 347 Mo. 175, 146 S.W. 2d 631, 635." (Black's Law Dictionary 6th Edition)

Some on the Left have argued that “unrealised income” should be taxed.  The very argument shows a complete lack of economic understanding.  “Unrealised income” means there has been no liquidity event since it is “unrealised.”  The so-called “income” is on paper.   Let’s walk through a few scenarios:

Just imagine seniors. They bought their houses in the 1970s or 1980s. They paid off their mortgages. They have an enormous capital gain, which they would like to leave to their children, but the Left would have them pay a tax to the Federal government every year on that "unrealised income" even though they are retired and may be on a fixed or, at least, very reduced income.

Just imagine small businessmen and women, who create companies that have an asset called "goodwill." Goodwill is an "unrealised gain." The business' value has grown tremendously because of the owner’s labour and good management. Yet, again, the Left would have the Feds send the owner a tax bill on income that he or she has yet (a may never because the business could be destroyed or go bankrupt in the future for some reason) to realise.

           

Oh, and poor Mr Buffett’s secretary!  One year, she might have to pay taxes on increases in her 401(k)s due to a bull market.  Would she get a refund in a bear market?

What about those public sector workers, whose retirement funds have unrealised gains?

Some on the Left want to tax “income” that people have yet to realise, have yet to touch, have yet to put to use, that are on paper, and may never, ever materialise.

Fortunately, the Sixteenth Amendment only permits the taxation of income and income has been defined.  The Federal government is prevented from taxing land and, by extension, wealth. The Constitution's Article I, Section VIII, gave the Federal government power to levy taxes, duties, imports and excises, as “indirect” taxes, requiring only that the duties, imposts and excises be “uniform throughout the United States.” The 16th Amendment authorised a “direct” tax on “incomes, from whatever source derived.”   The intent of the Founding Fathers—almost all large landholders—was to prevent the new Federal government from using land as a tax base.   The Sixteenth Amendment exempted income taxes from the constitutional requirements regarding direct taxes, after income taxes on rents, dividends, and interest were ruled to be direct taxes in Pollock v. Farmers' Loan & Trust Co., 157 U.S. 429 (1895).

The Federal Constitution prohibits a direct tax on individuals. Article I, Section 9 reads: "No Capitation, or other direct, Tax shall be laid, unless in proportion to the Census." It took the Thirteenth Amendment to authorise a direct income tax. Seemingly, therefore, Congress cannot directly tax individuals based on their wealth.  The estate tax was upheld by the courts on the grounds that the government was not taxing a person's wealth as such, but focusing on a specific event, namely the death of the individual, as the basis for the tax.*  It is an indirect tax.   Income taxes on income from personal services such as wages are also indirect taxes in this sense.

"Only three taxes are definitely known to be direct: (1) a capitation, (2) a tax upon real property, and (3) a tax upon personal property,” Murphy v. Internal Revenue Service and United States,  case no. 05-5139.

Traditionally, a direct tax in the constitutional sense means a tax on property "by reason of its ownership"  (such as an ordinary real estate property tax imposed on the person owning the property as of January 1st of each year) as well as a capitation (a "head tax" or poll tax).  In the late 1800s, the Federal courts also began to treat an income tax on income from property, such as rental payments, as a direct tax.  In constitutional law, an "indirect tax" or "excise" is an "event" tax, a transaction or other event must occur such as the sale of a product subject to a VAT tax. In this sense, a transfer tax (such as gift tax and estate tax) is an indirect tax.

In the United States, Article I, Section 9 of the Constitution requires that direct taxes imposed by the national government be apportioned among the states on the basis of population. After the 1895 Pollock ruling (essentially, that taxes on income from property should be treated as direct taxes), this provision made it difficult for Congress to impose a national income tax that applied to all forms of income until the 16th Amendment was ratified in 1913. After the Sixteenth Amendment, no Federal income taxes are required to be apportioned, regardless of whether they are direct taxes (taxes on income from property) or indirect taxes (all other income taxes).

