Today the American tax system is a contradictory, arbitrary, duplicative, and deeply injurous to the American democracy and our place in the world. Delaware became the 36th state to ratify the Sixteenth Amendment to the Constitution stating, "The Congress shall have power to lay and collect taxes on incomes....without regard to any census or enumeration."
Politics can have a very long reach.
Today the federal tax system is a national disgrace: 4 million words, tens of thousands of special favors to rent-seeking individuals and companies, hopeless complexity. It is contradictory, arbitrary, duplicative, and deeply injurious to the federal fisc, American democracy, and our place in the world.
But had Rufus King, a delegate from Massachusetts to the Constitutional Convention, received an answer to a reasonable question in 1787, or had a Supreme Court justice not changed his mind — for reasons unknown — in 1895, it’s possible that the American federal tax system in 2013 might not be the mess it is.
On February 3, 1913, Delaware became the 36th state to ratify the Sixteenth Amendment to the Constitution. In 30 fateful words it read, “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.”
On February 25, 1913, just as the administration of William Howard Taft was expiring, the outgoing secretary of state, Philander Knox, proclaimed the amendment adopted. It had been a long time coming.
The Constitution (Article I, Section 8) gives Congress the power “To lay and collect Taxes, Duties, Imposts, and Excises,” but it also mandates (Article I, Section 9) that “No Capitation, or other direct, Tax shall be laid, unless in Proportion to the census or Enumeration.” When this clause was under discussion at the Constitutional Convention, Rufus King asked what a direct tax was. Madison’s notes record that King received no answer.
The federal government’s main sources of revenue for the first hundred years and more were the tariff, excise taxes such as those on distilled spirits, and the sale of public land as the country expanded westward.
The Civil War, of course, placed an enormous strain on government finances. Existing taxes were raised sharply and new taxes imposed, including an income tax of 3 percent on incomes over $800 (a working-class income at that time). The income tax was raised twice, and it was made progressive. The Revenue Act of 1864 imposed a tax of 5 percent on incomes over $500, 7.5 percent on incomes over $5,000 (then a very comfortable upper–middle class income) and 10 percent on incomes over $10,000.
The Civil War income tax was lowered after the war and allowed to expire in 1872. What was not lowered was the tariff. As the American economy expanded explosively, revenue from the tariff greatly exceeded government expenditures. In 1882, revenues ran an astonishing 36 percent ahead of outlays. The political influence of manufacturers, mostly in the Northeast and Middle West, kept the tariff high, but it was deeply resented in the less developed South and West.
The biggest problem with the tariff was that it, like all consumption taxes, was inherently a regressive tax. The poor, by definition, spend all of their income, and thus are taxed on their entire income when they buy things. The rich bank most of their income and thus escape consumption taxes on the unspent portion.
Republican Senator John Sherman — no radical — put the problem, and the solution, in a nutshell:
Here we have in New York Mr. Astor, with an income of millions derived from real estate ... and we have along side of him a poor man receiving a thousand dollars a year ... Everything that he consumes we tax, and yet we are afraid to tax the income of Mr. Astor. Is there any justice in it? Why, sir, the income tax is the only one that tends to equalize these burdens between the rich and the poor.
Needless to say, those whose incomes would be taxed opposed an income tax and, being wealthy, they had disproportionate influence. But with a Democratic Congress and a Democratic president, a new income tax became law in 1894. It was a very different tax than the Civil War tax, as it was aimed specifically at the affluent. It imposed a 2 percent tax on the incomes of those earning more than $4,000 a year. In 1894, only 85,000 households out of a total 12 million met that threshold, less than 1 percent.
A lawsuit immediately ensued, arguing that the income tax was a direct tax and thus unconstitutional. The case, Pollock v. Farmers’ Loan and Trust Company, generated intense interest and resulted in one of the great switcheroos in Supreme Court history.
At first, the court split four to four with one member absent due to illness. With public interest being so high, the court agreed to rehear the case with the missing justice, Howell Jackson of Tennessee, rising from his bed to hear the case. (He was, in fact, mortally ill and died less than three months later). Jackson was known to favor the income tax, and everyone was expecting a five-four decision in support of it.
The court ruled that while taxes on income from wages were excise taxes, and thus lawful, taxes on interest, dividends, and rents — by far the major sources of the incomes of the rich — were direct taxes on property and thus unconstitutional. Astor’s millions could not be taxed.
But while the Supreme Court threw out the law, the political pressure to make the rich “pay their fair share” only intensified. In 1909, Representative Cordell Hull of Tennessee (later President Franklin D. Roosevelt’s secretary of state) proposed reenacting the 1894 law and, in effect, dared the Supreme Court to nullify it a second time. He had good reason to think that it wouldn’t, as the court had become much more liberal in the years since 1895.
But President Taft was horrified at the idea of defying the court in this way. Taft revered the court (he would serve as chief justice in the 1920s, an office he vastly preferred to the presidency), and feared that this would diminish its prestige.
Instead, he proposed a very clever — and very lawyerly — alternative. He would propose a constitutional amendment to permit a personal income tax, and meanwhile, he would ask Congress to enact an income tax on corporate profits, which was, technically, an excise tax, measured in income, on the privilege of doing business as a corporation.
In the first decade of the 20th century, the stock of corporations was owned almost entirely by the rich. So taxing corporate profits was, in a very real sense, taxing the rich. Congress passed the legislation and in 1911 the Supreme Court ruled unanimously that the tax was constitutional.
Once the Sixteenth Amendment was ratified, of course, Congress (with strong Democratic majorities in both houses) quickly passed a personal income tax, aimed at the upper middle class and above, with a top rate of 7 percent on incomes over $500,000.
Unfortunately, the personal income tax did not replace the corporate income tax that had originally been intended only as a stopgap. Nor did Congress integrate the two taxes so that income, whether corporate or personal, was only taxed once. The two taxes simply ignore each other as if corporations are owned by Martians, not people.
At the tax levels of the early 20th century, the harm was inconsequential. But when tax levels rose dramatically to fund the great wars that soon followed the personal income tax, the pressure to legally avoid taxes rose equally. As a result, the two separate, uncoordinated tax systems became a uniquely powerful engine of complexity as accountants and lawyers have played the two systems off each other and Congress has tried, unsuccessfully, to close or regulate the resulting “loopholes.” For instance, the Revenue Act of 1942, which brought the personal income tax to those of modest income for the first time since the Civil War, was 208 pages long (fifteen times the length of the 1913 legislation). Fully 162 of those pages dealt with the fiscal and economic effects of past tax legislation.
The two income taxes have been the main reason that the tax code has exploded to a 4-million-word incomprehensible mess. Today, on the 100th anniversary of the Sixteenth Amendment, there are few areas of American public life more in need of thorough reform — and, alas, more difficult to change — than the tax system.