Thursday, March 20, 2014

A Bit of Sixteenth Amendment Originalism

-- Posted by Neil H. Buchanan

One of the pleasures of teaching the same course many times is that one occasionally sees issues from an unexpected perspective.  Often, this happens in response to an out-of-left-field question from a student, or sometimes it is just a matter of seeing something as if for the first time.  No matter the reason, I had such an experience this week in my Federal Income Taxation class.

On Tuesday, we discussed Eisner v. Macomber, the famous 1920 case in which the U.S. Supreme Court decided, 5-4, that it violates the Sixteenth Amendment for Congress to tax income that has not been "severed" from its original source, for a taxpayer's "separate use, benefit and disposal."  It is an utterly confused opinion, which has been roundly repudiated by scholars and courts, with the Supreme Court itself distinguishing Macomber effectively out of existence in 1940's Helvering v. Bruun decision.  Even so, most tax professors still teach Macomber because of its historical significance, and because it is a way to introduce the fundamental concept of "realization," which is when taxpayers turn appreciated (or depreciated) property into cash.  (There are some other ways to realize gains or losses, but cash sales are the paradigm case.)

Eric Segall's guest Dorf on Law post earlier this week discussed a recent conference in which various leading legal lights argued the relative merits of originalism and the theory of "living constitutionalism."  As I went over the Macomber case in class later that day, I took special notice of the dissent that Justice Holmes filed in the case.  (The other dissent was written by Justice Brandeis.  As I tell my students each semester, it is obviously not a sure thing that Holmes and Brandeis are right, but it should not be surprising if the 5-justice majority that opposes them turns out to be confused.)  In order to understand Holmes's dissent, a bit of technical background is necessary.

The government had assessed a tax liability on a part of the "gain" received by Ms. Macomber when Standard Oil of California issued a "stock dividend."  Although not technically identical, a stock dividend can usefully be thought of as a "stock split."  In this instance, every shareholder in the company exchanged 2 old shares for 3 new shares of the company.  Measured at a benchmark price called "par value," which in this case was $100 per share, it therefore appeared that Ms. Macomber and every other shareholder were 50% richer than before.  Ms. Macomber's 1100 additional shares (after turning 2200 shares into 3300 shares) thus seemed to make her $110,000 richer.

Of course, as a matter of economic reality, no shareholder was richer than before.  This is logically equivalent to cutting a pie into 6 slices, where two people own 3 slices each rather than the 2 each that they would have owned had the pie been cut into 4 slices.  The pie's size does not change, so if you own half of the shares, you own half of the pizza.

This makes the government's position in the case appear to be quite stupid.  Why would the IRS assess tax on an illusory $110,000 gain (reduced to just under $20,000 for reasons not germane here), when everyone knew that Ms. Macomber's net worth (like those of other SoCal shareholders) had been unaffected by the issuance of the stock dividend?

The answer is simple.  The IRS was -- as so often happens -- blamed for faithfully applying a nonsensical law that Congress had written.  Specifically, as the majority opinion in Macomber notes, the Revenue Act of 1916 (the updated version of the original income tax act passed in 1913, after the adoption of the Sixteenth Amendment) stated that "stock dividend[s] shall be considered income."  That is, Congress did not merely write the tax law in a sloppy way that happened to sweep some non-income into the definition of income.  It wrote the law unambiguously to say that income includes the illusory gains from the issuance of a stock dividend.

Enter Holmes.  In his brief dissent, he essentially takes an originalist view: "I think that the word 'incomes' in the Sixteenth Amendment should be read in 'a sense most obvious to the common understanding at the time of its adoption.' ...  I cannot doubt that most people not lawyers would suppose when they voted for it that they put a question like the present one to rest.  I am of the opinion that the Amendment justifies the tax."

Note that this decision was issued in 1920, only seven years after the adoption of the Sixteenth Amendment.  I have not checked whether the relevant language in the 1916 Revenue Act existed in the 1913 Act; but even if it did not, the people in Congress who defined stock dividends as income were overwhelmingly the same people -- not just the same constitutional body, but the same human beings -- who passed the amendment allowing an unapportioned tax on incomes.  Holmes's point, that most people would have thought that stock dividends were income (even though they would be incorrect, as a matter of economic reality) thus applies not merely to the "not lawyers" who voted for the amendment, but to the Congress as a whole that then turned the amendment into legislation.