In Brushaber v Union Pacific Railroad, 240 U.S. 1 (1916), which overruled Pollock, the Supreme Court ruled that (1) the Sixteenth Amendment removed the Pollock requirement that certain income taxes (such as taxes on income "derived from real property" that were the subject of the Pollock decision), be apportioned among the states according to population; (2) the Federal income tax statute does not violate the Fifth Amendment's prohibition against the government taking property without due process of law; (3) the Federal income tax statute does not violate the Article I, Section 8's uniformity clause (relating to the requirement that excises, also known as indirect taxes, be imposed with geographical uniformity).

Precedent requires that there be a "taxable event" on income "derived from real property" before the Federal government can tax.   Gift and estate taxes are indirect taxes.  The triggering event in either case is the gift or death.   Events that give rise to income whether through salary, bonus, dividend, capital gain, etc., are taxable.     The underlying asset is not taxed.  The income is. Some would like to tax unrealised capital gains, which are likely the largest source of investment gains, but they are not defined as income for purposes of taxation.  An increase/decrease in the value of a security is not "real" because the asset has not been sold.  They would tax on the  assumed ("deemed") investment return (income).  In other words, the tax would be on phantom income.

Can you imagine what would happen if unrealised income was taxed?  An elderly couple that owns their home outright would be taxed every year on the value of that asset even though the couple is retired and has received nothing in the form of income from the property.  Progressives would have this elderly couple either figure out a way to raise the money to pay the tax (which would be additional to the local and state property taxes) or have the government seize the asset and sell it, likely for less than its value.  Fortunately for us, such taxes are unconstitutional.

There is nothing in the law that permits taxation on wealth.  In fact, a wealth tax would probably violate the Fifth Amendment’s Takings Clause.  Furthermore, there is no taxable event on wealth.  The appreciation and income are taxable, but other than that, there is no taxable event.  The wealth is stationary.

Progressive champions of a wealth tax will have to get 38 states to ratify a constitutional amendment that permits direct taxation on wealth.

A 2006 article in The Washington Post entitled "Old Money, New Money Flee France and Its Wealth Tax" pointed out some of the harm caused by France's wealth tax. The article gave examples of how the tax caused capital flight, brain drain, loss of jobs, and, ultimately, a net loss in tax revenue. Among other things, the article stated, "Eric Pichet, author of a French tax guide, estimates the wealth tax earns the government about $2.6 billion a year, but has cost the country more than $125 billion in capital flight since 1998."  In the time since, most countries in Europe, including American Progressives' idea of a Socialist Heaven - Sweden - have repealed their wealth taxes.  In fact, Sweden has repealed its estate/inheritance taxes.

There are four major flaws in a wealth tax system:

1) Valuation of illiquid assets including real estate, privately held businesses, antiques, art, etc., can be purely arbitrary.  Should the government decide how much a Picasso is worth or should art experts?  Let's assume that the government values the painting at $100 and the painting is worth $80, which valuation should be used to calculated the tax?

2) Wealth valuation fluctuates in time due primarily to the money supply fluctuations.

3) This creates a moral hazard whereby governments can use inflation as a direct means of raising revenue.  Think about that.  If the government wanted to increase its revenue, it could adopt a high inflation position.  While inflation would stealthily be stealing your money, you would also be paying higher prices for everything.  If the government wanted to raise tax revenues, it could just arbitrarily increase the money supply, which would increase your tax burden without any taxable event ever occurring.

4)  Finally, elderly citizens and the disabled, whose income is much smaller than their non-revenue generating assets may find it near impossible to pay their taxes without continued asset liquidation.  The government would be extremely tempted to continue to raise that unrealised taxable rate until the property was seized.  Seizing the property through outrageous taxation would allow the government to gain control of the asset and sell it to raise money.  It doesn't cost the government anything.  Even if the property is sold below market value, the government would still see a profit because its basis in the asset was zero.  Do not forget that this scenario actually played out during Reconstruction.  Property taxes were extraordinarily increased by local and state officials in order to punish the plantation owners and gain control of the land.

