Reuven S. Avi-Yonah is the Irwin I. Cohn Professor of Law at the University of Michigan Law School. He thanks Jake Brooks, David Gamage, Moshe Jaffe, and Nicola Sartori for helpful comments.
In this installment of Reflections With Reuven Avi-Yonah, Avi-Yonah examines whether the United States should subject federal income tax law to judicial review of its constitutionality and whether Congress should amend — or abolish — certain tax deductions and other benefits that disproportionately favor the wealthy.
Moore is the first Supreme Court case involving a constitutional challenge to a federal income tax law since Macomber, which was decided more than a century ago.1 Whatever way the Court rules, other such cases are likely to be brought and some of them may reach the Court. Moore won’t be the last case of its kind.2
All this litigation focuses on two narrow constitutional issues: the scope of direct tax subject to apportionment by population in the taxing clause and the definition of income in the 16th Amendment. Those are also the focus of the academic literature.3
This column focuses on whether constitutional challenges could be brought against other provisions of federal tax law. Besides its decision to hear Moore, another reason for thinking that the Supreme Court might be ready to address other constitutional issues related to federal tax law is Chief Justice John G. Roberts Jr.’s opinion in NFIB v. Sebelius,4 which held that the “penalty” in the Affordable Care Act was a tax and therefore constitutional. In my opinion, Roberts got it wrong because the case involved a regulatory tax (that is, not a tax that was primarily for raising revenue, which is what the taxing clause is about5) and regulatory taxes should be subject to constitutional limitations under, for example, the commerce clause.6 NFIB suggests that at least the chief justice is open to considering constitutional tax issues other than the meaning of “direct tax” and “income.”
Another reason this issue is interesting is that the United States is exceptional in not subjecting tax law to constitutional review.7 In most developed democracies, tax law is subject to full constitutional scrutiny based on a constitutional definition of equality. In those countries (such as Germany and Italy), an initial determination that a given tax law deviates from a constitutional equality requirement is followed by: (1) an inquiry into legislative purpose and (2) a determination whether the deviation from equality is proportional to the legislative purpose or could be achieved by less restrictive means.8
Why does the United States deviate from the norm here?
A common answer is that the Court became wary of constitutionalizing income tax law after Macomber, which was widely regarded as wrongly decided. In particular, tax academics have warned the Court against constitutionalizing income tax law because Congress could not fix the Court’s mistakes. The D.C. Circuit dared venture into these waters in Murphy,9 holding that taxing damages for nonphysical injuries was unconstitutional because they were not “income.”10 The criticism was swift, and the court ultimately retracted its opinion.11 Moore has strengthened this academic consensus because of its potential to inflict massive collateral damage on the code.12
But that is not the whole story, because the Court frequently invalidates state tax laws on grounds of equal protection and due process, and on commerce clause grounds. In the first two categories, the Court gets the final word. In the commerce clause cases, even though Congress can overrule the Court (because it has the authority to regulate interstate commerce), it rarely does, meaning that the Court sometimes finds it necessary to overrule itself.13
Several problems arise because the Court refuses to constitutionalize tax law.14 One is that tax is relegated to a technical subject fit only for specialists, rather than one at the heart of the relationship between the state and its citizens. Another problem is that many deviations from equal protection remain unexamined and continue unabated because Congress lacks the political will to limit them, primarily because of lobbying pressure.
Which parts of the code may benefit from constitutional scrutiny? Some examples come to mind.
Employer-Provided Healthcare Premiums
Employer-paid health insurance premiums and other medical expenses are not included in employee gross income, even though the employer deducts them as a business expense.15 This exclusion is the largest tax expenditure in the federal budget, costing $3.366 trillion from 2023 to 2032.16 The exclusion means that employees who work for an employer that provides those benefits receive a tax subsidy because they do not have to include the employer’s contribution to their health insurance and medical care as income. Employees who receive no health benefits and self-employed individuals generally must pay for health insurance and medical care with after-tax dollars.
The exclusion imposes some major costs. First, as noted above, it leads to a considerable loss of revenue. Second, it is regressive, because tax rates rise with income and thus high-income taxpayers benefit most from it. Third, it is biased toward more robust insurance coverage because premiums are paid with before-tax dollars, so the cost does not fall on the taxpayer.
