It sometimes seems that every policy disagreement is immediately turned into a constitutional question. People who lose elections and then face the consequences—the passage of laws that they do not like—are all too tempted to scream: “You can’t do that. It violates my constitutional rights!” Many times, that is true; but most times, it is just a desperate plea from people who lost at the ballot box.
The latest version of this argument comes from American conservatives who are shocked to learn that one of the biggest tax advantages enjoyed by rich people—the nontaxation of huge amounts of capital gains income—might be partially pared back under a new proposal from the Democrats. Republicans’ response was not merely, “We think that’s bad policy, and here’s why,” but “That’s unconstitutional…we hope.”
The problem for Republicans is that there is no theory available under which Democrats’ tax proposal would fail to pass constitutional muster. The word “income” is in italics in the previous paragraph for a reason, which is that the relevant constitutional provision (the Sixteenth Amendment) allows the federal government to tax “all incomes, from whatever source derived.” All incomes, not merely certain types of income.
That, however, does not stop the immediate chatter from being all about a constitutional challenge from Republicans. The problem, again, is that there is no legal hook for such a challenge, and the closest thing to a precedent on which they could rely has been repudiated both by the Supreme Court and by nearly every tax scholar (no matter their ideology) for more than half a century.
That does not mean that the Supreme Court as currently constituted might not simply invent a new doctrine to save the billionaires who would pay increased taxes under this proposal. But to do so, the Court would have to do some extremely creative rewriting of the law. Short of that judicial freelancing, the question: “Is the Democrats’ new plan constitutional?” is trivially easy to answer: “Yes, it is obviously constitutional.”
Tellingly, the people who are wondering aloud whether there is a constitutional challenge available are not pointing to anything plausible to back up their hope, instead saying in essence: “This is new, and it will hit the ultrarich. They won’t put up with that, will they?” Unless the American legal system soon becomes even more corrupted than we had reason to believe it was, the ultrarich will have to put up with what the Democrats might pass into law.
What Is the Democrats’ New Tax Proposal?
Senate Finance Committee Chair Ron Wyden (D-OR) has announced a proposal to begin to tax a small part of what is known as “unrealized” income. For most people, receiving income is a matter of being paid a salary or wages, and that type of income is legally “realized” as soon as it is received. That is, you are paid money for doing your job, so you have more money.
Unrealized income is still income, but it is received in noncash form. If your boss paid you not in cash but by giving you 1,000 shares of stock worth $100 per share, you would have received $100,000 for doing your job. Should you be allowed to avoid paying tax on that $100,000 of income simply because it was not paid to you in the form of cash? No, but Congress does have the power to decide not to tax any sub-category of income, if it so desires. Doing so, however, would not turn income into non-income as a constitutional matter. It would continue to be income, but it would not be taxed.
And what if, instead of paying you in future years by giving you more shares of stock, your boss told you that she would work it out to make your shares go up in value, so that a year from now your shares will be worth $200 each? You would thus be another $100,000 richer at the end of your second year, and under the Constitution, that income can be taxed.
You might wonder why you would accept payment in shares of stock rather than salary, because grocery stores do not accept shares of stock to pay for food. But if you could take out an interest-free loan against your valuable shares of stock, you would have the cash you needed for daily living. We generally do not do things this way for typical people, but sheltering income from taxation in these ways is standard behavior for the ultrarich. They are receiving their outsized incomes in noncash form, but no matter the form, in substance they are most definitely receiving income.
What I described above is completely uncontroversial among tax scholars. Indeed, the fundamental definition of income is known alternatively as the “economic definition of income” or the Haig-Simons definition of income, and it is the universal standard for defining income in tax analysis. Specifically, the Haig-Simons definition says that your income in any given year is equal to the sum of your consumption and the change in your net worth. It is a simple, powerful concept.