So, Holmes's simple point is that, as a U.S. Senator put it more recently in a different context, "The people have the right to be wrong."  There are various ways in which to define income, and if we want to know which definition was in the minds of the framers of the Sixteenth Amendment, the language of their revenue acts is pretty darned good evidence of what they thought about stock dividends.

In this view, Congress was thus not required to include stock dividends in gross income in the tax code, but it was not prohibited from doing so by the Sixteenth Amendment.  This, presumably, is the same point that people like Justices Scalia and Thomas make when they say that, for example, we cannot replace the framers' understanding of "cruel and unusual punishment" with a more modern understanding.

Can Congress be counted on to fix the statute, to reflect what we now view as economic reality?  Although the law has been changed such that stock dividends are no longer taxed, there is plenty of evidence that economic reality means nothing to most members of Congress.  (Compare, e.g., the bipartisan ignorance regarding budget deficits and federal debt.)  Holmes's point would be that there is simply nothing, other than the political process, stopping a Congress from taxing what we might think is not really income.

How would the "living" version of this story be different?  The question would presumably be whether it is acceptable for a court to define "income" for Sixteenth Amendment purposes to exclude what is really not income.  Given that an income tax is, by definition, supposed to determine citizens' respective tax responsibilities by measuring their incomes, and especially given that Congress has from the beginning set up the tax system to be progressive (exempting entirely all but the most wealthy people from the federal income tax, in the early years), one could make an ability-to-pay argument for what the word income means, in a living sense.

That is, it is possible -- and probably desirable -- for courts to have the ability to say that the amendment's framers' purpose was to tax income in a substantial sense, not in a formal sense.  If our understanding of what is and is not income changes over time, then the Sixteenth Amendment's coverage would change.  Similarly, in NFIB v. Sebelius (the ACA case from 2012), the Chief Justice's controlling opinion held that it does not matter what Congress calls something (or, presumably, what Congress thinks it is doing), because if it looks and acts like a tax, then it is a tax for Constitutional purposes.

To be sure, one can get to that same living constitution result using "new" or "semantic" originalism.  In this view, widely held by academics who call themselves originalists, the framers of the Sixteenth Amendment enacted a text -- "income" -- that invokes a particular concept, and it is the concept itself, not their subjective beliefs about the concrete applications of the text, that is fixed as the constitutional meaning.  So I am describing a contrast between living constitutionalism and the "old" intentions-and-expectations originalism that still plays a prominent role in the practice of self-described originalist judges and in the rhetoric of conservative politicians.

What is interesting is that the living constitutionalists' view as I have described it here would limit Congress's powers, whereas a Holmesian originalist view would give Congress more power to tax non-income under the powers granted by an amendment that was supposed to be limited to taxing income.  I am sure that there are plenty of other examples of such a role reversal, but given the centrality of the income tax to the development of the modern federal government, I find this irony to be particularly provocative.


Michael C. Dorf said...

Two thoughts on a side point:

1) Consider the Holmesian move of saying that the people who wrote the relevant statutory text are authorities on the constitutional text because they also wrote that text. The SCOTUS sometimes says this sort of thing, although there are prominent examples of the Court not following this supposed rule--the most prominent being Marbury v. Madison, which invalidated a provision of the Judiciary Act of 1789 on the ground that it was inconsistent with the nearly contemporaneously produced Art. III of the Constitution.

2) The argument for any sort of originalism is probably strongest when the relevant case arises shortly after the enactment of the relevant constitutional text. Richard Primus's When Should Original Meanings Matter discusses this point, which as he notes, is conceded by non-originalists including me. See

Anonymous said...

Neil is confusing the concepts of error and truthfulness. I do not see Eisner v. Macomber and NFIB v. Sebelius as “similar” on this issue. For Holmes the purpose of judicial restraint was to give Congress a greater degree of freedom in the statistical sense, what we would call a “margin of error”. He viewed this as a pro-democratic stance because he believed that the alternative was violence. So for Holmes whether slicing the economic pie into two or four or eight slices was error or not was irrelevant (he probably thought it was error) but it made no difference because Congress had the freedom to error. Holmes would have abhorred the idea that “Congress has a right to be wrong” because he would have felt that this confused a moral claim (wrongness) with a statistical claim (error).

