The Mischiefs of Tax Withholding and Separate Income and Payroll Taxes

August 13, 2009

Charles Murray has an op-ed in the Wall Street Journal criticizing tax withholding and the separation of payroll taxes from income taxes:

Fold payroll taxes into the personal tax code, adjusting the rules so that everyone still pays the same total, but the tax bill shows up on the 1040. Doing so will tell everyone the truth: Their payroll taxes are being used to pay whatever bills the federal government brings upon itself, among which are the costs of Social Security and Medicare.

The finishing touch is to make sure that people understand how much they are paying, which is presently obscured by withholding at the workplace. End withholding, and require everybody to do what millions of Americans already do: write checks for estimated taxes four times a year.

Both of those simple changes scare politicians. Payroll taxes are politically useful because low-income and middle-income taxpayers don’t complain about what they believe are contributions to their retirement and they think, wrongly, that they aren’t paying much for anything else. Tax withholding has a wonderfully anesthetizing effect on people whose only income is a paycheck, leaving many of them actually feeling grateful for their tax refund check every year, not noticing how much the government has taken from them.

There’s definitely something to it. Most people hate property taxes more than any other tax precisely because it is so visible. People get angry, they scrutinize how property tax money is spent, and that’s a good thing. We could use more scrutiny of expenses with income and payroll tax money.

Milton Friedman, of all people, invented payroll tax withholding during World War II as income tax rates soared. He later regretted what he had wrought.

The income-payroll distinction goes back to idea that Social Security and (later) Medicare are somewhat based on the benefit principle. People pay in, they later get benefits. This is why Social Security taxes aren’t collected past a certain income level: someone paying in above that cap would never get that money back unless they lived virtually forever. But it does make that “FICA withholding” seem no different from any of the other myriad withholdings on the pay stub. And it’s probably deceptive to pretend that Social Security isn’t a government program intertwined with the rest of the federal budget.

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