November 11, 2021 Reading Time: 7 minutes

A wealth tax, recently redubbed a tax on “unrealized capital gains,” is all the rage in Washington, D.C. these days. While the economic implications of this proposal are sufficiently flimsy to discount its claimed purpose of revenue generation, the proposed wealth tax faces a greater obstacle to its adoption: it is blatantly unconstitutional.

It is true that a number of law professors have attempted to carve out a justification for wealth taxation through a combination of legal sophistry and bad history, but the certainty of a constitutional challenge remains in the event that Congress ever passes such a measure. To understand why such a challenge would likely doom the proposal, we must turn back to the economics of wealth taxation and – specifically – a little-noticed passage by Adam Smith.

First, let’s consider the constitutional issue at hand. Article I, Section 8 of the U.S. Constitution establishes the power of Congress “To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States,” however this power is not absolute. A second clause constrains this power, noting that “No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.”

The “Capitation Clause,” as it is sometimes called, divides taxation into two categories: direct and indirect. Indirect taxes include those specified in the earlier clause, “Duties, Imposts and Excises.” A direct tax is a different instrument, constitutionally speaking. Before we get to the definition of that term though, suffice it to say that the Capitation Clause imposes substantial constraints on the enactment of direct taxation. In order to pass constitutional muster, the burdens of a direct tax must be apportioned across the individual states according to their share of the national population. This requirement would preclude a national tax policy, as that burden would be assessed for a state as a whole. Virginia would “owe” a sum commensurate with its population, as would California, as would Idaho and so forth. The rate of direct taxation on individuals living in each state would accordingly vary to the point of making such a tax system politically impractical if not impossible to administer.

The applications of the Capitation Clause have undergone some modification in our constitutional history. In 1909 Congress passed the 16th Amendment. This measure was intended as a workaround that would exempt the direct taxation of income from the apportionment requirement of the Capitation Clause. As the amendment reads, “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.”

The history of the 16th Amendment is complex, but its immediate occasion came from a revision to the tariff system – the main source of the federal government’s revenue for most of the 19th century. While debating the Payne-Aldrich Tariff Act of 1909, a group of anti-protectionist Democrats proposed a revenue swap that would replace the import tariff system with an income tax and thereby alleviate the former regime’s burdens on international trade.

The income taxers of 1909 recognized that they had a constitutional problem though. They previously attempted to initiate the revenue swap strategy in 1894, only to run directly into the Capitation Clause. Within a year of its enactment, the Supreme Court invalidated a key portion of the 1894 income tax on the grounds that it imposed an unapportioned direct tax, running afoul of the constitutional requirement. The complex findings of the Pollock v. Farmers Loan and Trust case were controversial in their day and some members of Congress wished to press the case further by attempting another legislatively enacted income tax in 1909. To defuse the volatile constitutional situation, President William H. Taft negotiated a compromise that would allow the tariff bill to proceed without the revenue swap in exchange for a new constitutional amendment that would exempt future income taxation from the Capitation Clause and the Pollock case. The 16th Amendment met the ratification threshold four years later, giving us the federal income tax.

Legal arguments for wealth taxation today typically try to bring the definition under the umbrella of the 16th Amendment, or argue around the implications of Pollock, which technically remains a matter of standing case law. Income and wealth are two very different instruments, however, and the “unrealized capital gains tax” relabeling of the latter gives away the game. Income refers to generated earnings – usually taxed on an annual basis – whereas wealth refers to what a person owns, whether or not it increases in value from year to year. A tax on “unrealized capital gains” would thus assess a levy against the change in an owned asset’s value even if it remained unsold and thus unconverted into income.

This brings us back to the definition of “indirect” and “direct” taxation. Since the 16th Amendment only applies to income earnings, it is plainly insufficient to cover unrealized gains as envisioned in the current wealth tax proposals. That means the constitutionality of the wealth tax rests on whether it is an “indirect” or “direct” form of taxation. If it is “direct,” then it would still be subject to the apportionment rule of the Capitation Clause.

To answer that question, we must turn not only to legal history but to economics. The question of direct taxation came before the Supreme Court in one of its first major constitutional challenges, the 1796 case of Hylton v. United States. This case is something of a historical oddity as it came from the earliest days of American jurisprudence. Rather than speaking for the Court as a whole, its opinion came in seriatim – basically a succession of statements by each justice, explaining how they reached their decision. Hylton involved a constitutional challenge over whether a federally assessed tax on carriages fit the definition of “indirect,” as per an excise tax, or qualified as a “direct” tax on property ownership in carriages. If the latter, it would have been subject to the Capitation Clause, making the measure unconstitutional.

Arguing on behalf of the government against the challenge, Alexander Hamilton’s brief in the Hylton case argued that carriage taxes were “indirect” and thus not subject to the Capitation Clause. He did so by delineating the categories of taxation that qualified as “direct:”

The following are presumed to be the only direct taxes. Capitation or poll taxes. Taxes on lands and buildings. General assessments, whether on the whole property of individuals, or on their whole real or personal estate; all else must of necessity be considered as indirect taxes.

