Income Tax Withholding and Government Growth

Prior to World War II most Americans paid no income tax. The standard deduction was high enough that people who had factory or office jobs didn’t earn enough income to owe any income tax. That changed when the standard deduction was lowered in 1940 (and again in 1941 and 1942) to raise revenues to finance the war. At the same time, income tax rates were raised substantially.

Income tax withholding began in 1943. Before that time, taxpayers paid their income taxes in quarterly payments they sent to the Treasury. Withholding requires employers to deduct taxes directly from workers’ paychecks so workers never see that tax money. It goes directly to the federal government. Then, by April 15 of the next year, taxpayers file returns and either get a refund if too much was withheld, or pay an additional amount if too little was withheld.

In a book chapter I co-authored with Robert Gmeiner, who earned his Ph.D. in economics at FSU in 2018, we looked at income tax collections after tax rates went up in the early 1940s and compared collections prior to withholding to collections after withholding. When withholding was implemented in 1943, tax collections went way up even though rates barely changed from 1942 to 1943 (after going way up in 1940 and 1941). This enabled us to estimate the amount of tax evasion that occurred prior to the implementation of withholding, and it appears that prior to withholding, about a third of taxes that were legally due were not paid.

Without withholding, the federal government would never be able to raise the amount of revenue from income taxes that it does today. For one thing, people’s income tax liabilities are high enough that many people would not have the financial discipline to set aside enough money to make quarterly payments, as was done prior to withholding. In addition, higher income tax rates create more of an incentive for tax evasion, as we found in our study. Withholding limits the amount of evasion, because the tax money is collected before the taxpayer has a chance to receive it. Withholding enables the federal government to collect more revenue and has contributed to the growth of government.

Would the federal government have been able to implement withholding without World War II? Probably not. Withholding applies only to wage and salary income, and when there was a move to extend it to interest and dividend income in the 1970s, citizen opposition stopped that from happening. People accepted withholding in 1943 only because of their patriotic support for the war effort. The effects of World War II contributed to the growth of government in a number of ways, and one was that it opened the door for income tax withholding.

Dr. Holcombe is a professor of economics at Florida State University and a Senior Fellow at the James Madison Institute. You can learn more about Dr. Holcombe’s research here.

Dr. Gmeiner is a visiting assistant professor of economics at Kennesaw State University and an externally-affiliated scholar at The Sunwater Institute. You can learn more about Dr. Gmeiner’s research here.

The feature image is from Pexels.

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