When U.S. Income Tax Was Illegal
WHY YOU SHOULD CARE
Because “death and taxes” weren’t always certain.… Well, the death part was.
By James Watkins
A band of hotshot lawyers from cities across the United States had sought out the plaintiffs to build the perfect case. The cost of litigation would add up to a staggering $1 million — quite the sum in 1895. Not to worry, the bill was largely footed by the megarich clients of the law firms in question, named by one newspaper at the time as “the Astors and other wealthy New Yorkers.” Their adversary? The very concept of federal income tax.
The legal team had “impeccable credentials,” having previously represented “some of the country’s largest business corporations and wealthiest individuals,” writes Ajay Mehrotra in Making the Modern American Fiscal State. They needed the pedigree: The case, known as Pollock v. Farmers’ Loan & Trust Co., should have been unwinnable. The legal all-stars were aiming to convince the Supreme Court that a federal tax on incomes was inherently unconstitutional, despite decades of precedent that had been inching toward the opposite conclusion.
The entire tax return (with instructions) fitted on a single page.
The key challenge: proving that taxing income was akin to what the Constitution calls a “direct tax.” The only problem was that the whole concept of income tax was new, and nobody was sure how to classify it. One of the lawyers fighting against the tax — by arguing it was direct and therefore subject to an almost impossible requirement to be apportioned equitably among the states — asked for advice from Edwin Seligman, one of the pre-eminent tax economists of the era. Seligman wasn’t convinced. “All attempts to declare the tax unconstitutional [would be] foredoomed to failure,” he said. He even asserted that the way the lawyers presented his research “betray[ed] a confusion of thought and an ignorance of economic distinctions.”
And yet those so-called ignorant arguments won in court. In a hugely contentious 5-4 decision, the Supreme Court ruled that income tax was unconstitutional, and the idea was consigned to the trash heap of history … for all of 18 years. It took the 16th Amendment in 1913 to overturn Pollock and enable the reintroduction of the income tax system we all know and (don’t) love today.
Pollock quashed the 1894 Revenue Act in time for Tax Day, so not a cent was ever collected under its income tax provision, which was similar to the temporary income taxes first introduced during the Civil War, says Sheldon D. Pollack, a business law professor at the University of Delaware. Despite what you may think, life before income tax wasn’t a glorious utopia. Most federal government funds at the time came from tariffs and excise taxes on things like alcohol and tobacco, the burden of which fell overwhelmingly on the poor, causing massive political divisions between farmworkers in the South and the newly wealthy industrialists in the Northeast, exacerbating Civil War divisions.
The new income tax was seen as a way to redress the balance, with only the very wealthiest slice of society subject to it. There was no withholding from your paycheck, so the taxpayers would submit a form at the end of the year with a self-assessment of their liability — and it was up to them to own up if they earned interest from anyone, not a 1099 form in sight. The entire tax return (with instructions) fitted on a single page. Incomes above $4,000 were taxed at just 2 percent, so it was hardly a massive revenue generator and more a political statement, says Pollack.
Because of this, the Supreme Court’s ruling against the income tax didn’t throw the government’s finances into disarray — but it was political dynamite. “As nasty as things are in Washington now, debates about the income tax in the late 19th century outdid anything we see today,” says Erik Jensen, emeritus professor of law at Case Western Reserve University. Those pushing for a more progressive system were often dismissed as socialists by their opponents, not least by the Supreme Court justices who contributed concurring opinions: “The present assault on capital … will be but the stepping stone to others, larger and more sweeping, till our political contests will become a war of the poor against the rich,” wrote Justice Stephen Johnson Field, a veteran and outspoken member of the Supreme Court bench.
Ironically, the main impact of the Pollock ruling was to galvanize political support around the 16th Amendment to reintroduce the income tax, says Mehrotra, who is the executive director of the American Bar Foundation. The 1913 reincarnation of the income tax was similar in kind: a 7 percent tax on the wealthiest members of society. But once again, war provided the impetus for change, with rates ballooning to 77 percent during World War I and the proportion of citizens subject to the tax widening to 64 percent during World War II.
And while most scholars hold that Pollock is now just a quirk of tax history — either it was the incorrect decision to begin with or it has since been rendered moot — there is a chance it could rear its divisive head once again, thinks Jensen. The prospect of a federal wealth tax, for example, could reignite the debate over the constitutional terminology of direct taxation and apportionment. Sounds almost as thrilling as filing taxes.