Module 1: Tax Powers

American democracy functions on the doctrine of separation of powers carved out in the U.S. Constitution. In the federalist system established by the nation’s founding documents, jurisdictional boundaries create clear divisions. Federal, state, and local governments all have the authority to levy taxes, but this power is limited. This module discusses how and when tax powers are limited, particularly in light of recent major changes in national tax policy.

Federal Taxation

Collecting taxes is an important way that governments  acquire revenue to fund public services. However, tax powers can be a double-edged sword. Excessive taxation has raised the public ire many times throughout the history of western civilization, and tax issues were the main motivator behind the Boston Tea Party – an event that helped ignite the American Revolution.[1] The governance issues that caused the American colonies to separate from England are reflected in the limited authority that the Constitution allows the federal government, particularly with respect to taxing powers.   

The Constitution listed specific tax powers for the federal government in the “taxing and spending” clause of Article I, Section 8. This clause empowers Congress to “lay and collect taxes, duties, imposts and excises, to pay the debts and provide the common defense and general welfare of the United States.”[2] This, according to the expressed terms of the Constitution, the federal government may tax its citizens only to raise money for common defense, general welfare of U.S. citizens and to pay down public debt. The Constitution does not allow the federal government to levy taxes for any other purpose.

Constitutional law divides federal tax authority into two categories: the power to levy direct taxes, and the power to levy indirect taxes. Indirect taxes are taxes on articles consumed or used by taxpayers, such as sales or consumption taxes. The Constitution allows the federal government to pass indirect taxes as long as the tax is levied in the same manner across all fifty states.[3] The federal government is endowed with broad authority to pass indirect taxes, allowing the numerous federal taxes and fees imposed on regulated goods and services. The only notable constitutional limitation on the federal government’s authority to impose indirect taxes is the Export Clause, which prohibits Congress from taxing goods set for export to trade partners.[4]

On the other hand, the federal authority to levy direct taxes is narrow. Direct taxes are taxes imposed directly on individuals, such as an income tax. Federal income tax traces its roots back to the Civil War era, but for much of US history, the notion was highly controversial.[5] The original language of the U.S. Constitution barred the federal government from levying direct taxes unless the tax was apportioned.[6] In other words, direct taxes could only be levied if they were weighted according to each state’s population.

When the federal government attempted to pass a uniform income tax, legal challenges inevitably led to the repeal of the law.[7] Federal income tax was considered unconstitutional until 1913 when Congress passed the 16^th Amendment, which gave the federal legislature the power to collect income taxes without regard to apportionment.[8] Today, direct taxes such as individual and corporate income tax make up the primary sources of federal tax revenue.[9] Given that federal income tax was once prohibited outright, this represents a major shift in federal tax powers.

In the modern era, the federal government has taken advantage of its increasing tax powers over the years to pass a suite of direct and indirect taxes, including federal estate and gift taxes, taxes on capital gains from investments, payroll taxes and many other fees and taxes imposed on activities. Federal tax law is contained in the Internal Revenue Code, which is enforced and administered by the Department of the Treasury.

The Internal Revenue Code, or “Tax Code,” contains the statutory language that makes up federal tax law. It takes up all of Title 26 of the United States Code, and it includes tens of thousands of pages of substantive and procedural rules. Each subtitle in the Internal Revenue Code addresses different federal taxes, beginning with federal income tax and then continuing with estate and gift taxes and miscellaneous excise taxes as well as alcohol, tobacco, and certain other excise taxes.[10]

The Internal Revenue Service is a federal agency in the Department of the Treasury responsible for enforcing federal tax law. The Secretary of the Treasury oversees the IRS and the agency is responsible for most of the day-to-day activities necessary for the national tax system to function. This includes offering taxpayer assistance as appropriate and enforcing tax laws.[11]

The IRS is constantly adapting to changes in federal tax policy. The IRS Restructuring and Reform Act of 1998 created the most comprehensive reorganization and modernization effort of the IRS in decades.[12] However, ongoing changes in federal law pose unique challenges to the IRS, as tax law is constantly evolving to address new issues. Thanks to the structure of America’s system of cooperative federalism, however, many of the more nuanced issues of taxation are left up to state and local governments.

