Welcome To              TaxHistory.com
 
Historical Perspectives on the Federal Income Tax










THE TWO "INCOME" TAXES

Yes, there are two separate and distinct taxes based upon the word "income", one being "direct" per Article 1, Section 9, clause 4, as established by the Supreme Court in 1895 (1) . The other "indirect" per Article 1, Section 8, as established by the Supreme Court in 1913 (2) . The trouble we have today in understanding our current "income" tax system may well be related to the error committed by the Supreme Court in 1895. In that decision the Supreme Court had difficulty distinguishing between the two different "income" taxes, as evidenced by their decision as to what a "direct" tax was, as opposed to the statement of facts made by Justice White in his dissenting opinion, as to what the tax really taxed (3) . The Sixteenth Amendment was specifically proposed and ratified to correct that error and prevent the court, and Congress, from ever making that mistake again (4) . What happened and why is the point of this web-site. This is not a "protest" of taxation nor an effort to bash our current tax system, it is offered simply as an educational tool. The more we understand about the tax system itself the easier it is to accept its provisions and correct its errors.

The point of beginning is distinguishing between a "direct" income tax, as one levied upon annual receipts (the "source"), and an "indirect" income tax, as one levied upon the "gains and profits" derived from those receipts (use of the "source"), for both are "income" by one definition or another (5) . The former (direct) is a tax levied upon the citizen in respect to the protection government affords all, the latter (indirect) is a charge levied upon the transactions the citizen chooses to make, in order to offset the cost of government. The first tax can not be avoided, while the second is paid by choice. The question presented to the Supreme Court, by Pollock, in 1895 was whether or not a tax upon the "income, as receipts", derived from property was "direct" upon the property owner, or, by the government, "indirect" upon the owner, when measured by "income, as gains and profits". The former was declared by Hamilton to be a tax upon the "source", while the latter had always been recognized as a tax upon the "use" (6) . The error committed by the court in 1895 was that they confused the two definitions of "income" by presuming the Revenue Act taxed the former (7) , when by its specific wording it taxed the latter. The error we have today is predicated upon our belief that there is a difference between the "income" produced by capital and the "income" produced by labor, when both, in fact, produce the same two "incomes" (8) . If the Sixteenth Amendment permits the former, the latter is automatically included, however, if the Amendment permits the latter, the former is excluded by Article 1, Section 9, clause 4, of the Constitution.

What is "income", and how did the definition of that term effect the wording of the Sixteenth Amendment? Confused? You're not alone for even Congress has difficulty understanding the two concepts of "income" . The following information, dealing with the specific issue of "income", is provided by the Congressional Record of August 28, 1913. Beginning on page 3843 the discussion in progress is over the wording of the first Revenue Act under the Sixteenth Amendment:

"Mr. Fletcher. I should like to inquire whether the Senator means to state that Congress can not by statute define what shall be regarded as an income tax?

Mr. Cummins. I do not think so, Mr. President. The word "income" had a well-defined meaning before the amendment of the Constitution was adopted (9) . It has been defined in all the courts of this country. When the people of the country granted to Congress the right to levy a tax on incomes, that right was granted with reference to the legal meaning and interpretation of the word "income" as it was then or as it might thereafter be defined or understood in legal procedure. If we could call anything income we pleased, we could obliterate all distinction between income and principle."

In 1913 the Supreme Court established the legal (statutory) meaning of the word "income" in relation to the Corporation Excise Tax of 1909 (10) and by 1920 confirmed that that definition must be controlling (the Constitutional definition) in all the "Income Tax Acts of Congress" (11) . In 1954 the court seemed to have broaden that definition to include "accessions to wealth clearly realized", but then "accessions" simply means "a gain, or increase", in wealth, and nothing more. The most common definition used by the court in recent years is the original, or "Constitutional" definition, "the gain derived from" (12) .

