The Supreme Court And The Meaning Of “Income”

The Supreme Court, in the Pollock decision, DID NOT rule the “income” tax unconstitutional. It merely ruled that the measurement of the tax by receipts derived from the use of personal property is unconstitutional, because the property itself is untaxable:

“The tax imposed by sections 27 to 37, inclusive, of the act of 1894, so far as it falls on the income of real estate, and of personal property, being a direct tax, within the meaning of the constitution, and therefore unconstitutional and void, because not apportioned according to representation, all those sections, constituting one entire scheme of taxation, are necessarily invalid.”

Like all of the “income” tax acts over the years, the act of 1894 had coyly declined to spell out what qualifies as “income”, other than the compensation of federal workers. It instructed government offices and agencies to treat and report their payments as such, by means which we will examine later, but left to all others the task of recognizing when the law does and does not apply to them. In Pollock’s case, the railroad-owning Farmer’s Loan and Trust Company (now Citibank of New York) had indicated its intention to declare its profits as “income” and pay taxes on them before distributing what was left to Pollock and other investors as dividends.  His suit established only that such dividends and their like could not be treated as “income” even if associated with a taxable activity. Nonetheless, the case was enormously significant. In large part, the 1894 act had had its sights set on the huge profits being made by investments in ventures such as railroads, declared by the Supreme Court during the 1880’s to amount to federal instrumentalities. The ruling thus took the meat-and- potatoes of the “income” tax’s potential to the federal treasury off the table– there wasn’t much left by which the tax on federal salary “income” could be supplemented.

In response to the Pollock ruling, the Sixteenth Amendment- “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.”— was declared ratified in 1913, promptly followed in October of the same year by a new revenue act.

Almost immediately, the Supreme Court had occasion to address the new amendment, in Brushaber v. Union Pacific R. Co., 240 U.S. 1 (1916).   The plaintiff in the case, Frank Brushaber, sought to defeat the taxation of dividends from his railroad investments under the new act. He cleverly suggested that the definition of “income” to which it and the amendment referred should be understood as having been expanded so as to encompass the objects of a capitation or other direct tax, yet without apportionment. His notion was to exploit the various Constitutional problems which would naturally arise from such a misunderstanding. The court patiently corrected his error, declaring that the amendment had done nothing more than establish that the excise on “income” can be laid without regard to its connection with personal property. The court also repeats and reinforces its declaration from the Pollock ruling that such a tax can only be laid as an excise– noting that the Article 1, Section 9 Constitutional prohibition on unapportioned direct taxes had not been repealed.

“We are of opinion, however, that the confusion is not inherent, but rather arises from the conclusion that the 16th Amendment provides for a hitherto unknown power of taxation; that is, a power to levy an income tax which, although direct, should not be subject to the regulation of apportionment applicable to all other direct taxes. And the far-reaching effect of this erroneous assumption will be made clear by generalizing the many contentions advanced in argument to support it…” “But it clearly results that the proposition and the contentions under it, if acceded to, would cause one provision of the Constitution to destroy another; that is, they would result in bringing the provisions of the Amendment exempting a direct tax from apportionment into irreconcilable conflict with the general requirement that all direct taxes be apportioned.”

The court points out that the amendment had in no way modified or expanded the meaning of the word “income” as lawfully used in a taxing statute. Nor had it changed the requirement that the application of any such statute must be confined to the forms and proper subjects of an excise- licensed or privileged activities. It simply provided that the constitutionality of such a tax could no longer be challenged by reference to untaxable property connected with any particular “income”. Such a challenge, in other words, can only argue against the taxability of the activity to which the “income” tax is being applied. The court upholds the 1913 revenue act at issue in Brushaber as being consistent with these requirements. All that it seeks to tax are “gains, profits, or income from whatever source derived” just as had the act of 1862, with no language seeking to tax common, private-sector receipts, such as unprivileged pay-for-work. (Nonetheless, the 1913 act deploys careful language acknowledging “income exempt from taxation by the fundamental law [the Constitution]” This acknowledgement subsequently moved into the regulations associated with the revenue laws after their codification in 1939:

