One staple of legal philosophy is the prohibition against retroactive laws. The late legal theorist Lon Fuller spared no anger in denouncing these laws as “monstrous,” because “to speak of governing or directing conduct today by rules that will be enacted tomorrow is to talk in blank prose.”

Nonetheless, large governments are often hard pressed to fund their ambitious spending programs. And so the Biden administration proposes to increase the capital-gains top rate from 23.8 percent to 43.4 percent to pay for its $6 trillion American Families Plan, which includes about $1.8 trillion for child care, education, and paid employee leave. But as its Treasury Report makes clear, it fears that the steep capital-gains rate increase will induce massive selling before the effective date of the statute in 2022. It therefore proposes an unprecedented step of imposing the higher capital-gains rate on any transaction that took place after late April, when that tax hike was first proposed.

But Treasury misfires badly. Sales of capital assets are good for the economy because they allow individuals to shift from weaker to stronger investments. The inefficiency comes from forcing premature transfers. Yet the massive rate increase proves that high rates, even when applied on a prospective basis, will distort the allocation of capital, depress overall share prices, and ensure that the new tax will fall short of its revenue goals, which are better achieved through durable tax cuts. But the Biden administration plainly ignores these drawbacks for long-term wealth creation in its relentless request for revenue today.

The Biden administration’s dubious strategy is highly questionable for yet another reason. There is no doubt that this bald threat will deter many individuals from making various capital gains transactions at some real financial cost of their own. Indeed, this provision has already been met with serious resistance, including from David Solomon, the CEO of Goldman Sachs, who has warned that the government should be “very, very cautious” about this tax, given the risk of “a chilling of investment activity.” Republican Senator John Thune has also denounced the retroactive tax as “terrible policy,” noting how it frustrates the plans that individuals have made under the current law.

The Biden administration hopes that by giving notice to the world of its intentions, it can dilute the opposition to the retroactive tax. The ploy is, however, deeply problematic. To be sure, notice is generally of value because its gives people the opportunity to mitigate their losses, which they can and would do if the tax increase were only given prospective effect. But this proposed rule offers no avenue of escape to wary taxpayers because the concept of notice is taken far beyond its proper use. Normally, notice lets taxpayer adjust their actions. This cannot be done with retroactive laws.

The Biden administration’s use of notice, however, carries a more sinister aspect because it attempts to legitimate state coercion. By way of comparison, think of a robber who announces that anyone who walks the streets at night will be robbed of his wealth. That notice might persuade sensible people to stay home. But the correct response is to arrest the individual who made the illegal threat, so that it is once again safe for innocent people to walk the streets. Thus, if the government were to give notice today that it may at some future time condemn property at a price that reflects only its current market value, it should nonetheless be required to pay full market value at the time of condemnation, for otherwise the government, through its unilateral declaration, creates a zero-cost option to purchase property at below its fair market value.

If the government wishes to enforce that option, it should be required to purchase at market rates an option to condemn the property from its current owner at its current price, which protects the landowner and curbs the government’s appetite to obtain something for nothing. That costly option will be exercised only when the gain to the government exceeds the property owner’s loss, which is what an efficient system requires.

At present, it seems unlikely that the Biden plan will pass in anything like its present form, which is probably why markets have continued to rise on the expectation of greater economic growth in the post-COVID era. But it is still worth asking how it is that these retroactive taxes came into such prominence and vogue. As is so often the case, the best explanation for the change in attitudes lies in the displacement of the classical liberal mindset in favor of the progressive views on the subject.

The classical liberal position always sought to find the middle ground between two untenable extremes—a government too weak to raise revenue, preserve order, and control monopoly power on the one side; and a Leviathan too strong for individual liberty to survive on the other. To maintain the right balance, two sets of safeguards were envisioned: structural limitations associated at the federal level with separation of powers, and the protection of private property and economic liberties. These ideals were imperfectly respected until the New Deal revolution of 1937, at which point they fell into rapid desuetude with the rise of regulation at both the federal and state levels.

The prohibition against retroactive laws was part of the general arsenal that guarded against excessive government. As late as 1935 in Railroad Retirement Board v. Alton Railroad Co., a sharply divided Supreme Court struck down a New Deal statement that required the railroads on a retroactive basis to fund pension plans for workers who were let go for cause or who had retired before the passage of the statute. A far better way to handle any perceived difficulties of private pension is to use general revenues, which would radically alter the willingness of the Congress to pass such statutes.

Yet that case, and the attitude that it represents, was de facto overruled in 1976 in Usery v. Turner Elkhorn Mining Co., which retroactively imposed extensive obligations on operators to deal with pneumoconiosis, or black lung disease, on behalf of those miners who had left employment prior to the effective date of the statute, and to whom the company had fully discharged all of its legal obligations. Again, the retroactive application of the rule violates Lon Fuller’s prescription, and the result is hardly justified by the court’s observation that “legislative acts adjusting the burdens and benefits of economic life come to the court with a presumption of constitutionality” and are “not unlawful solely because [they] upset otherwise settled expectations.” That last phrase sounds a warning bell: settled expectations within a given community create the needed stability for commercial transactions to take place.

By 1994, the court, armed with the Turner Elkhorn line of cases, upheld in United States v. Carlton the government’s decision to take back a narrow tax benefit that it had specifically and unwisely conferred on a small class of estate-tax payers, which astute tax planners quickly exploited. Rather than trying to narrow the scope of retroactive application, the Supreme Court wrote a broad opinion that allowed Congress to backtrack from its conscious and prudent decisions when it did not like how matters turned out—often because of its own financial mismanagement. 

In two key decisions from the 1980s, the Supreme Court held that Congress was entitled to impose new obligations on firms participating in government-sponsored pension guarantee programs, provided it let those firms withdraw for any reason at any time. When the programs started to go broke, Congress imposed financial penalties on these withdrawals in violation of the original deal. Once again, settled expectations did not matter. In rapid succession, the court rejected the claim that these new obligations violated either the due process clause in PBGC v. R.A. Gray & Co. (1984) or the takings clause in Connolly v. PBGC (1986) because the firms that participated in the program had “sufficient notice” that Congress had engaged in similar activities in these heavily regulated areas.

Thanks to the current line of Supreme Court cases, there is an ever-present risk that government will abuse its legislative discretion. Private parties must now anticipate government misdeeds or face the consequences—all of which weaken the stability of contract and property rights on which the success of the country depends. To be sure, the massive implications of undoing Biden’s retroactive capital-gains tax are a far remove from the specialized provision in Carlton, but it will take a major change of views to bring sound constitutional principles to the fore. It is not just individual taxpayers who suffer from arbitrary power, but the entire system of productive exchange.

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