The big government cheeseburger

If you’re looking for some relevant reading on this Tax Day, you could do much worse than Charlotte Twight’s essay on the history of income tax withholding in the United States. The topic is featured prominently in her excellent book Dependent on D.C. and I’m glad to see her work is now online as well.

She reports that prior to World War II income taxes were generally paid in quarterly installments in the year following the earnings to which they applied. For example, at the end of 1938 a person would calculate what he owed for the year and pay it gradually throughout 1939. This left taxpayers fully aware of what they were paying and allowed them to plan their payments in advance.

In 1943 the law was changed to implement withholding. This greatly advantaged the Treasury by obscuring the true magnitude of taxation:

We have seen that, on many levels, income tax withholding increases transaction costs to the public of understanding the magnitude of the income tax and of opposing it politically. Government officials always have regarded withholding as a seemingly “painless alternative” (U.S. House Hearings 1980: 35). Lacking an understanding of the concept of present value, many taxpayers do not perceive that withholding causes the real burden of their tax liability to be greater. Indeed, the common practice of overwithholding associates the payment of taxes with an apparent financial benefit rather than cost, distorting taxpayers’ assessments of the actual costs and benefits of government activity. Consistent with a transaction-cost-manipulation model, the expected return of such overpayments makes people feel “happier’” about sending in their tax returns on April 15. The very mechanism of withholding deflects blame from the government by requiring employers to initiate and bear the cost of the forcible extraction of people’s income. Piecemeal collection each payday from income the taxpayer never sees obscures the magnitude of the annual tax. And, because it is a forcible extraction, it raises the transaction costs to the public of expressing political resistance to taxes by not paying them. [...]

After 50 years of comprehensive withholding at the source of American workers’ salaries, people are used to wage withholding; most no longer question it. The relevant institutional machinery is entrenched, both through its administrative apparatus and through its acceptance in the minds of most taxpayers.

Many readers of this blog favor mandatory disclosure of things like nutritional information. You don’t think that it’s enough for the number of calories in a fast food cheeseburger to be merely available to consumers. You say the information must be placed prominently on the menu, forcing diners into the frame of mind to consider the health consequences of their actions. Should not the same be true of government? When citizens are tempted by the big government cheeseburger, shouldn’t they be reminded of its true cost?

It’s true that they could look it up on their pay stubs or tax returns, but that’s not the same as having it forcefully presented in a quarterly payment. By taking their money before they ever receive it, withholding obscures the link between bigger government and higher taxes. Throw in the exciting possibility of an annual refund and it’s no wonder voters say, “Super size me.”

So here’s the question for left-leaning readers: Do you think it’s legitimate for the government to distort voter preferences via income tax withholding? Or should withholding be abolished at the risk of decreased support for government spending you favor?

Update: Barzelay makes an excellent point in the comments:

… there is no reason why the government should handle withholding. This is an area that I think the private sector would unquestionably be better at.

Imagine going to H&R Block and sitting down for a brief meeting to describe your financial situation. The tax experts there estimate how much your taxes will be for the following year, considering such factors as other anticipated income, anticipated life changes, etc., and recommend a particular withholding percentage. You then have your workplace automatically deposit that percentage of your paycheck into a special H&R Block account. H&R Block then invests your funds for you (conservatively), guaranteeing that they will pay you back at least what you have put in. At the end of the year, they pay you back your withheld money, plus interest, having taken out a cut (say, .25%) for H&R Block. You then pay your taxes. As long as H&R Block can make more than .25% interest, they make money and you make money.

This would address two problems. By making people write a check from their own private account it would help raise awareness of the actual tax burden. And if people withhold excessively, they keep the extra funds and any interest that is earned on them. The difficulty is in transitioning to this idea from our current pay-as-you go system; I don’t know how to get there from here without causing significant cash flow problems for the government.

Comments

  1. RD says:

    I’m a little bit unclear here — how is it obscurred? I pay my taxes every two weeks, and the exact amount is presented to me with my paycheck every two weeks. It’s irksome, but I don’t consider it to be an unknown. I look at it all the time. This is exactly like displaying nutritional information on a menu — when you pay your taxes, you are told how much you’re paying and it’s not possible to miss it.

    In terms of my own personal life, I’d prefer this system (even with the potential loss of value) because (a) it requires less of my time spent paying taxes, (b) it doesn’t require me to save an unknown amount of money for quarterly estimates, (c) I don’t have to pay for Turbotax to do my taxes for me every four months (rather than every twelve months). (c) in particular probably outweighs the loss of value to me inherent in withholding.

    If you’re looking for a less opaque system, why fall back on quarterly estimates, why not make weekly estimates in which you have to calculate your taxes and send in a check every week?

  2. Jim says:

    I think if the only issue here was obfuscation for greater compliance your case would be stronger. The move from quarterly payments after the fact to prior withholding was made for greater and easier enforcement and collection, which not only arrived out of necessity but also increased revenue by 1) decreasing the pool of evaders and 2) being more efficient and therefore costing less administratively.