He continues on page 3844:

"Mr. Cummins. It will be observed that here is an attempt, Mr. President, to define the meaning of the word "income", to describe its scope, to determine its effect. I reiterate that the attempt will be ineffective and may be exceedingly dangerous.

Great Britain might employ such words as these in modification or explanation or enlargement of the word 'income', because Great Britain has no constitutional restriction upon her Parliament. A State might use these words with perfect propriety, because a State has a right to include whatever she likes within the meaning of the word 'income'; but the Congress has no right to employ them, because the congress can not affect the meaning of the word 'income' by any legislation whatsoever (13) . ...

Mr. Cummins. I do not say so. What I have said is, however, that it is not for Congress to say, either at this time or at any other time, what it means. If it were within the power of Congress to enlarge the meaning of the word 'income', it could, as I suggested a moment ago, obliterate all difference between income and principal, and obviously the people of this country did not intend to give to Congress the power to levy a direct tax upon all the property of this country without apportionment."

The point made by Mr. Cummins, and the courts, is that Congress does not have the authority to declare that something is "income". The only authority they have is to say that if it is "income" under the Sixteenth Amendment, they intend to tax it. It is well to keep this in mind when dealing with the items listed in Section 61 (a) of our current Tax Law. As stated by Mr. Cummins, the people of our country did not grant Congress the power to levy a "direct" tax upon property, or people for that matter, without apportionment. The authority, granted to Congress by the people, was the authority to tax the gains and profits derived from capital, in the same manner they already had the authority to tax the gains and profits derived from business and professional labors. In other words, the Sixteenth Amendment Income Tax is an excise tax, not a "direct" tax.

In summing up his argument he defines the power granted by the Amendment and confronts the members of the Senate with the portion of that power they elected to take through the impending Revenue Act. His statement is enlightening with respect to today's interpretation of the "income" tax, and the inclusion of the employee's annual receipts (wages) in "Total" (gross) Income on line 22 of the 1040 Tax Return. Again from page 3844:

"Mr. Cummins. I do not accept that at all, because it is entirely beyond the domain of Congress. In 1789, I believe, the people of this country gave to Congress the power to regulate commerce among the States. It is not within the power of Congress to say what commerce is. "Commerce" may mean a very different thing now as compared with what it meant in 1789; it has broadened with the times; the instrumentalities have changed with the course of years; but Congress can not make a thing commerce. The court must declare whether a particular regulation is a regulation of commerce, and in so declaring it defines for the time being what commerce is. *

Why, Mr. President, should Congress attempt to do more than is declared in the first section of the proposed bill? It is right; it is comprehensible; it embraces everything-no, I will withdraw that; it does not embrace the full power of Congress, because Congress can levy a tax upon gross incomes if it likes; it may diminish the extent of its taxing power or not exercise it at all; it may exclude certain things from the taxing power that it might include; but it can not change the character of the taxation; and when it is declared in the first lines of this bill that a tax is levied upon the entire net-income of all the citizens of this country, we have exercised all the power we have. If we desire to limit ourselves to net-income, we can not define "net-income"; we can not say what shall be include in income or what shall not be included in income. We are only preparing ourselves for delay, for disappointment, and possible defeat if we endeavor to interpret the meaning of the word 'income'."**

*[This also must apply to the to the word "income"]

**[Compare Mr. Cummins statement with the Congressional Record of 1942 and the definition of "Victory tax net income" (14)

According to Mr. Cummins, Congress, by virtue of the Sixteenth Amendment, had the power to tax "gross income", but, instead, chose to limit their power to the entire "net-income" of the citizen. According to Tellier, and other court decisions, the federal income tax remains a tax upon net-income, not gross income.

The questions then become: What was the statutory meaning of the term "net-income", as it applied to the Revenue Acts of 1913 to 1953 (15) ; and how is that meaning perceived today under Section 61 and 62 of the Internal Revenue Code ("income" in its constitutional meaning), for both identify the same "income"?