26 CFR § 39.21-1 (1956): Meaning of net income, (a) The tax imposed by chapter 1 is upon income. Neither income exempted by statute or fundamental law, nor expenses incurred in connection therewith, other than interest, enter into the computation of net income as defined by section 21.

and,

26 CFR § 39.22(b)-l: Exemption—Exclusions from gross income. Certain items of income specified in section 22(b) are exempt from tax and may be excluded from gross income.   These items, however, are exempt only to the extent and in the amount specified. No other items may be excluded from gross income except (a) those items of income which are, under the Constitution, not taxable by the Federal Government;

Today’s regulations put it this way:

26 CFR § 1.61-1 (Current) Gross income, (a) General definition. Gross income means all income from whatever source derived, unless excluded by law.)

The Brushaber court also seizes the opportunity to reaffirm the core element of the “income” tax by pointing out that the only way to square the Sixteenth Amendment with Article 1, Sections 2 and 9 of the Constitution was through a fixed, customized definition of what had been a legal term and was now a Constitutional term: “income”.  Because a tax on “income” is necessarily an excise, whatever is thus taxed as “income” MUST be confined to such things to which an excise can properly be applied. As the court puts it, taxation on “income” is,

“… in its nature an excise entitled to be enforced as such unless and until it was concluded that to enforce it would amount to accomplishing the result which the requirement as to apportionment of direct taxation was adopted to prevent, in which case the duty would arise to disregard form and consider substance alone, and hence subject the tax to the regulation as to apportionment which otherwise as an excise would not apply to it”

In other words, if the tax should mutate or be construed so as to embrace objects not appropriate for an excise, such as “all that comes in”, for instance (therefore becoming, de facto, a capitation, or other direct tax), it would have to be implemented under the rule of apportionment regardless of the fact that it was still being called only an “income” tax. In the same year as the Brushaber decision, the court acknowledges the concurrent jurisdictional limitation of the taxing power of Congress in Stanton v. Baltic Mining Co, 240 U.S. 103 (1916):

“Mark, of course, in saying this we are not here considering a tax… entirely beyond the scope of the taxing power of Congress, and where consequently no authority to impose a burden, either direct or indirect, exists. In other words, we are here dealing solely with the restriction imposed by the 16th Amendment on the right to resort to the source whence an income is derived in a case where there is power to tax”

Two years later, in Peck v. Lowe, 247 U.S. 165 (1918), the court observed again that the 16th Amendment in no way expanded that jurisdictional reach, saying:

“The Sixteenth Amendment, although referred to in argument, has no real bearing and may be put out of view. As pointed out in recent decisions, it does not extend the taxing power to new or excepted subjects, but merely removes all occasion, which otherwise might exist, for an apportionment among the states of taxes laid on income, whether it be derived from one source or another.”

Here are a few other relevant citations accenting, with varying acuity, some of the Brushaber court’s points:

“The Treasury cannot by interpretive regulations, make income of that which is not income within the meaning of the revenue acts of Congress, nor can Congress, without apportionment, tax as income that which is not income within the meaning of the 16th Amendment.” Helvering v Edison Bros. Stores, 133 F2d 575. (1943) “The provisions of the Sixteenth Amendment conferred no new power of taxation but simply prohibited the complete and plenary power of income taxation possessed by Congress from the beginning from being taken out of the category of indirect taxation to which it inherently belonged. . . “So. Pacific v. Lowe, 238 F. 847 (US Dist. Ct. S.D. N.Y., 1917); 247 U.S. 330 (1918) “Constitutionally the only thing that can be taxed by Congress is “income. “And the tax actually imposed by Congress has been on net income as distinct from gross income. The tax is not, never has been, and could not constitutionally be upon “gross receipts”… ” Anderson Oldsmobile, Inc. vs Hofferbert, 102 F Supp 902 (1952) “The general term “income” is not defined in the Internal Revenue Code’VS v Ballard, 535 F2d 400, 404 (1976)

As its jurisprudence expressing and implementing the Brushaber principle matured, the Supreme Court devoted a fair amount of attention to the phrase, “gains, profits and income”, in an effort to further clarify the necessary elements of what could be taxed as “income”. In its ruling in So. Pacific v. Lowe, 247 U.S. 330, (1918), for instance, the court says,

“… ‘income’, as used in the statute should be given a meaning so as not to include everything that comes in. The true function of the words gains’ and ‘profits’ is to limit the meaning of the word ‘income’.”

