1894: The Collapse of the Federal Income Tax

The Articles of Confederation, which secured the unity of the several independent States, tied the hands of the Federal Government by making them dependent upon the State Governments for revenue. This dependency almost destroyed the Union before it really got started. The Constitution, however, provided for a compromise between the independent State's rights to tax the people, and the Federal Government's right to concurrent taxation of the same people, so that both could support themselves without interfering with, or diminishing, the tax revenues of the other. This compromise was accomplished by a restriction placed upon the Federal Government as to the prescribed method used in obtaining tax revenues from the same people. The State Governments were to obtain their primary revenue directly from the people, i.e., through taxes levied upon real and personal property, poll taxes, and sales taxes. Whereas, the Federal Government was to obtain their primary revenue "indirectly" from the people through "Impost, Excise and Duty" taxes levied upon the importation, manufacture and consumption of commodities, as well as, tobacco products and liquor. When necessary, however, the Federal Government could levy Taxes "directly" upon the people, but such taxes were to be "apportioned" to the States by population.

As early as 1798 it became necessary for the Federal Government to levy an apportioned direct tax upon "dwelling houses, lands and slaves". This action occurred again during the Spanish American War in 1813 and 1815. The first Federal Income Tax, however, was levied during the Civil War (1861-1870) as a means of collecting additional tax revenue from sources not normally called upon to contribute to the Federal coffers. Whereas the Acts of 1798, 1813, 1815, and the Civil War Acts of 1861-70 levied an apportioned direct tax, based upon the assessed value of real estate, the Acts of 1861 to 1870 levied an additional un-apportioned tax based upon the "income" derived from real estate and invested personal property. In addition to these taxes on "income", the 1894 Act also levied an excise tax upon business transactions, i.e., "business, privileges, or employments (not 'employees')", measured by the respective "gain or profit" (income) derived therefrom.

The Income Tax Act of 1894 was different from those Acts levied during the Civil War period in that it did not provide for the apportioned direct tax based upon property value, and, more importantly, was levied in a time of profound peace. This Act, therefore, was challenged as falling within the "direct" class of taxation requiring apportionment. The reasoning, expressed by the court for addressing the issue of Constitutionality, in the case of the 1894 Act is found on page 573-574 of 157 U.S. 427 [Pollock v. Farmers' Loan and Trust]. There the Court explained:

1. That the distinction between direct and indirect taxation was well understood by the framers of the Constitution and those who adopted it.
2. That under the State system of taxation all taxes on real estate or personal property, or the rents or income thereof was regarded as direct taxes.
3. That the rules of apportionment and of uniformity were adopted in view of that distinction and those systems.
4. That whether the tax on carriages was direct or indirect was disputed, but the tax was sustained as a tax on the use and an excise.
5. That the original expectation was that the power of direct taxation would be exercised only in extraordinary exigencies, and down to August 15, 1894, this expectation has been realized. The Act of that date was passed in a time of profound peace, and if we assume that no special exigency called for unusual legislation, and that resort to this mode of taxation is to become an ordinary and usual means of supply, that fact furnishes as additional reason for circumspection and care in disposing of the case.

In other words, the Court recognized the Act of 1894 as being a change in Federal tax policy, and therefore reviewed it on the basis of that change in policy, not on the basis of the tax itself. This is evident by the dissenting opinions of Justices White, Harlan, Jackson, and Brown. In any event, the majority (5) of the court held the tax in question to be a "direct" tax requiring apportionment and thereby unconstitutional and void. In the first court case (157 U.S. 427 @ 583) the court provides this reasoning for their decision:

"But the acceptance of the rule of apportionment was one of the compromises which made the adoption of the Constitution possible, and secured the creation of that dual form of government, so elastic and so strong, which has thus far survived in unabated vigor. If, by calling a tax indirect when essentially direct, the rule of protection could be frittered away, one of the great landmarks defining the boundary between the nation and the states of which it is composed, would have disappeared, and with it one of the bulwarks of private rights and private property.

We are of the opinion that the law in question, so far as it levies a tax on the rents or income of real estate, is in violation of the Constitution, and is invalid."

Note the court's interpretation that the tax was levied upon the "rents or income of real estate" when, in fact, the tax was levied only upon the profits (net-income) derived from such "rents or income", as noted by Justice White in his dissenting opinion of page 645:

"This statement, I submit, is a misconception of the issue. The point involved is whether a tax on net income, when such income is made up by aggregating all sources of revenue and deducting repairs, insurance, losses in business, exemptions, etc., becomes, to the extent to which real estate revenues may have entered into the gross income, a direct tax on the land itself. In other words, does that which reaches an income, and thereby reaches rentals indirectly, and reaches the land by a double indirection, amount to a direct levy on the land itself. It seems to me the question when thus accurately stated furnishes its own negative response. Indeed, I do not see how the issue can be stated precisely and logically without making it apparent on its face that the inclusion of rental from real property in income is nothing more than an indirect tax upon the land."

Why did Justice White include the "exemptions" in his list of deductions from gross income? Answer: The "personal income tax" is paid by the owner (natural person), not the property or business which produced the income. It is because, the "income tax" falls directly upon the person owning the property or providing the services, that the tax must include a reasonable deduction for "personal living and family expenses" in order for the taxed income to qualify as the "net-income" of the natural person paying the tax. In other words, the existing definition of the word "income" was recognized to be "net-income" or profit; it was the surplus over and above the amount necessary to provide a reasonable standard of living. Justice Brown, in the second Case (158 U.S. 601), expressed this concept in his dissenting opinion on page 687:

"The exemption of $4,000 is designed, undoubtedly, to cover the actual living expenses of a large majority of families, and the fact that it is not applied to corporations is explained by the fact that corporations have no corresponding expenses. The expenses of earning their profits are, of course, deducted in the same manner as the corresponding expenses of a private individual are deductible from the earnings of his business."

In the second "Pollock" Case (158 U.S. 601 @ 625-26) the court again returned to their previous interpretation that Congress was attempting to change the tax policy of indirect taxation to that of "direct" taxation, by including the receipts derived from personal property as well. In this regard the court uses the meaning of "direct" tax attributed to Hamilton:

"He gives, however, it appears to us, a definition which covers the question before us. A tax upon one's whole income is a tax upon the annual receipts from his whole property, and as such falls within the same class as a tax upon that property, and is a direct tax, in the meaning of the Constitution."

The questions that definition raises today are: Is a tax measured by the "whole income", or annual receipts, derived from real and personal property something different than a tax measured by the "whole income" or annual receipts, derived from personal labor? And: By allowing any personal exemption, regardless of how arbitrary the amount is in comparison to the actual cost of living, does that allowance overcome Hamilton's definition?

House Document 601 (62-2) Volume 129, Serial Set 6311, "Income Tax Cases"

PACIFIC INS. CO. v. SOULE, 74 U.S. 433 (1868)

VEAZIE BANK v. FENNO, 75 U.S. 533 (1869)

EDYE v. ROBERTSON, 112 U.S. 580 (1884)