Is the federal income tax still a tax upon "net-income" as stated by the court in "Tellier" (1966) (16) , if so, does the employee's annual receipts (wages) fall within the definition of commercial "net-income", as defined by the Code of Federal Regulations in 1939 to 1953? That concept of "wages" does not sound logical, but then, I'm not sure such "wages" even fell within the definition of "gross income" under the Revenue Act of 1942. The reasons for my skepticism are found within the 1942 Statute under Section 466. Tax Collected at Source, (a) Requirement of Withholding, and the statements of Senator George and Senator Taft recorded in the Congressional Record of 1942. The Statute reads:

"There shall be withheld, collected, and paid upon all wages of every person, to the extent that such wages are includible in gross income, a tax equal to 5 per-centum of the excess of each payment of such wages over the withholding deduction allowable under this part.

If such "wages" were already "includible" in the existing gross income (section 22 (a)) section, what was served by implementing an "income tax" based upon "victory tax net income"; and then define that term to mean net-income from business and financial transactions, plus the gross income of wages? The "wages" received by the employee are most likely their only receipts, therefore, by Hamilton's definition constitute their "whole income"; and a tax upon such receipts was held to be a direct tax under the Constitution.

Second, and more importantly, are the statements of Senator George, the Chairman of the Senate Finance Committee, and Senator Taft of Ohio, recorded on pages 7987 and 7988 of the October 9th, 1942 Record. Senator George addresses this very issue of net income versus gross income:

"If we are going to depart during this war, as an emergency matter, from the concept which has run through out tax system, that is to say, imposing a tax on net income, there would seem to me to be little or no purpose to the pending proposal if no one would be reached who was not subject to the net income-tax provisions of the bill as passed by the House and as reported to the Senate. In other words, if it would not bring in additional taxpayers; if it would not reach the vast number of income producers who will not pay taxes on net income, there would seem to be very little reason in departing from the net-income system and going to the gross-income system in collecting the tax."

Even more confusing is Senator Taft's argument. If "gross income" is business receipts and employee "wages", then what is the "net income of the people" in reference to?

"I am sorry to have to say that the Senator from California is entirely wrong in his figures. The estimates upon which the tax bill is based show that the total net income of the people of the United States is $95,000,000,000. Of that amount $36,000,000,000 is not returned at all under the net income tax. It is not in the form of exemptions or anything else.

In addition to that, there is represented by exemptions $28,000,000,000. So under the bill as passed by the House, without the Victory Tax, $64,000,000,000 of the total net-income of $95,000,000,000 does not pay one cent of tax, and I do not think that under a net-income tax provision it ever will pay any tax."

The figure "$95,308,000,000" can be found in the 1950 Edition of the Statistical Abstract of the United States on Table 316, page 264, for the year of 1941. The Table is labeled "Personal Income and Disposition of Income: 1929 to 1949". This is a statistical report of national income from the Department of Commerce, Office of Business Economics, which has no relationship to the Sixteenth Amendment definition of "income".

This is the first indication that the common laborer received "net-income" in the form of "wages", even though the statistic were based upon "net-money income"; meaning the amount of cash money entering the household from all sources; something entirely different than the "commercial net-income" upon which the 1942 Income Tax was levied.

The Revenue Acts implemented under the Sixteenth Amendment prior to 1954 all used the same basic wording to describe the "net-income" basis of the tax. The term used from 1913 to 1917 was "the entire net income", and then defined net-income as being "gains, profits and income" derived from various uses of capital and or labor, including "salaries, wages, and compensation for personal services rendered". From 1918 to 1953 the term "net -income" was defined as gross income less the deductions allowed for expenses. "Gross income", then, was use as the basis from which net-income was determined. In other words, the Code now provided the basis upon which to determine the amount of "net-income" derived from the employment of each "source". Gross income then related to the gross business and or financial receipts less any invested capital. However, the term "gross income" was also defined as "gains, profits and income derived from", in the same wording as the definition of "net-income" under the 1913 to 1917 Revenue Acts. How could "salaries, wages, and compensation for services" be both gross income and net income? The following conversation recorded in the Congressional Record of August 28, 1913 explains how, and why. Page 3845:

Mr. Sterling: "I should like to ask the Senator from Iowa if the courts, in construing the word "income" would not take into consideration the usual and ordinary signification of that word?