    Like many other policies, this one came with good and bad elements and we have to choose the balance we prefer. I’m ok with this one (but I’m an unrepentant lefty, so you might expect that).

  3. Jacob Grier says:

    @RD: I think you’re in the minority if this doesn’t obscure your actual tax burden. I suspect most people don’t look at their paychecks nearly as closely or could give a good estimate of what they pay annually, nor do they factor in the loss of interest on taxes they’ve overpaid. Switching from a system in which people write checks to on in which they never receive the money in the first place and often receive a fun annual refund is also psychologically different. This is isn’t an exotic idea; it was one of the explicit reasons Congress implemented withholding in the first place.

    To clarify, the pre-withholding system wouldn’t require you to estimate anything or do your taxes more frequently. You would calculate your taxes once a year and pay them out the following year. Most people paid them in quarterly installments, but you could pay them all at once if you chose.

    In fact, the pre-withholding system actually required less estimation than the current one. Using myself as an example, going into April 15 I can easily look up what I’ve had withheld from my paychecks. I never have more than a rough guess, however, of what I’m going to owe from freelancing, cash income, capital gains, etc. Whatever the amount turns out to be, I have to be able to pay it on April 15. Under the old system I would have a much longer time to plan out my payments and would know exactly what they have to be.

    @Jim: Fair point. If compliance if your main concern, withholding certainly makes it harder to evade.

  4. Matt says:

    I tend to agree with RD, in that I do have a pretty good estimate of how much is being held out in taxes every time around, and I think a lot of people do have a good feel for that. At the same time, that doesn’t mean people are as aware of the true tax burden as they could be. Your point there has some great merit. The solution to that problem though isn’t to stop withholding, it’s other methods of elucidating the true tax burden. Just off the top of my head I’d say that quarterly tax notices that only spell out how much you’ve paid in could be effective, as would a tighter focus on your effective tax rate during annual filing.

    I also think you’re underestimating the value of convenience. I’m ok with the government getting more of my money upfront and then giving me a refund later. What I end up missing in income I more than make up for in convenience and psychological well-being.

  5. Barzelay says:

    I agree with others that most people actually are aware of how much they’re paying in taxes. If you were to ask Americans what their overall annual rate of taxation was (counting only IRS-collected income tax), most would be able to venture a pretty good guess. Nevertheless, I agree that the psychology is unfortunate, and I’d love to see official withholding abolished:

    Withholding forces people to save their money, to ensure that they will be able to pay their taxes. For many people, it adds convenience, and lessens the stress of tax time. That implies that withholding should be OPTIONAL. If you find it convenient, do it. If you would prefer more control over your money, with the ability to gain interest on those funds, you shouldn’t have to withhold. Furthermore, there is no reason why the government should handle withholding. This is an area that I think the private sector would unquestionably be better at.

    Imagine going to H&R Block and sitting down for a brief meeting to describe your financial situation. The tax experts there estimate how much your taxes will be for the following year, considering such factors as other anticipated income, anticipated life changes, etc., and recommend a particular withholding percentage. You then have your workplace automatically deposit that percentage of your paycheck into a special H&R Block account. H&R Block then invests your funds for you (conservatively), guaranteeing that they will pay you back at least what you have put in. At the end of the year, they pay you back your withheld money, plus interest, having taken out a cut (say, .25%) for H&R Block. You then pay your taxes. As long as H&R Block can make more than .25% interest, they make money and you make money.

    Oh, and by the way, you are not required to pay your taxes April 15. You are merely required to file your returns on that date. There are many options for delaying payment.

    I think that the federal government should include a rough breakdown of the federal budget and national debt directly on the tax forms, with a handy calculator. Although people realize “I paid $20,000 in taxes last year,” it is difficult to connect that with government programs. “I paid $4000 for the war in Iraq last year, and $3000 for the war in Afghanistan” is much more meaningful. I think the size of government might rapidly decrease if individuals were informed how much they personally contributed to various programs. Imagine the present going on television and saying, “We are going to invade Iraq. We anticipate that each of you will be paying about $2000 for this war, but the costs could go as high as $60,000 per American if our worst projections come true.” Who is going to support that war?

  6. Matt says:

    George W. Bush?

    I think you’ve got an interesting suggestion with the optional withholding. I kind of like it, though I wonder if creating that option would have some costs to it. I’m also intrigued by the private sector suggestion. I think it could certainly work for some people (namely educated individuals who will have to pay in significant amounts), but I worry about the number of people who would not benefit from private sector involvement. Specifically people who don’t have to pay in, people who don’t make enough that they could garner a decent return on their investment, and people who will fall victim to the inevitable hidden fees that always seem to accompany these types of programs. Even if this were to be handed over to the private sector there would need to be strict regulations limiting fees and expenses that could be charged to people, and we’d need to retain a government withholding option.

  7. Vanessa says:

    I like the with holding system because if the federal government billed me in quarterly payments I would not have the cash to pay them. This way I don’t have to go to collections because they garnish my pay in advance!

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