There is no rational basis for U.S. tax law’s distinction between employer coverage and independently purchased coverage, other than history and political popularity.17 To achieve horizontal equity, Congress should either repeal the expenditure and include the premiums as income or let people who don’t receive those benefits from their employer create equivalent tax-free health savings accounts. The goal of the tax law is to encourage individuals to obtain health insurance coverage, and it is disproportional to this goal to grant coverage only to those people whose employers pay into their health plans.
Gifts and Bequests
Generally, and under a Haig-Simons definition of income as the sum of consumption and the increase in savings, gifts and bequests should be included in income.18 Under current law, the value of property acquired by a gift or bequest is excluded from taxable income.19 The Treasury Department estimates the cost of those tax expenditures (based on carryover basis and the potential capital gains on gifts) to be $42.37 billion from 2023 to 2032.20 This exclusion is hard to justify because it perpetuates generational wealth and benefits the rich, who inherit substantial resources, excluding everyone else. The federal estate tax applies only to the superrich and could be abolished if gifts and bequests were included in income. Accordingly, the omission of gifts and bequests reduces the redistributive power of the income tax and raises questions of equity.
No rational basis can be identified for this exclusion. Although relieving some intrafamily affectionate gifts from taxation might be a valid purpose, excluding all gifts would be disproportionate to this intent, because it covers gifts that are not motivated by familial affection and excludes from income increases in ability to pay that are not excluded in any other contexts.21 Congress should repeal this exclusion on horizontal equity grounds.
Interest on State and Local Bonds
Interest earned on state and local government bonds is generally tax exempt.22 This is a tax expenditure that will cost the federal government $381.57 billion from 2023 to 2032.23 This expenditure is meant to indirectly subsidize state and local governments; however, that works only when the difference in the interest rate between taxable and tax-exempt bonds is equal to the top marginal tax rate, which happens only if individuals subject to the top rate purchase all the tax-exempt bonds.24 If the difference is less than the marginal tax rate, that is because individuals outside the top tax bracket purchased the bonds, so some proportion of the tax expenditure would actually benefit the superrich and not state and local governments. Less wealthy people who purchase the bonds don’t benefit because the difference in interest rates is equal to the avoided tax.25
Congress should also abolish this exclusion on horizontal equity grounds because as applied, it has no rational basis. Congress could use the revenue obtained from the repeal to directly subsidize state and local governments.26 As long as the exemption of the interest inures not to the benefit of state and local governments but to rich individuals, the exemption cannot be justified as advancing the legislative goal of helping state and local governments.
Mortgage Interest, Local Property Taxes
Despite the general rule that expenses incurred in relation to personal consumption (such as purchasing an owner-occupied home) are nondeductible, an owner-occupant may deduct mortgage interest paid on her primary residence. In addition, an owner-occupant may take a deduction for local property taxes paid on real property (the Tax Cuts and Jobs Act capped the deductibility of any state and local taxes, including local property taxes, at $10,000).27 The combined cost of those tax expenditures to the federal government is $1.49 trillion between 2023 and 2032.28 These deductions create an unprincipled distinction between homeowners, who can claim them, and renters, who cannot.29 Homeowners also benefit from the exclusion of the imputed income from homeownership (worth $1.679 trillion over 2023 to 2032).30
The alleged purpose of these deductions is to encourage homeownership, but empirical research shows that they may have a larger effect on the size of homes purchased than on the decision to become a homeowner.31 In other words, they are inefficient and ineffective at achieving their stated purpose because they disproportionately benefit wealthier individuals in purchasing more expensive property. Congress should amend these deductions to comply with horizontal equity by either allowing similar deductions for renters or removing them entirely.
