Most people take withholding for granted. Having discovered it when receiving their first paycheck, they learn to treat it as a routine fact of life.
Indeed, more than a few taxpayers seem to embrace these paycheck deductions, at least judging by the popularity of overwithholding. About three-quarters of U.S. taxpayers apparently like nothing better than a big fat refund. Making interest-free loans to the government might be a bad idea, as financial advisers are always eager to point out, but many Americans seem to value the psychological reward of a refund more highly than the opportunity cost of such a loan.
And all of this is by design.
Withholding is a practical necessity. Without it, no broad-based income tax will function. Members of Congress acknowledged that stark fact when they passed the Current Tax Payment Act of 1943, spurred on by dark warnings about the fragility of the income tax.
According to its champions, withholding would help taxpayers, especially new ones paying income taxes for the first time during the emergency of World War II. Under the pre-1943 system, people had to save throughout the year for tax payments due the following spring or make estimated tax payments along the way. But millions of inexperienced taxpayers — most of them in the lower-income brackets — were widely expected to fail this test of fiscal citizenship.
“Nothing is gained by arguing that people ought to save out of this year’s income enough money to pay the tax on this year’s income,” insisted Beardsley Ruml, champion of paycheck withholding. “The fact exists that they do not do it.”
According to Ruml and others like him, withholding would lighten taxpayers’ load and rescue them from their own poor financial planning. (Previous analysis: Tax Notes Federal, Mar. 4, 2024, p. 1731.) Fundamentally, however, withholding was designed to help the government, not taxpayers. Or more precisely, it was designed to help taxpayers so that they, in turn, could make government possible.
And not just any government, but Big Government, also known as Leviathan. “Though in 1943 the withholding mechanism was sold politically as a benefit to taxpayers, government officeholders even then widely regarded it as a means of extracting greater tax revenue,” argued economist Charlotte Twight in a 1995 article for the Cato Journal. “Withholding is the paramount administrative mechanism enabling the federal government to collect, without significant protest, sufficient private resources to fund a vastly expanded welfare state.”
Conservative Complaints
Twight is a conservative, as the titles of her books make clear: Dependent on D.C.: The Rise of Federal Control Over the Lives of Ordinary Americans (2002) and America’s Emerging Fascist Economy (1975). Her complaints about withholding are widely shared with her colleagues on the right.
Take Robert Higgs, an economic historian now retired from the Independent Institute. Higgs is one of the most prominent scholars to have written about the rise of big government, especially among those critical of this process. And he has several times made the conservative case against withholding.
“The withholding system has remained in effect continuously ever since 1943,” Higgs wrote in a 2007 article, “even though the war that prompted its creation ended 62 years ago, and the system’s perpetuation has contributed greatly to nourishing the postwar Leviathan state.”
The key issue, Higgs contended, was one of transparency — or the lack thereof. By removing people from the actual payment of taxes, withholding reduced their awareness of those taxes. That made it easier to collect those taxes in the short run — and to raise them in the long run.
The Treasury Department once admitted as much, according to Higgs:
The Treasury itself publicly acknowledges, in a fact sheet on the history of the U.S. tax system posted at its website, that wartime withholding not only “greatly eased the collection of the tax,” but “also greatly reduced the taxpayer’s awareness of the amount of tax being collected, i.e.[,] it reduced the transparency of the tax, which made it easier to raise taxes in the future.”
That fact sheet doesn’t seem to reside on Treasury’s website anymore; presumably it was stricken at some point in the past 15 years or so. But that inconvenient fact doesn’t stop people from citing the document like it’s still there. (See Jeff Jacoby, “Happy About Your IRS Refund? Don’t Be,” The Boston Globe, Apr. 16, 2024.) As the old saying goes, some facts are just too good to check.
Conservative Complicity
Many critics of withholding are drawn to one of the more delicious ironies surrounding its 1943 introduction: the important role of conservative icon Milton Friedman in developing the system.
Friedman was only 30 when he went to work for Treasury in 1941. As a young staffer in the Division of Tax Research, he was present at the creation of the wartime tax regime — a collection of fiscal tools that remain the basis of federal taxation even today.
While at Treasury, Friedman authored a series of memoranda on withholding. He conducted extensive research, evaluating foreign practices and interviewing employers to gauge their opinion on the reform. He later relayed the substance of these memos to members of Congress, testifying at hearings along with some of Treasury’s most senior officials.