Hamilton’s brief would seem to have our answer. A wealth tax, or tax on “unrealized capital gains,” fits the description of what Hamilton calls a “general assessment” – a tax on a person’s “whole real or personal estate.” As a direct tax then, it would be subject to the apportionment requirement.

The Court’s ruling in Hylton is what matters the most though – not Hamilton’s argument on behalf of the government in the case. That is where economics, and specifically the economics of Adam Smith, enters the picture.

The most detailed investigation of the definitional issue from Hylton came from the portion of the opinion written by Justice William Paterson. Referring to the carriage tax at hand before the Court, Paterson writes plainly:

All taxes on expenses or consumption are indirect taxes. A tax on carriages is of this kind, and of course is not a direct tax. Indirect taxes are circuitous modes of reaching the revenue of individuals, who generally live according to their income.

The carriage tax therefore passed constitutional muster as an indirect tax. Far less noticed, however, is where Paterson obtained this definition. His explanation continues by noting the source of the distinction: “I shall close the discourse with reading a passage or two from Smith’s Wealth of Nations.” 

The impossibility of taxing people in proportion to their revenue by any capitation seems to have given occasion to the invention of taxes upon consumable commodities; the state, not knowing how to tax directly and proportionally the revenue of its subjects, endeavors to tax it indirectly by taxing their expense, which it is supposed in most cases will be neatly in proportion to their revenue. Their expense is taxed by taxing the consumable commodities upon which it is laid out.

Consumable commodities, whether necessaries or luxuries, may be taxed in two different ways: the consumer may either pay an annual sum on account of his using or consuming goods of a certain kind or the goods may be taxed while they remain in the hands of the dealer, and before they are delivered to the consumer. The consumable goods, which last a considerable time before they are consumed altogether, are most properly taxed in the one way, those of which the consumption is immediate or more speedy in the other; the coach tax and plate tax are examples of the former method of imposing; the greater part of the other duties of excise and customs of the latter.

Paterson, accordingly, got his definition of indirect taxation from its economic use in Adam Smith’s taxonomy of different revenue measures. The citation of Smith is revealing, because Smith further discusses several types of indirect and direct taxation in adjacent passages. Among the items that would qualify as direct taxation, he notes, are “Taxes upon the Wages of Labour” as well as certain “Taxes upon the capital Value of Land, Houses, and Stock,” provided they are not assessed upon a transaction in that asset.

Per Smith, a tax is considered to be “indirect” as a result of the instrument of its assessment. For example, an indirect tax on property and other capital assets would occur through an assessment at the point of sale. Smith gives the examples of a tax that is assessed as a percentage of the sale price on a piece of land, or as a fixed duty upon the land transaction. As a contrasting example, he notes that direct taxation might be assessed against the non-sale transfer of property (for example, between family members) in which the unrealized value of the property is recorded by deed.

In Smith’s telling, “indirect” taxation arises from the means by which a tax is assessed – specifically on a type of transaction or exchange. His use of the term implicitly excludes both direct wage earnings, or income, and direct assessments on the value of an asset in the absence of a transaction. These would each be forms of direct taxation.

While Smith’s writings alone do not decide the legal implications of the terms, they illustrate plainly that Justice Paterson linked “indirect” taxation in the Hylton decision to economic reasoning. Paterson did not write in a vacuum, but rather turned directly to economic theory in assessing the case before him. When we look to those same writings today, we find that Smith’s reasoning is consistent with the later Pollock case’s association of income taxation with direct taxation. And while the 16th Amendment modifies the application of that case to income earnings, the same logic remains intact for any attempt to directly tax wealth or, as certain members of Congress now call it, “unrealized capital gains.” Let us hope that our better legal minds continue to draw upon economists such as Smith in navigating these constitutional waters.

Phillip W. Magness

Phil Magness

Phillip W. Magness works at the Independent Institute. He was formerly the Senior Research Faculty and F.A. Hayek Chair in Economics and Economic History at the American Institute for Economic Research. He holds a PhD and MPP from George Mason University’s School of Public Policy, and a BA from the University of St. Thomas (Houston). Prior to joining AIER, Dr. Magness spent over a decade teaching public policy, economics, and international trade at institutions including American University, George Mason University, and Berry College. Magness’s work encompasses the economic history of the United States and Atlantic world, with specializations in the economic dimensions of slavery and racial discrimination, the history of taxation, and measurements of economic inequality over time. He also maintains an active research interest in higher education policy and the history of economic thought. His work has appeared in scholarly outlets including the Journal of Political Economy, the Economic Journal, Economic Inquiry, and the Journal of Business Ethics. In addition to his scholarship, Magness’s popular writings have appeared in numerous venues including the Wall Street Journal, the New York Times, Newsweek, Politico, Reason, National Review, and the Chronicle of Higher Education.

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