Retroactive Tax Increases and The Constitution

This lecture was held at The Heritage Foundation on April 15, 1998.

I looked in a number of books for a good joke about taxes, but I couldn't find any. I then realized why: There's absolutely nothing funny about taxes, especially on April 15.

I did, however, find a great example of a Democrat condemning burdensome taxation:

When more of the people's sustenance is exacted through the form of taxation than is necessary to meet the just obligations of government and expenses of its economical administration, such exaction becomes ruthless extortion and a violation of the fundamental principles of free government.¹

I couldn't have said it better myself.

Two things inspired me to write a book about retroactive legislation. The first is the Superfund Law, which, as many of you know, retroactively imposes strict, joint, and several liability on firms that disposed of wastes long before the bill was passed in 1980. The Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA)² is, in a sense, a kind of retroactive tax, but it is imposed on those whom the government is easiest able to catch, and it may be imposed on someone whose actions may have been entirely reasonable and lawful at the time that he engaged in them.

The second event that inspired me to write the book was Bill Clinton's retroactive tax increase in 1993. In fact, as I learned, as retroactive tax increases go, Clinton's was not so bad and certainly not unprecedented. There have been far, far worse retroactive tax increases. Because I am speaking with Hill staffers, and you all love anecdotes, let me offer a few.

In the early 1980s, Congress created a tax deduction to encourage people to sell stock in a company to that company's employee stock option plan (ESOP). To get the benefit of that deduction, Jerry W. Carlton, the executor of the estate of Willametta K. Day, sold stock to an ESOP at a loss. Engaging in what Justice Antonin Scalia later called "bait and switch" taxation, Congress in 1986 repealed the tax deduction and applied the repeal retroactively, costing the estate more than $600,000. Justice Scalia's comment notwithstanding, the Supreme Court unanimously upheld the government's assessment of the tax.

In April 1976, E. M. Darusmont was notified by his Houston employer that he was to be transferred. He and his wife, of course, had to sell their home, which was a three-family house; they had rented the other two parts of the house to help pay the mortgage. The Darusmonts engaged a firm to advise them how best to sell the house to minimize the tax consequences. After weighing those different tax consequences, they sold the home outright, recognizing a gain of $51,000 or so. Under the rules then in effect, they had to pay tax on only half that amount. Then, in October, President Gerald Ford signed the Tax Reform Act of 1976, which retroactively increased the minimum tax. The Darusmonts had to pay an additional $2,280, which, for a family like the Darusmonts, in 1976 dollars, was not an insubstantial sum. This outcome wholly undercut their planning, yet the Supreme Court upheld the government's assessment of the tax.³

More outrageous still is a case in which the Internal Revenue Service (IRS) released final rules in 1993, which it applied retroactively to tax years effective for 1984. In this case, the IRS changed the rules for when a company can deduct interest owed to a foreigner, from when it is accrued to when it is paid. Companies needed to re-file returns going back as long as 10 years. The Third Circuit upheld the rule as within the IRS's authority because section 7805(b) of the Internal Revenue Code states that "The Secretary may prescribe the extent, if any, to which any ruling or regulation relating to the internal revenue laws, shall be applied without retroactive effect." The court held that "Clearly Congress has determined that treasury regulations are presumed to apply retroactively."

LESSONS LEARNED

At least three lessons emerge from these stories: First, that Congress is at fault for the imposition of retroactive tax liability, although, in every case, it was a Democratic Congress that imposed such a tax; second, the courts cannot be relied upon to protect people from retroactive tax increases; and third, just because a law may be constitutional doesn't mean that it's just or right.

Congress has been adopting retroactive tax increases for a very long time, essentially since the 1930s. The 1913 Revenue Act was the first one with an effective date before the date of the actual enactment. Generally, the increased tax rate is applied retroactively to the year in which it is enacted. But in 1918 and 1926, each of the Revenue Acts was applied to the entire calendar year that had preceded enactment. As early as 1935, one commentator pronounced restrictions on retroactive taxation to be "dead."

These laws were bad in their own right. They were also bad because they paved the way for the retroactive imposition of many other forms of liability. Since the 1930s, the courts have tolerated such retroactive legislation. The Supreme Court has narrowly construed most of the traditional constitutional protections against retroactive laws. Many Americans mistakenly believe that retroactive legislation is barred by the ex post facto clauses, which apply to both Congress and state legislatures. Since at least the early part of the 1800s, though, the ex post facto clauses have been interpreted as applying to criminal laws only.

Almost as disturbing is that the Supreme Court has been expanding its definition of what is "civil" and narrowing its definition of what is "criminal." This further reduces the scope and effect of the ex post facto clauses.

The Bill of Attainder Clauses, which also constrain state and federal governments, provide only limited protection against retroactive civil legislation. Although the Supreme Court has construed these clauses as protecting rights, the clauses bar only those laws that legislatively determine guilt and inflict punishment on identifiable individuals without the protections of a judicial trial. The Supreme Court has not struck down a law as an unconstitutional bill of attainder since the mid-1960s.