Due to valuation and accounting difficulties, wealth taxes systems have high management costs, for both the taxpayer and the administrating authorities, compared to other taxes. Per one study in the Netherlands the aggregated cost of the tax’s yield was roughly five times that of income tax.

In addition to the dubious constitutionality of a wealth tax, the government would end up with less tax revenue.  Of course, Obama would still support it.  You will recall that Charlie Gibson asked Obama if he supported an increased in the capital gains and dividend tax rates even though such has been shown to decrease revenues.  Obama said, "yes".  Why?  Because "fairness" is more important than revenue and good stewardship of the fiscal condition of the country.

  

* Pertaining to death/inheritance taxes, they are neither direct nor indirect taxes.  They are duties and death is the taxable event.  Death duties were established by the Roman and ancient law, and, by the modern laws of France, Germany, and other continental countries, England and her colonies, and an examination of all shows that tax laws of this nature rest, in their essence, upon THE PRINCIPLE THAT DEATH IS THE GENERATING SOURCE FROM WHICH THE PARTICULAR TAXING POWER TAKES ITS BEING, AND THAT IT IS THE POWER TO TRANSMIT OR THE TRANSMISSION FROM THE DEAD TO THE LIVING ON WHICH SUCH TAXES ARE MORE IMMEDIATELY VESTED.  Knowlton v Moore, 178 U.S. 41 (1900).

While the laws of all civilized states recognise in EVERY CITIZEN THE ABSOLUTE RIGHT TO HIS OWN EARNINGS, AND THE ENJOYMENT OF HIS OWN PROPERTY, AND THE INCREASE THEREOF, DURING HIS LIFE, during his life, except so far as the state may require him to contribute his share for public expenses, THE RIGHT TO DISPOSE OF HIS PROPERTY BY WILL HAS ALWAYS BEEN CONSIDERED PURELY A CREATURE OF STATUTE, AND WITHIN LEGISLATIVE CONTROL. 'By the common law, as it stood in the reign of Henry the Second, a man's goods were to be divided into three equal parts, of which one went to his heirs or lineal descendants, another to his wife, and a third was at his own disposal; or, if he died without a wife, he might then dispose of one moiety, and the other went to his children; and so, e converso, if he had no children, the wife was entitled to one moiety, and he might bequeath the other; but, if he died without either wife or issue, the whole was at his own disposal.' 2 Bl. Comm. 492. Prior to the 'Statute of Wills,' enacted in the reign of Henry VIII., the right to a testamentary disposition of property did not extend to real estate at all, and as to personal estate was limited as above stated. Although these restrictions have long since been abolished in England, and never existed in this country, except in Louisiana, the right of a widow to her dower, and to a share in the personal estate, is ordinarily secured to her by statute.  United States v Perkins, 163 U.S. 625 (1896).

From these principles it is deduced that the states may tax the privilege, discriminate between relatives, and between these and strangers, and grant exemptions, and are not precluded from this power by the provisions of the respective state Constitutions requiring uniformity and equality of taxation.' School- field's Ex'r v. City of Lynchburg, 78 Va. 306. (Va. 1884), Knowlton v Moore, 178 U.S. 41 (1900), Strode v Commonwealth, 52 Pa. 181, Minot v Winthrop, 162 Mass. 113, 26 LRA 259, Gelsthorpe v. Furnell, 20 Mont. 299, 51 P. 267.

