A Note on Direct & Indirect Taxes

Money Tax System Direct Indirect

Direct & Indirect Taxes

In recent installments, we have discussed some of the legal and political issues surrounding the income tax. Upon reviewing these installments, there can be little doubt that the history of taxation in these United States is quite complex. Though the Congress has always had a power to tax, the precise scope of its taxing power has evolved in tandem with various social, economic and military events. The taxing power of the Congress was clarified a great deal by the sixteenth amendment – by way of this amendment, the Congress gained the power to tax income “from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”

Before the sixteenth amendment, the Congress was limited in its ability to lay and collect “direct” taxes. Article 1, Section 2, Clause 3 of the U.S. Constitution states that direct taxes must be apportioned among the states according to their respective numbers; the rationale of this provision was to ensure that no state was disproportionately – and therefore unfairly – burdened by an oppressive tax system.

Every type of tax can be classified as being either a direct or indirect tax. Broadly speaking, a direct tax is one paid by the individual (or business entity) to the government; it is aimed specifically at the person who is paying the tax. By contrast, an indirect tax is one levied upon a transaction, it is not targeted to a specific individual. Sales tax, use tax and value added tax are all examples of indirect taxes. Historically, U.S. tax law regarded tax on labor (or wages) as an indirect tax.

Prior to the opinion made in Pollock v. Farmers’ Loan & Trust Co. (1895), tax on income derived from property (i.e. from real estate, stocks, bonds, etc.) was not considered a direct tax. The Pollock case overturned this consideration and ruled that such a tax was a type of direct tax and that therefore the income tax provision of the Wilson-Gorman act was unconstitutional. In effect, the Pollock decision made it essentially impossible for the government to impose a federal income tax without a constitutional amendment. The sixteenth amendment, which was ratified in 1913, was a direct response to the Pollock ruling: the politicians in the Congress came to understand the full implications of Pollock and so the sixteenth amendment simply did away with the longstanding requirements concerning direct taxes.

When viewed in proper historical context, the sixteenth amendment was a political act of truly monumental significance. Through this act, the dichotomy of direct and indirect taxes – a dichotomy which had shaped our system of taxation throughout our nation’s entire history – was suddenly made to have no meaning at all. Immediately subsequent to this act, the Revenue Act of 1913 was passed, and the progressive income tax system which we have come to know so well was implemented.

Image credit: Alejandro Mallea

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johnAbout john
Seattle CPA+John Huddleston has written extensively on tax related subjects of interest to small business owners. He is a graduate of Washington State University and the University of Washington School of Law.

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Huddleston Tax CPAs & accountants provide tax preparation, tax planning, business coaching, Quickbooks consulting, bookkeeping, payroll and business valuation services for small business. We serve Seattle, Bellevue, Redmond, Tacoma, Everett, Kent, Kirkland, Bothell, Lynnwood, Mill Creek, Shoreline, Kenmore, Lake Forest Park, Mountlake Terrace, Renton, Tukwila, Federal Way, Burien, Seatac, Mercer Island, West Seattle, Auburn, Snohomish and Mukilteo. We have a few meeting locations. Call to meet John Huddleston, J.D., LL.M., CPA, Tawni Berg, CPA, Jennifer Zhou, CPA, Jessica Chisholm, CPA or Chuck McClure, CPA. Member WSCPA.