For most of its history, the United States has recognized the difference between direct and indirect taxes, and this distinction informed the law prior to the creation of the 16th amendment. After the 16th amendment, congress was no longer bound to ensure that direct taxes follow the rule of apportionment outlined by Article 1, Section 9, Clause 4 of the Constitution. Given the rule of apportionment was the main reason behind the distinction between direct and indirect taxes, after the 16th amendment, the distinction was essentially meaningless.
Immediately after the rule of apportionment had been lifted, congress passed the Revenue Act of 1913 (also referred to as the Tariff Act). In addition to lowering tariff rates, this act implemented a progressive federal income tax system. This income tax was originally intended to compensate for the deficit created by the reduced tariff rates, but soon after its implementation, it became the chief source of revenue for the U.S. government.
Based on the 16th amendment, the tax on income could be derived from any source (wages, dividends, interest, rents, etc.). Amazingly, in its first several years of application, the federal income tax only applied to roughly 1% of the population as the other 99% did not meet the income threshold to qualify.
Even though the language in the 16th amendment was clear, not much time passed before the validity of the Revenue Act of 1913 was challenged. In the case of Brushaber v Union Pacific Railroad Co. (1916), the court upheld the ability of congress to tax income (whether direct or indirect) without the traditional constraint of apportionment.
Brushaber V Union Pacific Railroad Co: The Case
Mr. Frank Brushaber (plaintiff) owned stock in Union Pacific Railroad Company (defendant). The railroad attempted to pay a tax on Brushaber’s income and Brushaber brought a suit to prevent the railroad from doing so. Brushaber based his suit on several grounds. He claimed:
- The Tariff Act violated the Fifth Amendment — the government’s ability to take property.
- That the act was unconstitutional because it failed to follow the rule of apportionment.
What’s the Law Say?
Congress has always had the power to tax income. This power is derived from the Constitution and consequently there cannot be any conflict between this constitutionally conferred power and the due process clause.
The 16th amendment removes the requirement that direct taxes must be properly apportioned among the states according to population. Therefore congress is able to lay and collect taxes, both direct and indirect, without regard to the apportionment rule laid out by Article 1, Section 9, Clause 4.
Court Rules Against Brushaber
The Supreme Court threw out all three arguments made by Brushaber and ruled that the federal income tax created by the Tariff Act did not violate the Constitution. In essence, the court in Brushaber simply reaffirmed the clear language of the 16th amendment. Following Brushaber, any challenge to the validity of the Tariff Act became a pointless endeavor.
Significance of the Brushaber Decision in Modern Day
This court case is still referenced with regard to apportionment, the 16th amendment, direct and indirect taxes. Direct taxes are things like property taxes which are paid directly to the government, whereas indirect taxes more vicarious, such as sales tax on goods and services or through a business/employer.
This case often gets overshadowed by Pollock v Farmers Loan Trust Co. Prior to this, the question was on if the government can tax on personal property. Ultimately, the supreme court reasoned that if property taxes are direct taxes, then personal property should be subject to the same rules. Pollock overshadows Brushaber a bit because it’s cited as a reason why the government can receive a direct tax stock dividends in a company even if it’s not income.
It’s being talked about more often because cryptocurrency is another form of personal property that has a loose definition.
The early 20th century saw two extremely important developments in U.S. taxation: the consolidation of the taxing power of the Congress by way of the 16th amendment and the creation of the federal progressive income tax system.
Photo by Tiago Gerken