Although the issue central to this case involves the application of the law to corporate receipts, and the ‘profit’ aspect is not critical to our present analysis of the law as written since no tax has been imposed on private-sector receipts, profitable or otherwise, it is worth our while to indulge a brief diversion into its implications. The revenue acts, after all, draw, and can draw, no distinction whatever between the meaning of “income” to a corporation and the meaning of “income” to a natural person:

“It is obvious that these decisions in principle rule the case at bar if the word “income” has the same meaning in the Income Tax Act of 1913 that it had in the Corporation Excise Tax Act of 1909, and that it has the same scope of meaning was in effect decided in Southern Pacific Co. v. Lowe 247 U.S. 330, 335, where it was assumed for the purposes of decision that there was no difference in its meaning as used in the act of 1909 and in the Income Tax Act of 1913. There can be no doubt that the word must be given the same meaning and content in the Income Tax Acts of 1916 and 1917 that it had in the act of 1913. When to this we add that in Eisner v. Macomber, supra, a case arising under the same Income Tax Act of 1916 which is here involved, the definition of “income” which was applied was adopted from Strattons’ Independence v. Howbert, arising under the Corporation Excise Tax Act of 1909, with the addition that it should include “profit gained through sale or conversion of capital assets,” there would seem to be no room to doubt that the word must be given the same meaning in all the Income Tax Acts of Congress that was given to it in the Corporation Excise Tax Act, and that what that meaning is has now become definitely settled by decisions of this Court.” Merchants’ Loan & Trust Co. v. Smietanka 255 U.S. 509 (1921),

…and it is important for an overall understanding of lawful taxation to recognize that “income” which can be lawfully taxed must not only be a consequence of the exercise of a privilege, but it must also involve a meaningful gain. Even government workers otherwise properly taxed on receipts associated with their conduct of a public office can’t be taxed on money received as reimbursements, for instance. The key virtue of this exercise will be in illuminating why, among other reasons, under this particular settled doctrine of the court private-sector proceeds of work (in particular) cannot be taxed under an “income” tax.

Let’s begin with a simple mental exercise: Suppose that you were a shepherd who needed a new pair of shoes. You take a sheep down to your neighbor the cobbler, who trades you a pair of shoes for your sheep. You’re both happy, you with the shoes that you didn’t have before, and your neighbor with a week or two’s worth of dinner. Did either of you receive “income” (defined, for the purpose of this exercise, solely as profit)? Clearly not. The market value of your sheep was equaled by the market value of the shoes, and neither you nor the cobbler made a profit. Now, let’s suppose that, rather than carrying your sheep to the cobbler’s, you gave him an IOU which can be redeemed for one sheep (or traded to someone else for one sheep’s worth of value in other goods, who will trade for it knowing that they can redeem it for a sheep, or trade it away themselves). Now you’ve got the shoes and the cobbler has a claim on a sheep or its equivalent value. Any profits (“income”) now? Of course not.

OK, how about this- instead of an IOU for one of your sheep, you give the cobbler the note you’re holding from your other neighbor, the carpenter, for a day’s worth of carpentry, (or its equivalent, as explained earlier), that you got last week in trade for one of your sheep. Any profit or “income” now? Still no. And how about that carpenter, who redeems his note by doing a day’s worth of work for the cobbler. When the cobbler gives him the note, debt paid, has the carpenter received “income”? Clearly not.

No one received any “income” in our example because by merely trading what they already possessed for it’s equivalent value in someone else’s property, none of our citizens increased their wealth, they simply converted pre-existing assets to a different form. Some would make the argument that our carpenter is an exception, saying that he didn’t really trade anything, he simply was paid for his time- getting something for nothing. That argument implies that an individual doesn’t own, as a resource, his or her time/labor, leaving one to wonder to whom they would propose that it does belong; it also presumes or implies that the time/labor available to the carpenter, as to all of us, is not an all too finite resource– an absurdity not worthy of rebuttal. I will dismiss such arguments with the observations that the consumer of the carpenter’s work did not acquire its benefits by magic; and the carpenter could have spent his days making shoes like the cobbler or raising sheep like the shepherd if he wished, or studying to improve his skills. There is no practical difference between any of these choices, they are all just ways of using ones time/labor, and the specialization in one or the other toward which individuals naturally gravitate as they discover where their talents and interests lie simply maximizes the benefit to the whole community.  Besides, the very fact that someone would offer value in exchange for the carpenter’s time/labor establishes it as a legitimate tradable good.

