In the wake of my last commentary on the horrendous Supreme Court decision upholding Obama's health care plan, several people have pointed out that I erred in saying that the income tax is a "direct tax." While it is technically correct that the Court ultimately declared it to be an excise, not a direct tax, it is important to understand how it arrived at that opinion and why the decision has no practical relevance to the way the tax has been enforced. Just as it has done with Obamacare, the Court came up with a technically constitutional pathway to allow the government to collect a tax in a blatantly unconstitutional manner.
In the 1895 Pollock v. Farmers' Loan and Trust case, the Supreme Court declared the original Income Tax of 1894 unconstitutional because it imposed a direct tax that was not apportioned to the states according to the taxing provisions of the Constitution. For example it said that a tax on rental income is the same as direct tax on the property that produced the income. In other words, a tax on income was tantamount to a tax on its source.
To get around this, in 1913 Congress passed, and the state governments ratified, the 16th Amendment that authorized a tax on income from whatever source derived without regard to apportionment. However, in 1916 the Supreme Court ruled in Brushaber v. Union Pacific Rail Road that the Amendment "conferred no new taxing power to the Federal government," and that it "contained nothing challenging or repudiated its ruling in the Pollock case." Instead, the Court said that in order to be constitutionally taxed as an excise, income must first be separated from its source. A few years later in Eisner v. Macomber (1918) and Merchants Loan and Trust v. Smietanka (1921) the Court provided a practical guide to doing just that, by defining income, for purposes of the Sixteenth Amendment, as a corporate profit.
A corporation determines profit by subtracting its expenses from its income. The difference, called profit, could then be subject to an income tax. So if a corporation has rental income, but derives no profit after backing out all of its expenses, then the rents, and therefore the property, are not taxed. In that respect, the income is separated from the sources that produced it. Were it not for this separation, a tax on rents, dividends, fees, etc. would be a direct tax on the sources of income, as described by Pollock, Brushaber, Eisner and Smietanka. That is why many U.S. corporations can have billions of dollars of income but pay no tax, because they derive no profits from that income. This proves the income tax is, in reality, a profits tax.
An expert on money, economic theory, and international investing, Peter is a highly recommended broker by many leading financial newsletters and investment advisory services. He is also a contributing commentator for Newsweek International and served as an economic advisor to the 2008 Ron Paul presidential campaign.