The Contracts Clause once operated as a firm bar against redistributive legislation by states that violated existing contract rights by transferring the benefits of the bargain from one contracting party to another. The clause was intended particularly to prevent legislation that relieved debtors at the expense of their creditors. The clause was often invoked during the 19th century. In 1934, however, the New Deal-era Supreme Court refused to read the clause in accordance with its original understanding, and upheld debtor-relief legislation. Since that time, the Contracts Clause has rarely served as an impediment to retroactive laws. In any event, the Contracts Clause applies only to the states.

The Takings Clause has met with much the same fate as the Contracts Clause. Once a key impediment to laws that upset existing economic circumstances without compensation, the Takings Clause is now applied only in a few, extreme situations. The Supreme Court will require compensation for physical invasions, and where regulation deprives a property owner of all economically beneficial or productive use of land. A few scholars have been heralding a revival of the Takings Clause, but that revival has yet to materialize.

Some have declared retroactive legislation to be beyond the power of the legislature or a violation of due process. Given the history of retroactive legislation, it is not credible to declare all retroactive legislation beyond the power of Congress. Certain retroactive laws that have intruded into the judicial power have been found unconstitutional, but this covers a relatively small class of cases.

There is the temptation to contend that legislative deprivation of a "vested right" offends due process. The difficulty with this argument is that there is no way to define a "vested right" outside the context of the Takings and Contracts Clauses. Vested rights are defined as those that are beyond the power of the legislature to upset, and retroactive legislation is defined as a law that upsets vested rights. The definitions are entirely circular. Moreover, the Supreme Court has upheld against a due process challenge even the law, described above, that retroactively withdrew a tax break created by Congress that specifically induced an individual to sell stock at a loss to take advantage of the tax break.

There are more promising developments in the administrative law context, however. Courts have begun to restrict the ability of administrative agencies to punish companies when they adopt a new interpretation of a regulation. If the company genuinely tried to adhere to the law, and adopted a reasonable interpretation of the law, the courts have prevented agencies from imposing fines. Courts have made this decision even when they upheld the agency's new interpretation on a prospective basis.

BACK TO THE FUTURE?

It is not likely that the courts will soon breathe enough life into the ex post facto, Contracts, and Takings Clauses to make them significant impediments to retroactive legislation. Action is therefore up to Congress.

First, Senator Strom Thurmond (R-SC) has introduced a bill that would establish a presumption that all statutes apply prospectively, unless they expressly state, in the text of the statute, that they apply retroactively. This is an easy change to make; it wouldn't even really constrain Congress's future actions, but it would help in cases of ambiguity. It is also consistent with the way that Anglo-American law has traditionally dealt with retroactive legislation. Generally, courts try to avoid the problem by construing ambiguous statutes to apply prospectively. This would enshrine that principle in a statute.

Second, Congress should reverse the presumption that Treasury regulations apply retroactively. As is the case with most administrative rules, they should apply prospectively.

Third, laws that expressly refer to, and change, the past legal consequences of past events should be made subject to a super-majority requirement. Certainly this can be applied to retroactive tax increases. In fact, the House, during the 104th Congress, already passed an internal rule declaring retroactive tax increases out of order, and Senator Paul Coverdell (R-GA) pushed a similar reform through a Senate committee.

Fourth, Congress should pass legislation requiring the originating committee, or the comptroller general, to assess the effect of proposed legislation on investment-backed expectations. Bills determined to be retroactive should be declared out-of-order. This is consistent with the proposed Common Sense Legal Reforms Act of 1995, which would have required the committee report on any legislation "of a public character" to specify the "retroactive applicability, if any, of that bill or joint resolution." It adds teeth to that determination by making bills determined to be retroactive harder to pass.

Fifth, administrative agencies should also be precluded from enforcing statutes or regulations against individuals in certain instances. First, if the regulation is so ambiguous that it did not include fair notice; second, the individual reasonably relied on a written statement of agency policy that takes a different view; and third, the agency has not interpreted the statute or regulation and the individual's reading of it is reasonable.

A retroactive executive order, requiring agencies to assess the effects of their actions on investment-backed expectations, will also help raise consciousness about the unfair nature of retroactive rule making. At this stage, however, until these reforms are tried, a constitutional amendment banning retroactive legislation is not a good idea, in part because of the difficulties, which I have not discussed, in assessing when legislation is retroactive.

Most important of all is the need to build a political consensus against such laws. Everyone opposes changing the rules after the game has been played. People respond to stories about individuals having had the rug pulled out from under them. Retroactive laws are hostile to fundamental fairness. Let us make their existence a political issue, so that a consensus can form urging that they be prohibited entirely, except where curative.

Finally, a vigorous discussion of this subject might lead more people to conclude that, if it is not necessary to change, it is necessary not to change.

--Daniel E. Troy is an Associate Scholar at the American Enterprise Institute and a partner at Wiley, Rein & Fielding.