Douglas Adams, in ‘Life, the Universe and Everything’ one of the books in his wonderful ‘Hitchhiker’s Guide to the Galaxy’ series, describes a society that elected to make leaves legal tender, imagining that with this choice they would immediately all be rich, and without any effort! Eventually, they are forced to burn down all the trees, in order to curb inflation…

It is vitally important for the sake of clear thinking to understand that alltradable goods of any kind, including sheep and shoes as well as work (and by extension the notes or tokens, sometimes called money, used to facilitate the trading process), represent a unit of time/labor. If goods could be acquired without an expenditure of time/labor, they would have no value. They might still be desirable, as air is desirable, even necessary, but of no tradable value due to being attainable without any effort.  For instance if gold, a tradable good long used as a form of money, were as common as sand and as easily acquired, we might still like to wear it as jewelry but we would not use it as money, for it would not represent any meaningful unit of time/labor. It can be used as money only because acquiring it requires effort in the mining process, both in locating and extracting it, rendering it a tradable good with an inherent value. The same is true of our shepherd’s sheep. If a sheep could be had by anybody, anytime, by simply stepping outside and grabbing one- without hunting for it or husbanding it– sheep would have no value, and neither the cobbler nor the carpenter would offer their goods in trade for one. The value in these goods comes from the time/labor expenditure necessary to acquire them. All tradable goods consist of time/labor, either converted to a hard product through the picking of the apples, the raising of the sheep, the making of the shoes, etc.; rendered in its original form as service (which is to say, doing the same things for someone else); or as a combination of the two.

As an example of that last form, which is the most common form of tradable good in our complex economy, let us examine the shoemaker, who trades ‘x’ for his materials, and then sells (trades) his shoes for ‘x + y’?! Surely he has made a profit, and acquired “income”?!

What the shoemaker has done is mixed his time/labor, which is one of his resources, with his raw materials, creating more value for the raw materials as they become refined into a product of a different kind, but only to the same degree as the cobbler’s expenditure of his time and energy. If the cobbler attempted to sell his shoes for more than the value of the resources consumed in the production process, his customers, who also can acquire leather and thread, and also have time and energy, could make them for themselves. If those customers were to make that choice, and fashion their own shoes, they could surely not be charged with having received “income” represented by some calculation of the increased value of the leather and thread; no more can the cobbler.

This is not to say that the cobbler does not enjoy a competitive advantage in evaluating his goods for the market; he can take advantage of his greater experience and superior efficiency in making his products, making his expenditure relatively less than that faced by his customers in contemplating whether to buy or make their own. But that same advantage is enjoyed by all specialists in the market, and thus does not change the dynamic of trading value for equal value, with gain to none, and in any case does not represent some magical confusion of resource or value not originating from (and belonging to), the cobbler. (That any producer may also bring special artistry to his or her work, adding value beyond that of the other resources consumed, is true as well, but does not conflict with the basic point).

Theoretically, we all could make our own consumable products, spending our time hunting for materials, and sitting around fashioning the things we need, we would simply lose the greater efficiency of specialization which provides for less cost of time/labor in production. Choosing the advantages of specialization, and the necessary mechanism of trade to actualize its benefits, does not add to our inherent personal resources despite allowing us to acquire more and better goods than we could make or acquire were we to live as hermits.

