Supreme Errors
Euro Pacific Capital
By Peter Schiff
July 3, 2012

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 indirect 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.

The observation that the penalty is too low to work may be the one thing the Court actually 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.