Historical Perspectives on the Federal Income Tax
“Income” is defined as: “the gain derived from capital, from labor of from both combined”, it is considered to be the overall increase in wealth clearly realized from all sources during the year. It would seem logical then that whatever the “gain derived from capital” is, it must also be the same for that “derived from labor”, otherwise, capital and labor are not used in the same context and belong in different definitions, as they apply to different subjects.
This is where our preconceived idea of words overtakes our rational interpretation of what is said. In the definition of “income” what relationship exists between the term “gain” and the term “labor? Is the term “wages” considered to be that relationship? The Court did not say “the gain derived from capital” and the “wages derived from labor” did they? Consider this: In the wording of an Income Tax measure, how would you be sure to include all of the gains derive from capital and or labor? If the owner of a business, trade, profession, occupation or vocation was allowed to call all of their “gains”, wages, and those wages were not considered “income” for tax purposes, would those business owners ever have “gains” upon which to pay an Income Tax? Wouldn’t it make sense that Congress, in order to prevent that from happening, would include the term “wages” along with salaries and compensation for services as part of “income”? As Senator Chilton said during the debates over the 16th Amendment, it must be “income” (gains and profits) before it could be taxed, no matter how it was derived. The owner of the business, trade or profession pays himself either out of overhead added to the cost of materials (gain) or out of the actual “gain or profit” derived from the total operation of business. These “gains” are then passed on to the owner through disbursements called salaries, wages or compensation for services. If such “persons” are unable to make a profit or recover their overhead, any payment for time spent, received by them, becomes a return of invested capital and is not taxable as “income”.
Employees, on the other hand, are hired by such businesses to perform certain functions (mental or physical labor) and as such the costs, including wages paid, are deductible as expenses to that operation or business. The owner is not paying the employee out of “gains and profits” earned, but out of actual “labor” costs added to the price of materials or services, for which he also added overhead costs and profit. This is the second half of the definition given to the term “income”, “the gain derived from labor or from both combined”. “Gain” in this definition, is the same for both capital and labor, in that it excludes the capital invested and the labor employed.
Under what standard would the employee be receiving “gain” in exchange for their labor? They are not recognized as being in business, they do not possess the “privileges” of being in business, nor can they add profit and overhead to their “wages”. How would “gain”, to the employee, be derived from their labor? By the amount of wages they are paid? Wages, in that case, are the employee’s annual receipts, the amount they receive from the sale of their “labor”. Where is the method by which Congress converts these annual receipts (wages) to “gains”, so that the tax is levied upon “the gain derived from labor”, not the “labor” itself?
The answer is found in the “Income Tax Cases” and the definition of the word “Income”. From Chief Justice Fuller’s Opinion of the Court 158 US 601 @ 635 we find this statement:
“We have considered the Act only in respect of the tax on income derived from real estate, and from invested personal property, and have not commented on so much of it as bears on gains and profits from business, privileges, or employments, in view of the instances in which taxation on business, privileges, or employments, has assumed the guise of an excise tax and been sustained as such.”
Follow the context of his statement. Pay careful attention to the interchange of “income” and “gains and profits” and the relationship of those words to each other. For this has been the foundation of the “Revenue Acts of Congress” from the beginning. “Income” taxation, on real and personal property, is a Tax levied directly upon the “income” (gains derived from rents, interest and dividends) derived from the use or sale of capital. Whereas, taxation on business, privileges and employments, is an Excise Tax levied directly upon, the “use, action or privilege” employed in the operation of business, measured by the amount of “gains and profits” (income) derived. Both Taxes accomplish the same end result, that is, an indirect charge upon the “source” (annual receipts) from which the “income” (gains and profits) was derived. The “Income Tax” then is indirect upon both capital and labor, because, it is measured by and paid out of the “gains and profits” (income) derived from their respective annual receipts. In other words, gains, profits and income are interchangeable terms meaning the same thing. What the court said was; that this Income Tax on labor (business, privileges and employments) was not under consideration in the pending case (Pollack), because such taxation has always been accepted as an Excise Tax and sustained as such by the courts. Nothing is changed by the 16th Amendment tax on “Income”. A tax levied upon the wages earned by labor for hire (employees under the master and servant relationship) is not even addressed by this case, it only deals with business, privileges and employments (the hiring of employees). We assumed that the term “labor”, as used by the court, is referring to all who labor, but that would not fit the definition of an Excise Tax, unless the laborer is in “business”.
In order to resolve this conflict between wages and labor I refer to CRS Report- 92-303A, published by the Library of Congress in 1992. The report is written by John R. Luckey, a Legislative Attorney for the American Law Division. On page CRS-11 we find this statement:
“The Sixteenth Amendment clarified the power of Congress to lay and
collect taxes on incomes, from whatever source derived. Income has
been defined as gain derived from capital, from labor, or from both combined.
The operative word in this definition is gain. Gain, in the tax context,
is the “surplus” when the basis of an item (in many cases, and in the following,
basis is synonymous with cost) is subtracted from the item’s fair market
“Wages to be taxable must pass the same type of examination. For example if John Doe works five hours for $5.00 per hour, is the $25.00 he receives taxable income to him?
If this type of “income” must pass the same type of examination, then wages, as income, must also be considered surplus. This would then indicate that the wages earned by employees are comparable to the “profits” earned by business. Somehow that just does not seem reasonable for employees (labor for hire). The report goes on to explain this examination:
“As we have seen in the above analysis, we must determine there has
been a “gain” which is realized and recognized.
To see if there was a gain we do not look only to the fair market value of the labor, but rather we determine the difference between the fair market value and his basis (cost) in the labor. Generally one has a zero basis in one’s own labor.”
This must be a mistake, because, if someone has a zero basis in something it must mean that it was free to begin with and that it cost nothing to maintain, otherwise, how else would it be a zero basis?
Here is the more common explanation I’ve heard over the years and I believe these people were very sincere when they said it.
“Yesterday I was broke, but today I went to work and earned a hundred bucks, therefore, I’m a hundred bucks richer today than I was yesterday.”
That certainly would be considered a “gain”, but, is that “gain” a surplus? What did it cost to get from yesterday to today and what is it going to cost to get to tomorrow?
The “Income Tax” is an indirect [excise] Tax levied upon the thing called
“Income”, “the gain derived from capital, from labor or from both combined”.
It is a Tax levied upon “Accessions to wealth clearly realized” through
the transaction of business. It is not a Tax levied upon Life, Liberty
or the Pursuit of Happiness [direct].
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