Some fans give Friedman sole credit for the introduction of withholding. “He invented automatic payroll tax withholding, that World War II emergency measure that is strangely still with us,” The Los Angeles Times noted on the occasion of Friedman’s death in 2006.
Calling Friedman the inventor of withholding is a gross exaggeration. Other Friedman fans have offered more defensible descriptions of his role. In 2013, for instance, the Tax Foundation recalled that “when Friedman was a Keynesian and employed in the Treasury Department in the early 1940s, it was largely his innovation to have income taxes withheld each payroll period.”
Similarly, Jason De Sena Trennert recently claimed in The Wall Street Journal that “free-market legend Milton Friedman was instrumental” in creating the withholding mechanism of 1943.
These descriptions of Friedman’s role are closer to the mark. And Friedman himself was even more modest when describing his contribution. Withholding would have happened “had I been involved or not,” he recalled in his memoirs.
When looking back, Friedman also marveled at his transformation. He wrote, “I had completely forgotten how thoroughly Keynesian I then was!” But Friedman was doing some of his own exaggerating; as historian Jennifer Burns of Stanford University recently pointed out, he was never much of a Keynesian, even in those early days of his career.
To be sure, Friedman advanced and defended Keynesian ideas while working in Franklin Roosevelt’s Treasury Department. But he was acting and speaking as a public servant, not as an independent scholar.
He was also being practical. As Burns wrote in her 2023 biography, Milton Friedman: The Last Conservative, Friedman was defending taxation “within the context of available policy options”:
He understood that the realistic alternative to wartime taxation was not an unfettered free enterprise system paired with wise monetary management, but rather continuous monitoring of consumer and industry prices by a newly empowered government bureaucracy.
For the young Friedman, “taxation represented a less intrusive and more intrinsically conservative approach,” Burns concluded.
Whatever his views might have been in 1943, Friedman came to regret his role in developing withholding. “At the time, we concentrated single-mindedly on promoting the war effort,” he wrote in his memoirs. He continued:
We gave next to no consideration to any longer-run consequences. It never occurred to me at the time that I was helping to develop machinery that would make possible a government that I would come to criticize severely as too large, too intrusive, too destructive of freedom. Yet, that was precisely what I was doing.
“Truly,” Friedman lamented, “the road to Leviathan is paved with good intentions.”
Hurts So Good
The older Friedman yearned for the days when taxpaying was inconvenient. Like many other conservatives, he believed that more friction in the taxpaying process would create more accountability in the world of public finance.
“If people paid their taxes after receiving their income — the way they pay for every other good or service — they might expect more value for their money,” Trennert wrote in his Wall Street Journal piece.
Jeffrey A. Tucker of the Foundation for Economic Education has been even more explicit. “If we really wanted to make a wonderful change in favor of transparency and decency, one that would mark a shift in people’s perceptions of the costs of government, the withholding tax could just be repealed completely,” Tucker wrote in 2016. He posited that:
Such a seemingly small change would have a dramatic effect on public perceptions of taxation and government. Even from the age of 16, every citizen would have a more pungent reminder of the costs of government. We would no longer live the illusion that we can all get something for nothing and that government isn’t really expensive after all.
In a 2008 article, Sal Nuzzo of the James Madison Institute explained his complaints about withholding in notably vivid terms, comparing the device to the invention of casino chips. “I have often considered one of the most brilliant market inventions of the 20th Century to be the development and implementation of casino chips,” Nuzzo wrote, saying:
Consider — in separating gamblers from their actual cash and replacing it with colorful plastic discs, casino owners were able to gain a unique and very important psychological advantage over patrons. It’s a challenge to separate a player from a crisp $100 greenback featuring the bust of Ben Franklin himself; it’s far easier to part with a colorful plastic disc. The cash already feels gone — it’s just a matter of playing with the discs until there are no more left. The casino has won, even before you’ve placed a single bet.
Something similar happened with the advent of withholding, Nuzzo contended. “The federal government accomplished what casino owners would with the development of casino chips — it implemented a psychological barrier separating people who had earned wages from their money before the tax bill was officially due — and even before they had received their earned wages.”
On balance, it’s hard to argue with this assessment. Even if we reject the prospect of abandoning withholding as a functional impossibility, it seems clear that paycheck deductions have been a pillar of big government. Historians have certainly endorsed that conclusion.
“Collecting taxes at source — directly from the employer, rather than the employee — was more efficient,” concluded Friedman biographer Burns. “It was also more politically advantageous, because the tax bite was less obvious.”