Today in History: Income Tax Ruled Unconstitutional in Pollock v. Farmers Loan Trust Co.

On this date in 1895, the U.S. Supreme Court decided Pollock v. Farmers Loan Trust Co., striking down the federal income tax of 1894. The bill had passed as part of a general reduction in tariffs, although President Cleveland was no fan, letting it become enacted without his signature.

The tax – 2 percent on all income over $4,000 (roughly $90,000 today) – was America’s first peacetime national income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. . It was promptly challenged on the grounds that the Constitution requires direct taxes to be levied in proportion to each state’s population. The federal government had levied indirect taxes (such as on carriages, whiskey, and other specific products), but Pollock raised the question of whether the income tax was a direct tax or an indirect taxAn indirect tax is imposed on one person or group, like manufacturers, then shifted to a different payer, usually the consumer. Unlike direct taxes, indirect taxes are levied on goods and services, not individual payers, and collected by the retailer or manufacturer. Sales and Value-Added Taxes (VATs) are two examples of indirect taxes. . Charles Pollock, a stockholder in Farmers Loan Trust, sued the company to stop it from paying the income tax (and notifying the government about who it paid income to).

In a 5-4 vote, the U.S. Supreme Court ruled that the income tax is a direct taxA direct tax is levied on individuals and organizations and cannot be shifted to another payer. Often with a direct tax, such as the personal income tax, tax rates increase as the taxpayer’s ability to pay increases, resulting in what’s called a progressive tax. . Chief Justice Melville Fuller, writing for the majority, first showed a surprisingly keen awareness of economic concept of incidence:

Ordinarily, all taxes paid primarily by persons who can shift the burden upon someone else, or who are under no legal compulsion to pay them, are considered indirect taxes; but a tax upon property holders in respect of their estates, whether real or personal, or of the income yielded by such estates, and the payment of which cannot be avoided, are direct taxes.

However, he went further and analyzed the writings of the Framers, the tax writings of Adam Smith, the ratification debates in the states, and observations by early justices and members of Congress. From this he concluded that it was well understood that “all taxes on real estate or personal property or the rents or income thereof were regarded as direct taxes.”

Since direct taxes must be apportioned by state population under the Constitution, the 1894 law was void. While admitting that such a method of imposing income taxes would be considered unfair by many, its purpose was “to restrain the exercise of the power of direct taxation to extraordinary emergencies, and to prevent an attack upon accumulated property by mere force of numbers.”

Justices Edward White and John Harlan, dissenting, repeatedly disparaged “the views of economists” as irrelevant to the legal inquiry, instead noting that the early Supreme Court held that a tax on carriages was not a direct tax, and in dicta, that only taxes on land would be a direct tax. He urged that the Court defer to Congress with respect to its powers of taxation.

After a rehearing, the Court reissued opinions on May 20, 1895, extending its holding from just rental property income to income from bonds and stocks also, a fatal enough blow to strike down the entire income tax law. Justice Harlan dissented again (echoing Justice White’s views from the month before). Justice Henry Brown also rejected the idea that “the definitions of a direct tax given by the courts and writers upon political economy” were binding, showing (in my opinion) his bias by concluding that “the decision involves nothing less than a surrender of the taxing power to the moneyed class.” Justice Howell Jackson and Justice White also dissented.

The decision was highly unpopular, in part because the 1894 law was a hard-fought compromise that reduced tariffs and imposed the income tax, and the decision voided half of that political compromise. Champions of progressive taxation found their voice for the first time, arguing that the federal tax burden should be on “accumulated wealth” rather than consumption. Populists and Progressives pushed hard for other taxes on wealth and high incomes, leading to a federal inheritance tax (1898), a corporate income tax (1909), and ultimately, the Sixteenth Amendment (1913). That amendment conceded that the income tax is a direct tax, but removed the constitutional requirement of apportionment for income taxes.

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