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In the wake
of my last commentary on the horrendous Supreme Court decision upholding
Obama's health care plan, several people have pointed out that I erred in
saying that the income tax is a "direct tax." While it is
technically correct that the Court ultimately declared it to be an excise,
not a direct tax, it is important to understand how it arrived at that
opinion and why the decision has no practical relevance to the way the tax
has been enforced. Just as it has done with Obamacare,
the Court came up with a technically constitutional pathway to allow the
government to collect a tax in a blatantly unconstitutional manner.
In the 1895
Pollock v. Farmers' Loan and Trust case, the Supreme Court declared the
original Income Tax of 1894 unconstitutional because it imposed a direct tax
that was not apportioned to the states according to the taxing provisions of
the Constitution. For example it said that a tax on rental income is the same
as direct tax on the property that produced the income. In other words, a tax
on income was tantamount to a tax on its source.
To get around
this, in 1913 Congress passed, and the state governments ratified, the 16th
Amendment that authorized a tax on income from whatever source derived
without regard to apportionment. However, in 1916 the Supreme Court ruled in Brushaber v. Union Pacific Rail Road that the Amendment
"conferred no new taxing power to the Federal government," and that
it "contained nothing challenging or repudiated its ruling in the
Pollock case." Instead, the Court said that in order to be
constitutionally taxed as an excise, income must first be separated from its
source. A few years later in Eisner v. Macomber
(1918) and Merchants Loan and Trust v. Smietanka
(1921) the Court provided a practical guide to doing just that, by defining
income, for purposes of the Sixteenth Amendment, as a corporate profit.
A corporation
determines profit by subtracting its expenses from its income. The
difference, called profit, could then be subject to an income tax. So if a
corporation has rental income, but derives no profit after backing out all of
its expenses, then the rents, and therefore the property, are not taxed. In
that respect, the income is separated from the sources that produced it. Were
it not for this separation, a tax on rents, dividends, fees, etc. would be a
direct tax on the sources of income, as described by Pollock, Brushaber, Eisner and Smietanka.
That is why many U.S. corporations can have billions of dollars of income but
pay no tax, because they derive no profits from that income. This proves the
income tax is, in reality, a profits tax.
The problem
is that the modern income tax is not merely being levied as an excise tax on
corporate profits, but as an unapportioned direct
tax on the personal income of every American. This is precisely what the
Supreme Court has repeatedly held to be unconstitutional. Yet lower courts
have serially ignored the reasoning behind these Supreme Court decisions and
have allowed the Federal Government to impose a tax in the precise manner
that the Supreme Court ruled it lacked the constitutional authority to do.
The Founding
Fathers made it difficult for Congress to levy direct taxes because they
considered the more easily avoidable excise taxes to be self-correcting as to
abuse. They also wanted to make it more difficult for poorer states to vote
for taxes that would be paid disproportionately by wealthier states. As a
result, they believed that during peacetime the Federal Government would rely
primarily on excise taxes and would resort to direct taxes mainly during
wartime.
To levy an
apportioned direct tax on personal income, Congress would first have to
decide how much it wanted to raise and then assign each state its pro-rata
share. So a $1 trillion dollar income tax would require Mississippi and
Connecticut (each with about 1% of the U.S. population) to pay about $10
billion. However since per capita income in Connecticut is 80% higher than it
is in Mississippi, federal income tax rates in Mississippi would have to be
80% higher than the rates in Connecticut. This makes it less likely that
Mississippi would support such a tax. But given the way the income tax is
currently enforced, Mississippi happily votes for levies that fall
predominately on residents of wealthier states. This is precisely what the
Constitution was written to prevent.
Just as a tax
on land based solely on its rental income is the same as a direct tax on the
land itself, a tax on individuals based solely on their decision not to buy
health insurance is a direct tax on individuals. To get around this, Chief
Justice Roberts ruled that the new healthcare tax is indirect because not
everyone will have to pay it. However, the percentage of people ultimately
subject to a tax does not determine into which category it falls. Less than
two percent of Americans were subject to the original income tax, yet the
court still viewed it as a direct tax.
The bottom
line is that the Supreme Court has a history of giving the government
latitude to get around the Constitution. Instead of looking at the intent of
legislation (even when the legislators are alive to be asked), or even its
practical effect, the Court looks for any legal technicality upon which to
base a ruling of constitutionality. That is what happened with the income
tax, and is now occurring with the Affordable Care Act. Had the Supreme Court
been more forthright with the income tax, the country would not now be
suffering from a destructive and pervasive tax that was originally intended
to be a small levy targeted only at the top 1% of American earners.
Remember, the
Court's sole rationale for ruling the exactions in the Affordable Care Act
are taxes rather than penalties was its belief that the taxes are too low to
actually compel anyone to buy health insurance. This made it consistent with
the Court's view that Congress lacks the authority, under the commerce
clause, to compel Americans to buy health insurance. If the Court believed
that the tax was actually high enough to leave Americans with no rational
choice, Roberts would have ruled it unconstitutional. This may be the one
thing the Court got right.
However, once
the government realizes that it has underpriced the fines, it will certainly
raise the tax rate substantially to stop healthy people from rationally
dropping their coverage (because insurance companies could not deny them
similarly priced coverage after they got sick). Just as they routinely do now
with respect to the income taxes, the lower courts will likely misinterpret
the Supreme Court's ruling and rubber stamp any future rate hikes. For
political reasons it is unlikely that a Constitutional challenge to such an
increase will ever make it back up to the Supreme Court.
This leaves
us few good options. Unless Congress repeals the legislation quickly we will
likely have to live with it for a long, long time. Sadly, despite the Romney
and the Republicans' promises to do just that with election victories this
fall, there is virtually no precedent for government giving up a power that
it has fought to take. In the end Americans will be forced to purchase health
insurance in the manner the Supreme Court just ruled to be unconstitutional.
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