Wealth tax proposed by Elizabeth Warren could be illegal

The constitutionality hinges on the issue of direct versus indirect taxation

Jan 31, 2019 @ 3:06 pm

By Greg Iacurci

Sen. Elizabeth Warren set the financial advice industry abuzz last week when the presidential hopeful proposed a "wealth tax" on ultra-rich Americans.

Her proposal would levy a 2% annual tax on each dollar of a household's net worth above $50 million; the tax would increase to 3% on each dollar above $1 billion. It's estimated that the tax would affect about 75,000 households and raise around $2.75 trillion over a decade.

But there's a heated debate among economists, lawyers and tax policy analysts as to whether the policy is even legal. The issue can be distilled to this central question: Is a wealth tax a "direct" tax?

"What is a direct tax is rather murky," said Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center. "My view is, reasonable people can answer that question differently."

Think of a direct tax as tax directly levied on a person or entity, while an indirect tax, such as a sales or excise tax, is levied on a transaction. The Constitution doesn't define what types of tax it considers to be direct, which leaves the subject open for interpretation, according to tax scholars.

The issue is important for this reason: The Constitution requires that federal direct taxes be apportioned, or allocated by state according to population. In the case of a wealth tax, that would mean dividing up the United States' total wealth tax bill by the relative populations of the states. So, states with the same populations would owe the same tax, and spread that tax among their residents.

Opponents of a wealth tax like that proposed by Ms. Warren say it's a direct form of taxation, thereby making the tax infeasible and nonsensical. Consider two states with similar populations, one poor and one rich — the states would have similar tax burdens at the state level, but taxpayers in the poorer state would owe more tax on a relative basis than residents of the wealthier state.

"It can't really function that way," said Joseph Bishop-Henchman, an executive vice president at the Tax Foundation.

The estate tax, another type of tax on the wealthy, was upheld by the Supreme Court as an indirect tax on the transfer of wealth, not a direct tax on individuals. Income taxes are exempt from apportionment because of a constitutional amendment.

The crux of the disagreement around the constitutionality of a wealth tax derives from a 19th century Supreme Court case, Pollock v. Farmers' Loan & Trust Co.

Prior to the 1895 ruling in the Pollock case, the three branches of government had consistently held direct taxes only to be capitation taxes (a fixed, per-person tax) and real property taxes, Dawn Johnsen of the Indiana University School of Law and Walter Dellinger of law firm O'Melveny & Myers said in a 2018 paper.

However, the Supreme Court ruled in the Pollock case that an annual tax imposed on carriage owners was unconstitutional, and "greatly expanded the reach" of the apportionment requirement, Ms. Johnsen and Mr. Dellinger wrote.

The 16th Amendment, which legalized income taxes as we know them today, was a response to that ruling, tax scholars said.

Proponents of a wealth tax argue that the Pollock case was wrongly decided and that the 16th Amendment's aim was to overrule Pollock in its entirety, rather than merely providing a carve-out for income taxes, said Mr. Bishop-Henchman of the Tax Foundation.

He believes that the Supreme Court today would likely find Ms. Warren's wealth tax unconstitutional, but said the case "is not a slam dunk."

Tax experts wonder whether Ms. Warren would try skirting the constitutionality issue by assessing the tax not directly on wealth but indirectly on an individual's privilege of living in the U.S. as a wealthy person. That would follow similar logic in a 1911 Supreme Court case, Flint v. Stone Tracy Co., which held that corporate income taxes are excise taxes on the privilege of doing business in the corporate form, rather than direct taxes on the value of shares or income, Mr. Bishop-Henchman said.

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