Much of tax law’s complexities, in fact, arise from decisions that Congresses have made over the years to carve out exceptions and timing-related advantages for certain types of income. Again, however, choosing not to tax one or another type of income does not mean that it is not income, it just means that the income is untaxed because of a policy choice.
In fact, the key provision of the tax code, Section 61, defines “gross income” as “all income from whatever source derived,” but it gives Congress the ability to exclude one or another type of income from a taxpayer’s gross income. For example, if a person receives free meals on the job, that is certainly consumption and thus income, but Congress has said that under some circumstances, that income can be excluded from gross income when determining tax liabilities. Without that explicit exclusion, however, the fringe benefit would be taxable because it is income.
The billionaires who are worried about this new tax proposal are not like the rest of us, and one of the ways that they are different is that the tax code allows them to become richer and richer without having to pay tax, even as their net worth goes up and up.
Senator Wyden’s proposal says that, for only the wealthiest Americans, this free ride is over. If a person were somehow to be paid $1 billion in cash salary in a given year, she would have to pay tax on it. If that same person becomes $1 billion richer by owning shares that have gone up in value, she currently does not have pay taxes on that income, but she should be required to do so. That is the Wyden plan.
Would that be strange? No, the strange aspect of our tax code is in fact what the Democrats’ plan would fix: the so-called realization requirement allows people who hold assets that go up in value to put off (often forever) their tax liability. In what amounts to an interest-free loan from the rest of us to large property holders, rich people under current law can see their fortunes rise, but so long as they do not sell their shares for cash, they never have to pay tax. As a kicker, if they die without having sold the shares, the income embodied in those shares is never subject to income tax, even in the hands of lucky heirs who might sell the inherited shares right away.
The Search for a Constitutional Bar to Taxing Unrealized Income
Both by definition and as a matter of substance over form, then, unrealized income is income and thus can be taxed under the Constitution. The people who have enjoyed the free ride provided by the realization requirement are, however, unsurprisingly annoyed by the possibility that they might have to pay taxes like the little people do, so they are starting to complain.
Even so, an excellent explainer in Tuesday’s New York Times ends with this:
The problem may be in the Constitution, which gives Congress broad powers to impose taxes, but says “direct taxes”—a term without clear definition—should be apportioned among the states so that each state’s residents pay a share equal to the share of the state’s population.
The 16th Amendment clarified that income taxes do not have to be apportioned, and Mr. Wyden was careful to say his billionaires’ tax was a tax on income, not wealth: “You can’t have wealth without income,” he said.
Wyden is correct. People become wealthy, and wealthy people become wealthier, because increases in their wealth are income—income that heretofore has enjoyed an incredibly generous subsidy from the rest of us, but income all the same.
As an aside, I should also point out that the Wyden proposal would not become a “tax on wealth” simply because sometimes people will have to reduce their net worth (possibly by selling some shares of stock) to pay their taxes. After all, when most of the readers of this column pay any remaining tax that they owe (after accounting for withholding taxes) by sending a check to the IRS on April 15, their wealth goes down. That, however, does not mean that their wealth was taxed. Their income was taxed, and paying those taxes necessarily results in having less wealth than otherwise. If a tax were a wealth tax merely because it reduced people’s net worth, then every tax would be a wealth tax. But that cannot be what the 16th Amendment means.
Is There Any Relevant Supreme Court Precedent?
Notwithstanding the long-accepted, completely uncontroversial logic of everything that I have summarized above, we know that sometimes the Supreme Court comes along and changes the meanings of constitutional provisions by creatively redefining or ignoring terms. For example, the Heller case announced that the “well-regulated militia” language in the Second Amendment was a mere “prefatory clause” that did not bother the 5-justice majority in the least when they rewrote that area of law.
As it happens, the Supreme Court in 1920 did indeed make a huge mistake in an early case challenging an aspect of the then-new federal income tax system. In Eisner v. Macomber, five justices (over dissents written by Justices Brandeis and Holmes) did indeed hold that the Sixteenth Amendment’s definition of income excluded unrealized income. The Court held against all logic that unrealized income is not income at all. It would be like saying that there are Americans over age 50 and Americans under age 50, but somehow only those over age 50 are Americans.