All of our players in this example are participants in a specialization based market economy, the same market economy in which you and I participate in every detail, rendered a little tricky to perceive by the use of different terms for key Ingredients, most notably IOUs (or notes) for money, and the references to work as a tradable good. The money that we use today in the United States is simply IOUs which, for convenience and efficiency, we have recently (about a hundred years ago) decided should be written by a central authority for the sake of uniformity. After all, goes the argument, transactions are often wide-ranging in the players they involve and the distances and layers of ownership and obligation that they navigate. That centralization removes from money the personal IOU obligation of the original notes. Thus a dollar bill, for example, no longer has the name of the carpenter on it, identifying him as the origin of the note and his time/labor as the backing for the notes value, because the market’s participants all understand that everyone’s notes are tradable for everyone’s goods, since everyone’s tradable goods ultimately are of the same nature.

It was only in the early 20th century that the American economy began this experiment with centralized printing of money; prior to that time paper money consisted exclusively of banknotes issued by individual financial institutions redeemable upon demand by the bank for a tradable good such as gold or silver, as well as drafts against personal accounts. Our Federal Reserve scrip of today will not be redeemed by the issuing institution, but is imbued with value by our general agreement as participants in the market to accept it as a trading medium. This distinction does not mitigate its nature as a token symbolizing time/labor. When you are paid dollars by one participating member of the market, you are receiving notes of obligation against the common pool of market wealth equal to your contribution to that pool, and redeemable in the form of any other equally valued portion of the pool. That pool is the aggregate of all the time/labor invested by the participants in that market.

The true nature of money is an important issue for society for many reasons, but for our purposes here, it is because those benefiting from already confusing “income” tax laws try to further muddy the waters by focusing our attention on the acquisition of money- as though the tax were laid upon money, rather than on taxable (privileged) activities, the extent of which is measured by the money they produce. Such beneficiaries like very much to have the legal object of the “income” tax be a blurry moving target in the minds of their victims, and they are delighted to borrow from the widespread confusion regarding the nature of money.

Money, of course, being property, can only be taxed by a direct (therefore, apportioned) tax. Furthermore, it is important to keep in mind that the money itself, particularly our printed scrip form, has no inherent value at all– its sole value is in its representation of, or ability to command redemption by, labor. You can’t eat the money, you can only eat the product of labor for which the money can be traded. When you give someone money, you’re actually giving them, at bottom, labor; when you receive money, you are receiving debt instruments representing labor owed to you. In a complex economy, the distance between currency and the foundational labor of acquiring, defending, coaxing yield— and eventually surplus- from the land; and the basic production of all the other things made possible by that fundamental formation of wealth is great indeed, but that labor remains the source of value of every dollar.

To summarize all of this in a nutshell: remuneration for work literally IS labor; and the seizure (whether called a tax or anything else) of remuneration that is the result of simply working for a living amounts to slavery. There is no meaningful distinction that can be drawn between the taking of 25% of a worker’s pay in taxes with which to purchase [his or his competitor’s] products and services, and forcing that worker Into a government factory to produce those products and services for free 2 hours out of every 8-hour workday. That the latter would be grossly unconstitutional needs hardly be said; that the former also is should be clear as well. In light of the requirement that a lawfully taxable activity be measured by profit (without even concerning ourselves with the privilege requirement), it is equally clear that in neither case can “Income” be alleged. Just as it is impossible to characterize two hours of labor in the government factory as profit, the two hours worth of work taken as money also fails the test.

(For someone working for the taxing authority, of course, the “tax” would be nothing but a pay cut, and would represent a voluntarily accepted condition of “employment”, all remuneration from which constitutes, by law, profit).

This discussion of labor and money allows an only slightly tortured segue to another topic by virtue of the underlying wisdom awaiting discovery, as so often is the case, behind words long associated with those two subjects. In this case, it is our expression “making money” that reveals the truth about money’s nature; for restated with more accuracy and clarity, what we mean by these words is “creating wealth”, a true description of our behavior when we expend our labor- wealth being nothing more than the durable product of labor, whether that labor is devoted directly to physical production or improvement, or is in the form of services by which others are made able to so directly produce. The creation, of course, is the property of the creator; by which principle both our own wealth is secured to us, and that created by virtue of government privilege is made amenable to a government claim of an ownership interest.

This same principle informs the nature of lawful government and its proper authority, and the laws that can be made under that authority; which we will briefly explore next. While a thoughtful and informed perspective on those subjects is not absolutely necessary to understand and apply the tax law as written, it is nonetheless very helpful in that endeavor – and a virtue in any free and sovereign citizen.