Roberts is after something altogether different in NFIB. There the claim isn't whether or not Congress is in error (Roberts probably thought it was) but whether Congress was being truthful when it tried to claim that something wasn't a tax when it obviously was. All that Roberts held was that labels must give way to facts.

The current briefs in the SCOTUS case of Clark v. Rameker highlight these divergent concerns. Rameker's core argument is essentially that Congress is being untruthful. That if an IRA doesn't function like an IRA and doesn't serve the purpose on an IRA then Congress shouldn't be able to call it an IRA. Clark, contrariwise, traces the history of the law and shows how the definition of an IRA has expanded through the years and argues that maybe it doesn't make any sense to call it an IRA but Congress is free to error.

David Ricardo said...

As in many situations, one can turn to Abraham Lincoln for sufficient light on a subject to render it comprehensive to even the most tax ignorant member of Congress.

In a situation not relevant here Lincoln raised the following question.

How many legs does a dog (or maybe it was a calf) have?

His audience answered “four” of course.

Then Lincoln supposedly said, “if you call the tail a leg, how many does it have”.

When the answer came back “five” Lincoln said no, the correct answer was still four. Just calling the tail a leg does not make it a leg.

Just calling a stock dividend income does not make it income.

Anonymous said...

David makes the mistake of reification. The example he borrows from Lincoln works insofar as one is dealing with a material object. Calling the sun a moon does not make it a moon. The difficulty occurs when one considering a purely intellectual construct or a legal fiction. The IRA example is instructive. An IRA has no material reality; it is purely a legal construct. An IRA is simply whatever a lawful authority defines an IRA to be because it has no material reference point. A dollar bill has a material reality, a coin has a material reality, an IRA has no material reality and if Congress wanted to abolish IRAs tomorrow it could and IRAs would become extinct because they exist no where else than within the law.

Income falls into the same category as an IRA. It is true that income as an intellectual construct exists outside the law, notably within the field of economics. But even within the field of economics income has no fixed definition and different definitions of income are used for different purposes. In any event, even if economics did have a fixed definition of income that definition of income would not be determinative for Congress and indeed the law also defines income differently depending on the context.

If people are confused about what a cow's tail actually is an individual can simply grab the tail of a cow, point to it, and say “this is the tail” and then point to a hoof and say “this is a hoof” and only an observer who suffers from some type of physical or mental disability would not be able to tell the difference. With an intellectual construct there is nothing to point to except other intellectual constructs. This is why we do not look at concepts for an ultimate judgment but to people...legislators or judges.

David Ricardo said...

Jimmyd is correct in that there is no fixed definition of “income” and that there may be many definitions. I believe the most widely accepted broadest definition of income (leaving aside the issues of recognition and realization) is something along the lines of “income is created by an event when immediately after that event the net worth of an income is higher than it was immediately before that event.”

But others may have a different definition. In that case I would challenge everyone to present a definition of income that is reasonable and acceptable that would encompass a stock dividend as income, a definition other than “something is income because I say it is income”. I do not believe it is possible but I would be happy to be proven wrong.

And no, Congress, individuals and judges must play by the same rules as everyone else. They cannot declare something that is not income to be income any more than they can declare that the Grand Canyon was created about 4,000 years ago by Noah’s Flood. They can believe it but a belief, no matter how sincerely held does not make something true. One can apply strict definitions to intangible items and not be guilty of a false reification (and yes I had to look it up).

I repeat, a stock dividend is not income and cannot be made to be income by designation of Congress or the courts. Heck, it is not even a dog’s leg although it could be argued that it is closer to being a dog’s leg than it is to being income.

Joe said...

The last comment as was the previous one citing Lincoln is conclusionary. Four justices dissented and thought it 'possible,' Brandeis providing his patented verbose analysis.

It might be useful to explain why they are wrong. How this in not akin to saying that upcoming Noah's Ark movie is historical drama. It is not merely "I say so" but based on some plausibility.

I would note that though it is supposedly a very "broad" definition, looking up the word "income," the word "immediate" is not included.

I checked both and Merriam Webster, which seems to be fair under Holmes' general understanding to the average person rule. Both reference a certain sort of "gain" but do not reference the "immediate" test. What "gain" means to my admittedly non-economist mind is debatable.

