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.