On April 8, 1895, the U.S. Supreme Court struck down the Federal Income Tax of 1894, which was designed “to restrain the exercise of the power of direct taxation to extraordinary emergencies, and to prevent an attack upon accumulated property by mere force of numbers.”
At issue, in Pollock v. Farmers Loan Trust Co., was whether the federal income tax was a direct tax or an indirect tax. And the general reduction of tariffs included in the bill in question, was enacted without President Grover Cleveland’s signature.
In a 5-4 vote, the Court ruled that the income tax was a direct tax, making the law void.
The Federal Income Tax of 1894 was America’s first peacetime national income tax. The 2 percent tax was levied on all income over $4,000 (roughly $90,000 today). It was immediately challenged as unconstitutional, on the grounds that the Constitution requires direct taxes to be levied in proportion to each state’s population. (Up to that point, the federal government had levied indirect taxes (on carriages, whiskey, and other products)).
Chief Justice Melville Fuller, speaking for the majority, said:
Ordinarily, all taxes paid primarily by persons who can shift the burden upon someone else, or who are under no legal compulsion to pay them, are considered indirect taxes; but a tax upon property holders in respect of their estates, whether real or personal, or of the income yielded by such estates, and the payment of which cannot be avoided, are direct taxes.
Based on the writings of the Framers, Adam Smith’s writings on tax, the states’ ratification debates, and arguments made by former justices, Fuller argued, “all taxes on real estate or personal property or the rents or income thereof were regarded as direct taxes.”
Because direct taxes must be apportioned by state population under the Constitution, the 1894 law was void.
Justices Edward White and John Harlan, dissenting, repeatedly disparaged “the views of economists” urged the Court to Congress on its own powers of taxation.
The case was reheard– and on May 20, 1895, the Court reissued opinions that expanded taxation parameters beyond solely rental property income to income from bonds and stocks, which effectively killed the entire law.
In addition to Justices Harlan, Jackson, and White, Justice Henry Brown rejected the idea that “the definitions of a direct tax given by the courts and writers upon political economy” were binding, and argued that the Court’s ruling “involves nothing less than a surrender of the taxing power to the moneyed class.”
The Court’s rulings caused an uproar, especially since the 1894 law had been a hard-fought compromise to reduce tariffs and impose an income tax. The Court’s decision voided half of this political compromise. Progressive taxation proponents of course were happy because they had been arguing that federal taxation should be levied on “accumulated wealth” not consumption.
This ruling helped expand even more taxation efforts: the creation of the federal inheritance tax (1898), the corporate income tax (1909), and ultimately, the Sixteenth Amendment (1913), which defined the income tax is a direct tax and removed the constitutional requirement for population apportionment.