Mr. Cummins: I have no doubt of that Mr. President.

Mr. Sterling: And the court would have recourse to a standard dictionary, would it not, in construing that word?

Mr. Cummins: Unquestionably; and not only so, but to the common acceptation of the word and the judicial opinions, of which there have been very many, in which the word has been considered.

Mr. Sterling: If the definition of the word "income", as given in a standard dictionary, the words "gains and profits" are also given as synonymous with the term "income" would there be anything wrong in the use of those words in the section to which the Senator refers?

Mr. Cummins: I do not think there would be, although they would be wholly unnecessary.

"Mr. Chilton: Well, so far as the Senator has gone. Let me offer this suggestion: On page 167, beginning on line 3, it is provided that the "income derived from salaries, wages" and so forth, shall be included. It has to be income before it can be taxed, no matter how it is derived. We could say that only income from salaries or income from property or income from interest should be taxed. We have simply mentioned certain things: but they must be income before they can be taxed. We use the very language of the Constitution."

Note. There is no reference made to "receipts", it reads "income derived from" salaries, wages or compensation for services, therefore making a distinction between the "salary, wage, or compensation" and "income". The word "Income", as used in the Sixteenth Amendment, is synonymous with, not in opposition to, "gains and profits". If the employee's wages are "gains and profits", what are those "gains and profits" in relation to? Business? They didn't have the money yesterday and the they do today? In other words, what is the basis of "gain" in relation to such "wages'?

The definition of the word "income" is gain, or realized gain, it is not now, nor has it ever been, defined as receipts under the Sixteenth Amendment. Under the 1913 to 1917 Revenue Acts the term "net-income" related to the entire net income derived from all sources, it therefore included the "salary, wage, or compensation" earned by the taxpayer as a portion of that "net-income"; the same as line 12 of the 1040 Tax Return today. The later Acts included "salaries, wages, and compensation" in gross income because they represented a portion of the business or financial gain, which then transferred to the 1040 Tax Return as a portion of the aggregate (total) net income subject to tax (the same as it does today). In either case the "salary, wage, or compensation" was a portion of the realized gain derived from the receipts of the business or financial transaction, they did not represent the receipts themselves. Senator Williams put it this way:

"Mr. Williams: Mr. President, the object of this bill is to tax a man's net income; that is to say, what he has at the end of the year after deducting from his receipts his expenditures or losses. It is not to reform men's moral characters; that is not the object of the bill at all. The tax is not levied for the purpose of restraining people from betting on horse races or upon "futures" but the law is framed for the purpose of making a man pay upon his net income, his actual profit during the year. The tax does not care where he got it from, so far as the tax is concerned, although the law may very properly care in another way."

[Congressional Record of Aug. 28, 1913, page 3849, Commissioner v. Tellier, 383 U.S. 687 (1966)]

Note that the above statement did not say the object of the tax was 'to tax a mans paycheck', but instead its purpose was to tax "net-income", or the profit derived from business and financial transactions (17) . The following quote from Congressman Hull, in his synopsis of the 1913 Revenue Act, again identifies the object of the tax as being annual aggregate "profits", not annual receipts.

"The Treasury regulations soon to be prepared will make clear to every taxpayer the requirements of the law and its application to income derived from the various kinds of business. To any person who keeps familiar with his business affairs during the year to the extent that at the end he knows with reasonable accuracy the amount of his aggregate annual profits, the matter of executing his tax return would be both simple and convenient."