There also is not a "net" income component in the "broadest" understanding of the absolute minimum definition of what "income" means, again, at least, if we are going by common dictionary definitions, which seems to be common over economic experts (see, e.g., the PPACA opinion, which I admit I look upon with some distaste).

The term "income" should have some meaning, yes, but it is unclear how the dissent in this case fails that low bar.

David Ricardo said...

If it will bring the definition of “income” into consistency with a dictionary definition one can leave out the term “immediately” and substitute “other things being equal” (our favorite term) which is always implied when talking about changes in variables, so that the definition of income is “other things being equal, income is created from an event when after that event the net worth of the individual is greater than the net worth prior to the event”.

The term ‘gain’ I would argue is well defined in finance and economics (my field) as simply the difference between benefits and costs, or consistent with the above definition the difference between the net worth prior to the event and, other things being equal, the net worth after the event. I fail to see how this is the least bit controversial, but if someone has an argument against this I am sure we would all be happy to consider it.

As for the term ‘net’ in ‘net income’ again there is neither inconsistency nor controversy. Since net refers to the difference between costs and benefits, a person’s (net) worth can only increase if the benefit is greater than the cost, so whether or not one uses the term ‘income’ alone or ‘net income’ is really irrelevant.

Congress specifically and governments in general have a great deal of power, but not the power to declare something income when it is not, nor even the power to declare a dog’s tail as being one of its legs. And a king cannot command the tides to keep him from getting wet.*

All of this may sound silly, but it is a serious issue. In North Carolina, my home state, the state legislature ruled by conservatives has tried to declare that by statute sea level cannot rise above a certain level in the future. Presumably they will also legislate that a dog’s talk is a leg, that fits their mentality.

*Canute began by being a Bad King on the advice of his Courtiers who informed him (owing to a misunderstanding of the Rule Britannia) that the King of England was entitled to sit on the sea without getting wet. But finding that they were wrong he gave up this policy and decided to take his own advice in future - thus originating the memorable proverb, "Paddle your own Canute"

Joe said...

First, my last comment had too many typos. Sorry.

"Congress specifically and governments in general have a great deal of power, but not the power to declare something income when it is not, nor even the power to declare a dog’s tail as being one of its legs."

I apologize, but this is getting a bit tiresome. Who here is saying that words here should not have ANY content?

The only thing I found a bit "silly" is that your definition of "income" was put out to be quite "broad" but a common understanding (which is Holmes approach in that case, which is valid, though as usual, he didn't "show his work" on the point) of the term seems to my admittedly economically uneducated eye to not include various limiting principles you put in. So, your comment came off as boilerplate and assumption.

With respect, I still don't know why Brandeis' dissent is wrong.

David Ricardo said...

With respect to the issue of the definition of income so far no one has presented what they would consider the proper definition of income. So I would repeat my challenge, if anyone can present a definition of income that would be acceptable to the economic/finance/tax/accounting community and would allow inclusion a stock dividend as income I would be more than willing to change my position.

As for why Justice Holmes is wrong, it is because he would designate to the Congress the power to define a term in any way they want as long as it was based on common understanding of that term (whatever that meant and however it could be identified). I will not bore readers with the tens of thousands of examples of historically how common understanding is not only wrong but dangerous. Suffice it to say that it was common understanding centuries ago that the sun revolved around the earth, that this belief was enshrined in law and that to suggest otherwise could result in burning at the stake.

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Joe said...

I am not an economist and do not know what is acceptable to the class of people cited. So, someone else will better be able to define "income."

Still, I thought DR might cite why Brandeis was wrong, particularly since unlike Holmes, he went in deep detail (with citations to economic sources).

It is noted that the "common understanding" approach can be "dangerous" etc. What is the alternative there? Some "natural law" definition of terms?

I find it a bit silly to compare usage of the provision here to 'burning at the stake.' This level of emotional chest thumping is not overly helpful to me.

To be clear, some strict original meaning approach is not how I'd interpret things. Holmes was writing at the time of enactment though, so common understanding overlapped with current common understanding. And, I think some minimal level of rationality should be in place. Plus other constitutional limits.

Other than "don't take Holmes so literally that burning at the stake is okay," I would still hold that overall his view here made sense. "Income" should be given a broad interpretation, left to political checks unless it violates some other constitutional provision.

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