‘Tax Awareness’ and Federal Income Tax Withholding

April 13, 2006

Do taxpayers understand the full cost of the government services they demand? There’s and interesting op-ed in this morning’s USA Today exploring the role federal income tax withholding has played in shielding the cost of federal spending from taxpayers:

Two sentiments about government spending prevail as we approach Tax Day, traditionally April 15: First, that it’s out of control, and second, no one cares. They’re related, the latter causing the former. The reason no one cares comes down to one word: withholding.

If you’re like most Americans, the government extracts taxes from your wages before you ever see the cash. You might have been upset about that when you got your first paycheck, but you soon learned to skim to the take-home section. Out of sight, out of mind.

That collective shrug is precisely the reason Congress implemented mandatory withholding in 1943. It feels relatively painless for the 131 million Americans who pay this way — especially when a refund check arrives. Consequently, few withholdees truly care what happens with their money.

But others do. Nearly 12 million of us, the IRS reports, pay estimated taxes by writing checks to the government, usually every quarter. Often self-employed types, we deposit checks into our accounts, dream of the vacations those funds could finance, and then mail those funds to the U.S. Treasury instead. It’s a painful process.

Spreading the pain But one way to slow out-of-control spending in Washington is to make everyone feel the same pain that quarterly payers experience. Ending withholding would do that — and it’s not as crazy as it sounds.

Most Americans have paid taxes through withholding for so long, we think it’s as inevitable as taxes themselves. But the income tax wasn’t even constitutional until 1913. For its first three decades, citizens usually paid in lump sums. They grumbled, which kept rates low and made new programs hard to justify. For both those reasons, Congress insisted that Social Security taxes be withheld from paychecks when that program began in 1935.

Officials suspected that withholding “makes it harder for people to see the amount of money that’s actually been taken from them,” notes Charlotte Twight, Boise State University economist and author of Dependent on DC. Citizens would not see a connection between their payments and the things governments chose to finance.

When it began Upon the outbreak of World War II, the Treasury needed more blank checks, so in 1943, Congress decreed that income taxes be withheld alongside Social Security ones. Against the backdrop of war and heavy propaganda, Americans acquiesced.

The scheme worked as planned. Americans didn’t revolt when rates rose. Taxpayers even started to think of withholding as convenient, though people often overpay; last year, about $100 in potential investment returns was lost on the average refund of $2,423. Most people can’t imagine another system.

But the nearly 12 million Americans who pay estimated taxes can. Technology makes starting businesses easier and cheaper than ever these days; as the ranks of the self-employed grow, more Americans are discovering the pain that writing tax checks inflicts.

Don’t be fooled by the moaning. As a freelancer, I think it’s a good pain, one that keeps you conscious. (Read the full piece here.)

As we’ve written before, some economists have criticized federal income tax withholding on grounds that it conceals the “price” of federal programs. After all, if we expect voters to make good choices about the level of government spending, they’ll need good information about the full costs. For all the administrative efficiency of federal income tax withholding, this reduction in tax transparency is a major drawback.

However, even if you don’t find that criticism persuasive, there’s another big problem with income tax withholding—the uncompensated opportunity cost borne by taxpayers for making interest-free loans to the U.S. Treasury.


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