Tuesday, April 13, 2010

Truly Trivial: Why was the original US income tax struck down?

Seal of the United States Internal Revenue Ser...Image via Wikipedia
The average rate of error for US income tax returns is roughly 21 percent, which is to say that one out of every five tax returns filed each year is wrong. To be fair, much of this wrongness is due to the complexity of printed tax return forms, as less than half a percent of all electronic tax returns are filed with errors. You can thank all those self-checking tax preparation software applications for the vast improvement in e-filed returns.

That it's possible to achieve a 99.5 percent accuracy rate with tax prep software doesn't mean the tax code isn't needlessly complex. Frankly, the fact that you need hand-holding software to prepare an accurate return argues that our tax code has gotten entirely too Byzantine. For cripes sake, the instructions for the simplest IRS tax return form, the 1040 EZ, run to 40 pages.

Ironically, the current version of US income tax -- made possible in 1913 by the 16th Amendment to the US Constitution -- was designed to simplify a problem which led to the abolition of the previous income tax system.

Why was the original US income tax system struck down?

The first national US income tax was a product of the Revenue Act of 1861, which was levied to raise funds to pay for the US Civil War. This tax system was revived and extended for the next 30 years, until the landmark 1895 US Supreme Court decision Pollock v. Farmers Loan & Trust. The court essentially ruled that the administration of the income tax -- though not the tax itself -- was unconstitutional. To administer an income tax as permitted by the US Constitution would have been so impractical as to prove impossible. Here's why.

Article 1, Section 2, Clause 3 of the US Constitution, reads:

"Representatives and direct Taxes shall be apportioned among the several States which may be included within this Union, according to their respective Numbers..."
In layman's terms,  any revenue from direct taxes (which Pollock v. Farmers ruled an income tax largely was) had to be apportioned. In Constitutional terms, apportioning meant that each state was entitled to a specific percentage of income tax revenue equal to its percentage of the US population. Thus, if California had 10 percent of the US population, it was constitutionally entitled to 10 percent of federal income tax revenue. (And you wonder why people fight over census figures.)

This wrinkle alone would have scuttled the original income tax, but the Pollock v. Farmers decision had another serious implication. The court held that income tax was largely a direct tax, but not entirely. In this context, a direct tax was a tax on income derived from property, usually land. Taxation of income derived from wages was
not a direct tax. Thus, if you were a physician who owned a farm, the income you derived from your farm would be taxed with a direct tax, and its resulting tax revenue would have to be paid out to the states through apportionment. The income you derived from your medical practice, however, was not taxed as a direct tax, and its resulting tax revenue could be paid out to the states in whatever fashion the federal government saw fit.

Figuring out what portion of national incomes was property-based and which portion was wage-based proved to be an impossible task in 1895. Going a step further and apportioning the property-based revenues was just adding insult to income tax injury.

The answer, so far as tax advocates were concerned, was to amend the Constitution to allow for an explicit, unapportioned income tax, which is what the 16th Amendment did in a mere 30 words:

"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."
This "simplification" has led to a modern tax code that, based on the version available from the Government Printing Office, runs to roughly 15,000 pages in 20 volumes (it's all the stuff listed under Title 26). That isn't just a historical irony, its a classic example of the Truly Trivial.
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