The "income tax" is levied upon the aggregate, or total, net-income derived from all "sources", that is, from all "uses" of capital, labor or both combined. The tax is not levied upon where the "receipts" came from, as though the tax was levied upon the purchaser, consumer, or employer as "sources" of receipts. In other words, the term "source", under the Sixteenth Amendment, is confined to the "capital" or "labor" employed by the citizen, and has nothing to do with who paid for it. The court understood this principle when they defined "income" as being the "gain derived from capital, labor or both combined", and not the receipts derived from consumers, purchasers, or employers.

In order to prohibit the tax from operating upon the citizen as though it was intended to be a "capitation, or other direct, tax", an allowance was made for "personal living and family expenses". Again from Judge Hull's synopsis:

"The statutory exemption of $3,000 is allowed for personal living and family expenses; however, this and other gross income for which special deductions are allowed by the law must be embraced in the return of gross income,"

[Congressional Record of October 16, 1913, p. 5679/synopsis of the Revenue Act by Judge Hull]

The only other place I have found that deals with the intended statutory purpose of the "personal exemption" is the briefs of Attorney General Olney, and the dissenting opinion of Justices Harlan and Brown, in the 1895 Pollock v, U.P. RR Case supra.

In the Case of Pollock 157US427 the reference is found on page 778, in the briefs of U. S. Attorney General Olney; it reads:

"In the present case there is no lack of uniformity as between corporations and individuals. The exemption of $4,000 a year in the case of individuals or families, as will be shown, is intended as a compensation for the necessarily excessive burden of consumption taxes upon small and moderate incomes.

There is no such situation in the case of a business corporation. Every cent which it expends is allowed it. It is taxed only on its net profits, deducting the wages account; which corresponds to the living expenses of the individual."

In other words, the personal exemption equals the living expenses incurred by the citizen, thereby making the tax a tax upon "net-income" applicable to both the natural person as well as the artificial one. Notice that Attorney General Olney relates the "wages account" to the living expenses of the individual. The following case illustrates the point:

For income tax purposes Congress has seen fit to regard an individual as having two personalities: 'one is [as] a seeker after profit who can deduct the expenses incurred in that search; the other is [as] a creature satisfying his needs as a human and those of his family but who cannot deduct such consumption and related expenditures.'" [Justice Harlan, United States v. Gilmore, 372 U.S. 39 (1963)]

Is every citizen a "seeker of profit" first, and a provider for the family second? If so, what is the basic meaning of "Life, Liberty, and the Pursuit of Happiness"? In other words, when those "rights" are reduced to their most basic level, is the resulting "right" that of welfare, or labor in the employ of another (18) ?

Justice Harlan's dissenting opinion explains: (Not the same Harlan as above)

"The basis upon which such exemptions rest is that the general welfare requires that in taxing incomes, such exemptions should be made as will fairly cover the annual expenses of the average family, and thus prevent the members of such families becoming a charge upon the public. The statute allows corporations, when making returns of their net profits or income, to deduct actual operating and business expenses. Upon like grounds, as I suppose, Congress exempted incomes below $4,000". [Justice Harlan, Pollock v. Farmers, 158 U.S. 601,676]

An additional reference is found in the dissenting opinion of Justice Brown, 158 US 601, 694:

"Irrespective, however, of the Constitution, a tax which is wanting in uniformity among members of the same class is, or may be invalid. But this does not deprive the legislature of the power to make exemptions provided such exemption rests upon some principle, and are not purely arbitrary, or created solely for the purpose of favoring some person or body of persons. Thus in every civilized country there is an exemption of small incomes, which would be manifest cruelty to tax, and the power to make such exemptions once granted, the amount is within the discretion of the legislature, and so long as that power is not wantonly abused, the courts are bound to respect it. In this law there is an exemption of $4,000, which indicates a purpose on the part of Congress that the burden of this tax should fall on the wealthy, or at least the well to do. If men who have an income or property beyond their pressing needs are not the ones to pay taxes, it is difficult to say who are; in other words, enlighten taxation is imposed upon property and not upon persons. Poll taxes, formerly a considerable source of revenue, are now practically obsolete. The exemption of $4,000 is designed, undoubtedly, to cover the actual living expenses of a large majority of families, and the fact that it is not applied to corporations is explained by the fact that corporations have no corresponding expenses. The expenses of earning their profits are, of course, deducted in the same manner as the corresponding expenses of a private individual are deductible from the earnings of his business."