The multistep word game that the Macomber majority used to reach that nonsensical result is actually amusing in its way, and I honestly look forward to teaching it every year in my Income Taxation course. But that is not relevant here, because the bottom line is that the holding in Macomber is no longer good law.
The Supreme Court repudiated the Macomber majority’s holding in a 1940 case, all but mocking the earlier court’s reasoning and limiting that case’s holding by pointing out that the triggering event in Macomber had not even created unrealized income. In other words, the later Court dropped the holding that “only realized income is income” and instead said that the taxpayer in Macomber had received no income of any kind. Since then, Congress has in fact started to tax some types of unrealized income, and those provisions have been upheld in the courts.
To be clear, this is not a contested view of the case law. The very mainstream casebook that I use in my tax course refers to the constitutional analysis in Macomber as “discredited,” which is putting it mildly. We teach Macomber to current students specifically to teach them that the realization requirement is not constitutionally mandated but was in fact adopted as a matter of policy by Congress, codified in what is now Section 1001 of the Code. And what Congress creates by statute, Congress can change by statute.
Could Today’s Supreme Court Mess This Up Again?
As matters stand, then—and as they have stood for over eighty years—there is no constitutional barrier to the Wyden proposal. But if the Court erred so badly in 1920, could it do so again more than a century later?
One need not be a hardcore legal realist to know that the answer to that question is a resounding: “Yeah, sure.” They could get this wrong, on purpose or otherwise. Even without malice, the Court’s members could well become confused and think, “Gee, unrealized income doesn’t feel like income to me…,” causing them to run off in the wrong direction.
And when the Court—especially the Supreme Court as it has operated in this century—wants to make a major change in the law, we have seen that nothing will stop it. Beyond Heller’s from-whole-cloth abandonment of settled doctrine on gun control, the first challenge to the Affordable Care Act (NFIB v. Sebelius) saw five justices embrace a completely untethered and novel “action/inaction distinction” in interpreting the Commerce Clause.
Similarly, the Court’s conservative majority celebrated Justice Kennedy’s last year on the Court in part by allowing him to vote to overturn a decades-old labor law precedent in Janus v. AFSCME. Like Heller, Janus was hugely beneficial to Republicans. (Sebelius was a major loss for conservatives, but not because of the Commerce Clause holding.)
Could the Court strike again? As the Times article quoted above put it: “But the 700 or so billionaires that would be hit with the tax would most likely disagree that unsold assets could be considered income, and they will have the wherewithal to take the matter to the Supreme Court, if necessary.” And it is indeed possible that the Court will give them a generous hearing, either by reviving Macomber or by claiming (completely nonsensically, but they might not care) that the Democrats’ tax plan is a tax on wealth and not income.
That, however, inadvertently shows that constitutional challenges to the Wyden plan would amount to an almost pathetic whimper: “But we don’t want our unrealized gains to be taxed. Can’t we throw some money at this to get the Supreme Court to do something?”
And yes, there are very good reasons to worry that this Supreme Court’s archconservative supermajority could invent a new rule to knock down the Wyden plan. Tax law professor Daniel Hemel even has a smart op-ed in The Washington Post explaining how the Court might go about doing so, and Hemel suggests that the Democrats might thus want—purely as a matter of political strategy—to try a different plan that could be less vulnerable to that kind of chicanery.
That, however, in no way denies that current law is crystal clear that unrealized income is income and thus can be taxed under the power of the Sixteenth Amendment. Democrats should certainly be aware when the Court might make unprincipled decisions that could undermine their proposals. We should not forget, however, that if this law is enacted and then ultimately struck down, it will be because at least five justices on the Supreme Court simply made up the law as they wanted it to be, not as it is or as logic and text demand.