Step-Up of Basis at Death
Under current law, capital gains on assets held at the owner’s death are not realized and therefore not taxed. Still, the cost basis of the appreciated assets is adjusted to the market value at the owner’s date of death (stepped-up basis), which becomes the basis for the heirs who can sell them without paying tax.32 This will cost the federal government $652 billion from 2023 to 2032.33
This tax expenditure has no rational basis because it is possible to calculate the original basis of real and personal property. The exclusion means that everyone is subject to the capital gains tax except heirs, and that people will be reluctant to sell assets when they’re old even if they would normally prefer to downsize their home. Again, the exclusion mostly helps the rich because everyone gets an exclusion of the first $500,000 on the sale of a primary residence. It is disproportional to any articulable legislative goal to allow all heirs to sell appreciated properties without paying any tax, while non-heirs must pay full tax on the realized appreciation in their capital assets. Congress should abolish this exclusion on horizontal equity grounds.34
What Would the Court Do?
So should the United States emulate other countries and constitutionalize income tax law (that is, subject it to constitutional judicial review)?
Right now, the answer must be no. The stakes are too high because the Court gets the final word. And the Court as currently constituted is not up to the task, for three reasons.
First, most of the justices incline toward textualism, which would prevent them from asking what Congress intended when, for example, enacting the home mortgage interest deduction. Inquiry into legislative purpose is essential to measuring deviations from equality against legislative intent under a constitutional proportionality standard.
Second, the Court lacks a well-developed doctrine of proportionality.35 Even if it found that a given deviation from equality was not required to advance Congress’s purpose, the current Court lacks the analytical tools to conduct a nuanced inquiry about the extent of the injury and whether other means could be used. Because most tax distinctions don’t involve suspect categories, it must apply rational basis, a category that is not flexible enough to consider proportionality.
Third, the current Court does not understand tax law.36 This is evident in some of its federal tax decisions, such as Gitlitz37 and PPL Corp.,38 which were excessively formalistic and reached absurd results.39 It doesn’t help that in recent years the Court rarely takes up federal tax cases and that none of the justices, and few clerks, have training in tax. Even former Justice Ruth Bader Ginsburg, whose husband was a renowned tax lawyer, joined the misguided majority in Gitlitz and PPL.
But that doesn’t mean the constitutional inquiry is worthless. Congress too is charged with upholding the Constitution, and Congress can ask, when considering a tax expenditure: What is its own purpose in deviating from equality, and is the deviation proportional and necessary? These are the two main issues underlying foreign court decisions, and Congress can learn from the way foreign courts analyzed the issues of equality and proportionality. Congress also has the requisite tax expertise.
This could be a new procedure for the staff of the Joint Committee on Taxation: For every tax expenditure, the JCT should ask not just how much it costs in forgone revenue, but also whether the deviation from equality is justified in terms of Congress’s purpose. A report along those lines may persuade members of Congress to finally stop listening to lobbyists and cut back on some of the more egregious tax expenditures.
FOOTNOTES
1 Moore v. United States, No. 22-800 (U.S.); Eisner v. Macomber, 252 U.S. 189 (1920).
2 See Reuven S. Avi-Yonah, “What Is the Best Candidate for a Post-Moore Constitutional Challenge?” Tax Notes Int’l, Jan. 1, 2024, p. 17. One such case, Altria, is already pending. Complaint, Altria Group Inc. v. United States, No. 3:23-cv-00293 (E.D. Va. 2023). See Avi-Yonah, “Effects From Moore: Does the Corporate Tax Require Realization?” Tax Notes Int’l, Jan. 22, 2024, p. 437.
3 See, e.g., John R. Brooks and David Gamage, “Taxation and the Constitution, Reconsidered,” 76 Tax L. Rev. 75 (2022); Brooks and Gamage, “‘From Whatever Source Derived’: The Sixteenth Amendment and Congress’s Income Tax Power,” Fordham Law Legal Studies Research Paper No. 4595884 (2023).
4 National Federation of Independent Business v. Sebelius, 567 U.S. 519 (2012).
5 The taxing clause explicitly focuses on taxes imposed “to pay the Debts and provide for the common Defence and general Welfare of the United States,” which is limited to pure taxes intended solely to raise revenue, not regulatory taxes.
6 See Avi-Yonah and Yoseph M. Edrey, “Constitutional Review of Federal Tax Legislation,” 1 Ill. L. Rev. 3 (2023).
7 The following is based on Avi-Yonah, “Should U.S. Tax Law Be Constitutionalized? Centennial Reflections on Eisner v. Macomber (1920),” 16 Duke J. Con. L. & Pub. Pol’y 65 (2021).