This is evidently the point relied upon by the Congressmen and Senators who proposed and debated the adoption of the Sixteenth Amendment. The following is a portion of their comments recorded in the Congressional Record of 1913:

"The exemption of $4,000 was fixed for a number of reasons. In the first place, as already stated, the people with incomes below $4,000 pay the principle part not only of our tariff taxes, but of the State and local taxes, and there is no injustice in requiring those with higher incomes to bear the amount of taxes this bill would impose." {Congressman Hull, April 26, 1913, pg. 508]

"If there is one tax which bears lightly on the shoulders of the individual paying it, it is that which comes out of a surplus income. It galls no shoulders, though it will probably gall some hearts. No man can seriously question that any tax paid under the graduated schedule proposed in this amendment would come out of a surplus income after allowing its recipient a sufficient amount to provide for his family and himself in a dignified manner. [Congressman Copley, May 6, 1913, pg. 1246]

"The man whose income is $1,000 must support his family, educate his children, and if possible, lay up something for a time when he can not earn anything." [Congressman Foster, May 6, 1913, pg. 1249]

Congressman Palmer of Illinois in his speech before the House on May 6, 1913 (page 1250).

"The second reason that appeals to me is this, that in levying this direct tax upon incomes we ought to rise above the point where the consumption taxes now bear out of all proportion to the incomes, and we ought to leave free and untaxed as a part of the income of every American citizen a sufficient amount to rear and support his family according to the American standard and to educate his children in the best manner which the educational system of the country affords. I think it safe to say that no man with the average American family of five children can support that family according to the proper American standard and send his children through the high schools and colleges of the land who does not have a gross income of $4,000 per annum. Out of that sum must be paid living expenses, interest on debts and other obligations, improvements to the home, education of children through colleges and universities, many comforts and some luxuries which American demand."

"There are those who would say that we should begin at $1,000 in lieu of $4,000. They forget the principle upon which this tax is founded, and that is that every man who is making no more than a living should not be taxed upon living earnings, but should be taxed upon the surplus that he makes over and above that amount necessary for a good living." {Congressman Murray, May 6, 1913, pg. 1252]

"After a man pays the tax which he must pay on consumption, then give him a chance to clothe and educate his family and meet the obligations of citizenship and preparation of those dependent upon him for citizenship before you add any additional tax. That is the basis of this exemption, and it is fair and just to all and toward all." {Senator Borah, August 28, 1913, pg. 3841]

The major difference between 1913 and now is that the "personal exemption" in 1913 excluded $4,000 of net income (profit), when the cost of living was $1,000, where today the personal exemption is $3,000 of the employee's yearly "wages", and the cost of living is more like $30,000.

So, does that mean that the "income tax" is unconstitutional, or invalid when it includes the "wages" of employees as part of the taxable income? Not necessarily, but then it does raise the question of whether or not the purpose of our current "income" tax system is that of "direct" or "indirect". As stated by those who wrote the Income Tax Statute in 1913; the purpose of the tax is to extract from the people a portion of their yearly "surplus" wealth, in order to defray the cost of government. The "personal exemption", properly adjusted to reflect the cost of living for the majority of citizens, wherever they may be, would seem to satisfy both the intent and the requirement of the Sixteenth Amendment "Income Tax", whether it be "direct" or "indirect" in nature.


For questions about the material on this site or for problems concerning the mechanics of this site contact info@taxhistory.com
Like the new site? Let us know! Don't like it Let us know that too