State Taxation

Like many other key terms in the Constitution, the “taxing and spending” clause has evolved over time. Over the past two hundred years, the Supreme Court has increased Congress’s power to tax and spend as litigants have raised challenges to federal tax laws. State tax powers, on the other hand, are more expansive. This is true because upon signing the Constitution, the states retained the majority of their sovereign lawmaking powers, including the right to impose nearly any type of tax.[13] Still, state tax powers are limited in one key manner: state and local taxes may not impose unreasonable burdens on interstate commerce[14] or international trade.[15]

States need expansive tax powers because they are responsible for the administration of many aspects of public governance. As a matter of constitutional jurisdiction, states are responsible for the protection of residents’ lives and property. This includes the obligation to maintain important public safety services, such as police, fire, and emergency responders. States must also maintain in-state transportation, utility services, and other infrastructure while also providing for the general welfare. States also must provide basic social services to their residents, such as public education and assistance for the disabled or elderly.[16] States use the revenue they collect from taxes, fees, and licenses to maintain their governments and fund the public services that they provide.[17]

Wisconsin was the first jurisdiction to introduce a successful personal income tax in 1911 and, subsequently, most states have followed suit.[18] Only nine U.S. states have no personal income taxes and, even among these, most assess a corporate income tax.[19]  Likewise, most states charge sales tax, which is levied on sales of retail goods. All but five states – Alaska, Delaware, Montana, New Hampshire, and Oregon – impose some sales tax on retail sales.[20]

There are three main types of sales taxes: vendor taxes, consumer taxes and combination vendor-consumer taxes. Vendor taxes are levied on the person doing the business, while consumer taxes are charged on the retail side. Some states also apply a use tax, which is imposed on the storage, use or purchase of personal property. It is typically applied to major purchases made outside the state, such as vehicles and equipment, or rental transactions.[21]

Sales taxes on goods produced, bought, and sold entirely within a state are one example of taxation authority that is reserved to the states. Sales taxes are indirect taxes, which the federal government may not impose without apportionment. Similarly, only state and local governments may tax real property – another form of indirect tax. A tax on real property was first introduced by the Massachusetts Bay Colony in 1646, well before the United States was even conceptualized.[22] Today, property taxes are an important source of state and local revenue.

Balance Between Federal and State Taxes

Sometimes, states and localities impose taxes that are in addition to taxes charged by the federal government. For example, many states charge an inheritance tax or an estate tax on the transfer of property after death. The decedent’s beneficiaries are responsible for paying these taxes in addition to whatever potential liability the estate incurs under federal transfer tax rules.[23]

Double taxation issues like this may be costly and frustrating, but they are generally permissible. However, all taxes are subject to the same constitutional limitations, which includes prohibition on undue burdens on interstate commerce. For example, in the 2015 case Comptroller of Maryland v. Wynne, the Supreme Court struck down a Maryland state tax because it had the effect of double-taxing income earned outside the state. In Wynne, the tax law at issue imposed a “special nonresident tax” on out-of-state residents who earned income within Maryland. According to the majority opinion, requiring nonresidents to pay a special tax in addition to their regular state income taxes was an unconstitutional overreach of state tax power. [24]

The balance of tax powers between states and the federal government has shifted substantially over time. This is particularly true in light the Tax Cuts and Jobs Act of 2017 and the Affordable Care Act.

The Supreme Court has gone back and forth regarding the degree to which Congress has the authority to tax to accomplish regulatory goals. This is particularly true when the federal government uses its tax powers to further policy agendas that would otherwise be outside the scope of its enumerated powers.  Early in American history, federal tax powers were tightly restricted. However, modern reform has changed this substantially.

