How often have you heard people say with pleasure, “I got a tax refund this year!”? Americans have grown so immune to income-tax withholding that many people regard IRS refunds as gifts. Misperceptions about withholding are widespread. In fact, withholding is a regressive, costly, and furtive system for collecting taxes.
Fifty-six years ago Congress approved the current system under which a sum is withheld from each paycheck and deposited with the government, with taxpayers and the government settling accounts once a year when tax returns are filed. According to Milton Friedman, who helped create the withholding system as a young economist in the Tax Research Division during World War II, withholding was justifiable during the war because it raised revenue for the war effort that could not have been raised otherwise.
Is Withholding Justified?
What justifies withholding during peacetime? Withholding is said to have three advantages over a system in which taxpayers pay their tax bills annually in one lump sum. First, withholding guards against the threat that people will have too little money on hand to pay their taxes. Some congressmen even argued in 1942 that withholding was necessary to protect taxpayers from loan sharks at tax time! Second, because it reduces current disposable income, withholding is said to be anti-inflationary. Third, withholding smoothes the government’s revenue stream, making government spending simpler.
None of these goals requires that employees who have taxes withheld not be compensated for lost interest. The government could do this simply by paying interest on the money withheld. This is not a new idea. In 1912, the federal government experimented with interest-bearing tax-anticipation notes; the secretary of the Treasury sold the first note to President Teddy Roosevelt. Flaws in the design of these notes doomed them to failure, but the principle remains correct—early payment of taxes ought to be compensated by the payment of interest.
Expensive and Regressive
Withholding costs taxpayers a great deal of money. With some back-of-the-envelope calculations based on IRS data, we estimate that since its inception in 1943 withholding has taken over $400 billion (calculated in 1995 dollars) in interest from taxpayers. In a single year withholding costs the average worker over $100 in forgone interest.
Not surprisingly, withholding also unfairly penalizes wage income relative to non-wage income. Consider two couples, Ted and Tammy Toiler and Pierre and Priscilla Plutocrat. Both couples have annual federal tax liabilities of $10,000, and both structure their withholding and estimated tax payments so that they legally minimize the amounts they pay to the IRS before April 15. The only difference between these couples is that the Toilers just have wage income and the Plutocrats live exclusively on investment income. Thus the Toilers have taxes withheld from their biweekly paychecks while the Plutocrats make four estimated tax payments a year. Using a 4 percent interest rate, at the end of the year the Toilers’ lost interest from withholding (about $273) is 17 percent higher than the Plutocrats’ lost interest (about $234). This disparity in tax treatment is caused by the government’s holding more of the Toilers’ money for a longer time than it holds the Plutocrats’ money.
Such disparities are rampant in our tax system. Procedural quirks and unintended consequences result in radically different tax rates for similar amounts of income based on the source, the taxpayer, and, for all we know, the phases of the moon. There is no rational basis for applying a higher implicit tax to wage income than to non-wage income. A business that behaved in a like fashion, randomly charging some customers higher prices for example, would quickly go out of business. The great “advantage” of government for the tax and spend crowd, of course, is that it short-circuits the market forces which penalize irrational behavior by private businesses.
The withholding tax is also a potent cause of fiscal illusion among taxpayers. Rather than write an annual check to the government for the full amount of their tax bills, most taxpayers on April 15 either send in a claim for a refund or pay only a small fraction of their taxes. In his 1989 book, A Law Unto Itself: Power, Politics and the IRS, David Burnham recounts a Harvard Medical School faculty member’s confession that he hardly notices his paycheck deductions. Burnham reports that accountants and tax lawyers now find that large numbers of taxpayers no longer view the IRS “as a hard-nosed tax collector” but rather as “a benevolent bureaucracy that gives away money to the needy middle class.” Thus, because taxpayers have become immune to the full magnitude of the tax bite, government growth is greater than it would be if there were no withholding or if withholding were less clandestine.
A Proposal for Reform
The best plan would be to abolish the income tax altogether. Until we can do so, however, the government ought to pay interest on money withheld as well as on estimated tax payments from the date of deposit of these sums with the Treasury. Short-term T bills provide a market rate of interest that can be easily used; a few lines of computer code can perform the calculations necessary to credit this interest to the “Amount Withheld” boxes on the W-2 forms employees receive at the end of the year.
Moving one step further to cure the problem of the disguised cost of government is almost as easy. Employers can deposit withheld tax payments (income and Social Security) into interest-bearing tax escrow accounts from which the government can borrow at T-bill rates. These accounts could then be released to employees before taxes are due. The government would be assured that individual taxpayers have the funds available to pay their taxes, while taxpayers would experience the full cost of Washington’s operations. Adoption of this proposal might significantly restrain the growth of government spending by erasing the fiscal illusion caused by the current withholding scheme.
Genuine fairness requires reform of the regressive and deceptive system of tax withholding. Championing reform of the existing withholding system promises to be a good first step for politicians who regard fairness as something other than a slogan for use in class warfare