"Equal protection of the laws requires equal operation of the laws upon all persons in like circumstances. Under the statute, in the present case, the graduated taxes are levelled equally upon all interests passing from nonresident testators or intestates. The tax is not upon property, but upon the privilege of succession, which the state may grant or withhold. It may deny it to some and give it to others. The state is dealing in this instance not with the transfer of the entire estate, but only with certain classes of property that are subject to the jurisdiction of the state. It must find some rule which will adequately deal with this situation. It has adopted that of the proportion of the local estate in certain property to the entire estate of the decedent. In making classification, which has been uniformly held to be within the power of the state, inequalities necessarily arise, for some classes are reached, and others omitted; but this has never been held to render such statutes unconstitutional." Beers v Glynn, 211 U.S. 477 (1909). This principle has been recognised in a series of cases in this court.  Board of Education of the Kentucky Annual Conference of the Methodist Episcopal Church v. Illinois, 203 U.S. 553 (1906); Campbell v California, 200 U.S. 87 (1906); Keeney v Comptroller of the State of New York, 222 U.S. 525 (1912).  "It has been uniformly held that the Fourteenth Amendment does not deprive the states of the right to determine the limitations and restrictions upon the right to inherit property, but 'at the most can only be held to restrain such an exercise of power as would exclude the conception of judgment and discretion, and which would be so obviously arbitrary and unreasonable as to be beyond the pale of governmental authority,' Campbell v California, 200 U.S. 87 (1906).  In upholding the validity of a graduated tax upon the transfer of personal property, to take effect upon the grantor's death, we said in Keeney v Comptroller of the State of New York, 222 U.S. 525 (1912)."

'The validity of the tax must be determined by the laws of New York. The Fourteenth Amendment does not diminish the taxing power of the state, but only requires that in its exercise the citizen must be afforded an opportunity to be heard on all questions of liability and value, and shall not, by arbitrary and discriminatory provisions, be denied equal protection. It does not deprive the state of the power to select the subjects of taxation. But it does not follow that because it can tax any transfer, Hatch v Reardon, 204 U.S. 152 (1907), that it must tax all transfers, or that all must be treated alike.'

  

The cases upholding the constitutionality of such are said to be based on two principles:  1.  An inheritance tax is not one on property, but one on the succession. 2.  The right to take property by devise or descent is the creature of the law, and not a natural right-a privilege, and therefore the authority which confers it may impose conditions upon it.  From these principles it is deduced that the states may tax the privilege, discriminate between relatives, and between these and strangers, and grant exemptions, and are not precluded from this power by the provisions of the respective state Constitutions requiring uniformity and equality of taxation.  Maxwell v Bugbee, 250 U.S. 525, 541 (1919).

In the United States, the tradition of taxing assets at death began with the Stamp Act of 1797 on inventories of decedents, receipt of legacies, share of personal estates, and probate of wills.  The revenue from this tax was negligible even for the 18th century and was repealed 5 years later.  To help finance the Civil War, the Tax Act of 1862 imposed a Federal inheritance tax. As costs mounted, the Congress increased the inheritance tax rates and added a succession tax in 1864. When the need for added revenue subsided after the war, the inheritance tax was repealed in 1870.  In 1874, a taxpayer challenged the "legality of the Civil War estate taxes, arguing they were direct taxes that, under the Constitution, must be apportioned among the states according to the census."  Scholey v Rew, 90 U.S. 331 (1874).  The Court upheld the Civil War inheritance tax categorising an inheritance tax as an excise or impost rather than a direct tax, which "pertained to capitation taxes and taxes on land, houses, and other permanent real estate."  The Court expanded the definition of direct tax to include income on interest, dividends and rents in Pollock v Farmers' Loan & Trust Company, 157 U.S. 429, (1895).

In the early 20th century, worldwide conflict cut into trade tariffs, a primary source of Federal revenues.  Searching for another source of revenue, Congress passed and Wilson signed the Revenue Act of 1916, which introduced the modern-day income tax.  The Revenue Act also contained an estate tax with many of the same features of current law. Estates valued up to $50,000 dollars (over $11 million dollars in terms of today's wealth) were exempt.  Those valued at more than $50,000 dollars were taxed at 1% and the rates progressed up to 10% percent on estates over $5 million dollars, which is over $1 billion dollars today. Estate taxes were increased in 1917 as the U.S. entered World War I; however, this time the estate tax did not go away after the war ended. Despite sizable budget surpluses, Congress increased rates and introduced a gift tax in 1924. Like the estate tax, the gift tax is a levy on the transfer of property from one person to another. During the 1920s through the 1940s, estate taxes were used as another way to attempt to redistribute income. Tax rates of up to 77% on the largest estates were supposed to prevent wealth becoming increasingly concentrated in the hands of a few.  It didn’t quite work out that way.