Consider the 1922 case, Bailey v. Drexel Furniture, in which the Supreme Court struck down a ten percent federal tax on the profits collected by employers who knowingly used child labor. In today’ world, preventing the federal government from enacting anti-child-labor policies may be rather shocking. However, the Supreme Court’s interpretation of the scope of federal and state tax powers reflected the careful balance the Constitution attempts to strike between state and federal authority in general. At that time, laws regarding child protection fell squarely within state jurisdiction, and so the federal attempt to use tax policy to accomplish goals that ought to be left to the states was struck down.[25]

Effect of the Affordable Care Act

In the past, the Supreme Court has been reticent to allow the federal government to use its tax authority in a manner that interferes with the states’ traditional roles. States have the right to set policy regarding local health, safety and welfare. However, modern tax policy has shifted towards a greater scope of federal tax authority. This shift is most clearly exhibited by the Supreme Court’s rulings regarding the Patient Protection and Affordable Care Act of 2010.[26]

Among other things, the Affordable Care Act imposed a tax penalty on people who did not have health insurance coverage. This policy was meant to encourage more healthy people to buy into health insurance programs to help drive down premium costs.[27] Thus, the Affordable Care Act raised an issue of tax authority that the Supreme Court has had to grapple with in the past: whether the federal government could use its power under the Taxing and Spending Clause to make healthcare policy.

Traditionally, healthcare policy has been a power constitutionally reserved to the states. The Supreme Court established a clear precedent to this effect in the 1925 case of Linder v. United States, in which the Court reversed a doctor’s conviction for prescribing cocaine to a medical patient suffering from addiction. The law represented an early attempt at the national prohibition of controlled substances, but it was passed pursuant to Congress’s tax power. The Court decided that the constitutional authority under the taxing and spending clause did not extend to healthcare policy decisions, such as which drugs doctors may prescribe to their patients.[28]

The precedent set forth in Linder limited Congress’s ability to set healthcare policy using its tax power. However, the Affordable Care Act – which does exactly that – withstood constitutional review. In National Federation of Independent Businesses v. Sebelius, the Supreme Court decided that the law was a valid exercise of federal authority under the taxing and spending clause. The Court, in a 5-4 decision, ruled that the federal government did have the authority, pursuant to its taxation powers, to penalize people for failing to maintain health insurance coverage. The Court ruled that even though setting healthcare policy is outside of the bounds of Congress’s lawmaking power under other Article I clauses, the "individual mandate" functioned as a tax and therefore was allowed pursuant to the federal taxing power.[29]

Sebelius represented a major expansion in federal tax authority over traditionally-held state rights, but the Court did not open the floodgates completely. In the majority opinion, Justice Roberts clarified that the law did not make being uninsured illegal, but rather, the failure to purchase insurance required a payment to the IRS. Thus, the Affordable Care Act gave people the option of paying a tax rather than purchasing insurance.

The Tax Cuts and Jobs Act of 2017

The Tax Cuts and Jobs Act of 2017 made major reforms to the Internal Revenue Code.[30] One of the law’s main goals was the overall simplification of federal tax filing requirements. To further this goal, the law included a substantial increase in the standard deduction and limited some commonly itemized deductions. This approach was meant to encourage taxpayers to take the standard deduction rather than to itemize, simplifying most tax returns filed.[31] However, many of the policies included in the Act meant to make life easier for taxpayers have had major impacts on state and local tax agencies.

One of the common federal tax benefits limited by the Tax Cuts and Jobs Act is the deduction allowed for state and local taxes. Under the Act, taxpayers can only deduct the payments of state and local taxes up to $10,000 per year. This substantially impacts those who live in high-tax jurisdictions.

While many of the reforms created by the Act are scheduled to expire in 2025, the law has a major impact on state tax policy. States commonly craft their state income tax policies to complement the federal rules,[32] but whether a state’s treasury can handle tax cuts as expansive as those included in the Tax Cuts and Jobs Act is a question that depends on local finances.

Conclusion

The federal government’s authority to set policy through tax incentives and penalties has expanded over time, but constitutional law polices the exercise of both federal and state tax authority. The balance of federal and state tax powers is constantly shifting as the Supreme Court grapples with new challenges to the limitations on state and federal tax power, but state and local tax authority remains expansive. The next module provides a more in-depth analysis of state tax powers, particularly with respect to licenses, fees and direct taxes on goods and services.