8 See, e.g., Oliver Lepsius, “Constitutional Review of Tax Laws and the Unconstitutionality of the German Inheritance Tax,” 16(15) Ger. L.J. 1191 (2015); Avi-Yonah and Edrey, supra note 6.
9 Murphy v. IRS, 460 F.3d 79 (D.C. Cir. 2006), vacated, 493 F.3d 170 (D.C. Cir. 2007).
10 Murphy, 460 F.3d at 92.
11 See, e.g., Gregory L. Germain, “Taxing Emotional Injury Recoveries: A Critical Analysis of Murphy v. Internal Revenue Service,” 60 Ark. L. Rev. 185 (2007).
12 Avi-Yonah, “If Moore Is Reversed,” Tax Notes Int’l, June 26, 2023, p. 1725.
13 See, e.g., South Dakota v. Wayfair Inc., 585 U.S. 162 (2018) (commerce clause); Quill Corp. v. North Dakota, 504 U.S. 298 (1992) (commerce clause); National Bellas Hess v. Department of Revenue, 386 U.S. 753 (1967) (due process and commerce clause).
14 As discussed below, I do not believe the current Court is qualified for this task, so I recommend that Congress (specifically, the Joint Committee on Taxation) undertake it.
15 Section 106(a) (2020).
16 U.S. Department of the Treasury, “Tax Expenditures” (Mar. 6, 2023) (tax expenditure analysis).
17 The exclusion was the result of the IRS encouraging employers to respond to wage controls imposed during World War II by providing health insurance.
18 Stanley S. Surrey and Paul R. McDaniel, Tax Expenditures 200 (1985).
19 Section 102 (1986).
20 See tax expenditure analysis, supra note 16.
21 See Jeffrey H. Kahn and Douglas A. Kahn, “‘Gifts, Gafts and Gefts’ — The Income Tax Definition and Treatment of Private and Charitable ‘Gifts’ and a Principled Policy Justification for the Exclusion of Gifts From Income,” 78 Notre Dame L. Rev. 441 (2003).
22 Section 103 (1988).
23 See tax expenditure analysis, supra note 16, at item 169.
24 J. Clifton Fleming Jr. and Robert J. Peroni, “Reinvigorating Tax Expenditure Analysis and Its International Dimension,” 27 Va. Tax Rev. 437, 446-447 (2008).
25 Surrey and McDaniel, supra note 18, at 211.
26 John K. McNulty and Daniel J. Lathrope, Federal Income Taxation of Individuals 101 (2004).
27 Sections 163(h)(3) and 164(a).
28 See tax expenditure analysis, supra note 16.
29 See also Surrey and McDaniel, supra note 18, at 233.
30 See tax expenditure analysis, supra note 16. Other countries, like Italy and the Netherlands, tax such imputed income on equity grounds.
31 See Mark P. Keightley, “The Mortgage Interest and Property Tax Deductions: Analysis and Options,” Congressional Research Service R41596, at 14-15 (2014).
32 Section 1014 (2015).
33 See tax expenditure analysis, supra note 16.
34 See also Surrey and McDaniel, supra note 18, at 254.
35 For a thorough explanation of proportionality, see Aharon Barak, Proportionality: Constitutional Rights and Their Limitations (2012).
36 That was not always true: The Court had a largely positive role in shaping tax law before the advent of textualism. See Avi-Yonah, “Why the United States Needs a GAAR,” Tax Notes Int’l, Mar. 4, 2024, p. 1313. The Court also decided many more tax cases in the formative period of the income tax so that it developed a much more nuanced understanding of tax law.
37 Gitlitz v. Commissioner, 531 U.S. 206 (2001) (8-1 decision).
38 PPL Corp. v. Commissioner, 569 U.S. 329 (2013) (unanimous decision).
39 Most tax scholars believe both were wrongly decided. See, e.g., Martin J. McMahon Jr., “Beyond a GAAR: Retrofitting the Code to Rein in 21st-Century Tax Shelters,” Tax Notes, Mar. 17, 2003, p. 1721; Jacob Goldin, “Reconsidering Substance Over Form in PPL,” Tax Notes, Dec. 10, 2012, p. 1229.
END FOOTNOTES