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Tax Reduction Planning Primer

Taxes don’t make sense! Why are some things taxed and others not?

You may not know this, but the original US Constitution specifically prevented Congress from levying an income tax. Article 1, Section 8, subsection 1 states that “Congress shall have the Power to lay and collect Taxes, Duties, Imposts, and Excises ….” However, that authority is limited by Article 1, Section 9, subsection 4: “No Capitation, or other direct, Tax shall be laid, unless in Proportion to the Census or Enumeration herein before directed to be taken.”, and subsection 5: “No Tax or Duty shall be laid on Articles exported from any State.”

During the Civil War, an income tax was passed by Congress to pay for the war, but after the war ended the income tax was challenged and the Supreme Court correctly ruled it unconstitutional. 

Early in the 20th century, politicians saw the signs of political unrest in Europe and Asia and tried to prepare for a war they thought was certain to come.  They knew financing the war via an income tax would require a Constitutional Amendment. So, on July 12, 1909, the sixty-first Congress set forth the 16th Amendment to be ratified by the state legislatures. On February 25, 1913, the Secretary of State proclaimed that 36 of the 48 states had ratified the 16th Amendment. Congress could now legally pass an income tax.

The 16th Amendment is one of the shortest constitutional amendments being only one sentence in length. “The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” The first income tax form used in 1913 was three pages in length plus one page of instructions. 

Over time, that monster has morphed into hundreds of pages. The US Tax Code of 1954 has been revised by every Congress and is currently about 64,000 pages. If we consider the related Revenue Rulings, Revenue Procedures, Publications, Instructions, and tax court cases, that guide the interpretation of the tax code, the number of pages that impact a citizen’s understanding of the tax code becomes many millions of pages.

Per the Constitution, all tax bills must originate in the House of Representatives. Every Congress since 1954 has put its mark on the tax code, by adding new sections, deleting old sections, clarifying definitions, etc. If it were a building it would be condemned immediately for safety reasons and lack of integrity. If compared to the human body, Frankenstein would be frightened by it.

In my first tax class in college, I learned that there are a few principles that lawmakers try to follow.

Adam Smith, the author of the landmark Wealth of Nations, developed his four famous canons of taxation:

(1) Equity:

The amount payable by taxpayers should be equal, by which he meant proportional to income; Fair.

(2) Ability:

The taxpayer should know for certain how much he will have to pay.

(3) Convenience:

There should be the convenience of payment.

(4) Economy:

Taxes should not be imposed if their cost of collection is excessive. (I call this Efficient. The cost to collect the tax should be small in relation to the tax deposited to the treasury. Some states have toll roads. If the cost to pay the salaries of the toll attendants is equal to the tolls charged to the motorists, then there is no money left for road improvement. The cost of the beauraucrasy means that little of the tax is used for public benefit.)

There are a couple others that I think are important.

(5) Neutrality:

Ideally, a tax system should disturbing market forces without a good reason.

(6) Wherewithal-to-Pay:

A taxable transaction should leave the taxpayer the funds with which to pay the respective tax.

Most of the other principles deal with social engineering and redistribution of wealth, of which I am an opponent. The Invisible Hand described by Adam Smith has been around longer than the economic scholars of any generation.

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