Constitutional Law

Is the proposed wealth tax constitutional? Answer depends on 'direct tax' definition

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A tax on unrealized investment gains of very wealthy people could lead to constitutional challenges that end up before a skeptical U.S. Supreme Court.

At issue is whether a federal tax on unrealized gains is a “direct tax” that must be apportioned based on state population under the U.S. Constitution or whether it is a tax on income that it exempted from the apportionment requirement under the 16th Amendment.

The Washington Post and the Wall Street Journal consider the issue.

The tax proposal unveiled Wednesday would apply to about 700 people, according to Senate Finance Committee Chairman Ron Wyden, an Oregon Democrat, report Roll Call, the Hill and NBC News.

The proposal would tax paper gains on stocks and other tradable assets that are held by people who have more than $1 billion in assets or who earn at least $100 million in three consecutive years. Current law taxes the gains only when the assets are sold.

The gain or loss on stocks, dividends and other tradable assets would be based on the change in market value in the previous year, an approach known as a “mark to market.” In most cases, the gain would be taxed as a long-term capital gain.

When the wealthy people sell real estate, closely held businesses or other assets that aren’t traded on an exchange, they would have to pay an extra charge in addition to capital gains taxes.

Tax law experts disagree on the constitutionality of a wealth tax, according to NBC News.

Daniel Hemel, a professor at the University of Chicago Law School, described the constitutional argument in an op-ed for the Washington Post.

The direct tax clause in Section 2 of Article 1 of the Constitution provides that “direct taxes shall be apportioned among the several States … according to their respective numbers.”

“In other words,” Hemel explained, “if a tax is a ‘direct tax,’ and 1.5% of the U.S. population lives in Alabama, then 1.5% of the revenue from the tax needs to come from Alabama. If the billionaire tax is deemed to be a direct tax, then the apportionment requirement would be impossible to satisfy: According to Forbes, Alabama has no known billionaires, and neither does Alaska, Delaware, New Hampshire, North Dakota, Vermont or West Virginia.”

So what is a direct tax? The answer is unclear, according to Hemel and the Wall Street Journal. Some early Supreme Court decisions suggest that a federal tax on land or a $500-per-person head tax would both be considered direct taxes that must be apportioned among the states.

An 1895 Supreme Court decision, Pollock v. Farmers’ Loan & Trust Co., gave an even more expansive meaning to direct taxes. In response to the decision, Congress passed the 16th Amendment, which allows a federal income tax without the need for apportionment among the states. But the amendment didn’t repeal the direct tax clauses; rather, it created an exception that cleared the way for federal income taxes.

Billionaires challenging the new tax will likely make two arguments, Hemel said. First, they will argue that the tax on unrealized gains isn’t a tax on income that qualifies for an apportionment exception under the 16th Amendment. The second argument against constitutionality is that the tax depends on taxpayer wealth that must be apportioned among the states based on population. That isn’t possible, given the geographic distribution of billionaires.

“Defenders of the billionaire tax will probably argue that the justices should jettison Pollock. I agree,” Hemel wrote. “But even if they did, that wouldn’t solve the problem entirely, because the billionaire tax still would depend in part on the value of a taxpayer’s land. And the Supreme Court has consistently said, even before Pollock, that a tax on land is a direct tax that needs to be apportioned.”

Prospects for the tax proposal dimmed soon after its unveiling Wednesday, when Democratic U.S. Sen. Joe Manchin of West Virginia commented, the New York Times reports.

Manchin said he didn’t like the idea that the tax targeted people who “contributed to society” and “create a lot of jobs and invest a lot of money and give a lot to philanthropic pursuits.”

Hat tip to How Appealing.

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