Withholding began as a wartime emergency in 1943 and simply never left

Quick quiz. What is the most successful tax-collection technology in the history of the United States? It is not a computer. It is not an audit. It is a sentence on your pay stub, a line that says "federal withholding," and the single best trick in it is that you never touch the money. You are told how much you earned and then, in the same breath, how much you did not.

Let me tell you how that line got there. It is a story of a war, a clever man at a department store, a famous economist who later wished withholding could be abolished, and a temporary emergency measure that has now outlasted everyone who voted for it. And it holds a lesson that every taxpayer should understand about the difference between a tax you pay and a tax you feel.

The world before withholding

Before 1943, most Americans did not pay their income tax out of each paycheck. The few who owed it paid after the fact. A person earned income during the year, filed a return the following March, and paid the bill in a lump sum or in installments. For a time, the tax was an annual event with a deadline, a visible bill, and a day of reckoning.

That arrangement had a feature the modern system does not: it made the cost of government vivid. A person who had to write a check for a year's tax in one stroke knew exactly what he was paying. He also had to save the money, which a good many people did not manage to do. The tax was real, and it hurt.

It also covered few people. The income tax before the Second World War reached only a small part of the population, a few million households. The rest of the country never filed a return.

The war changes the arithmetic

The war changed everything. The government needed money in amounts without precedent, and it needed it fast. The Revenue Act of 1942 reached deep into the working population, lowering exemptions and raising rates, so that, for the first time, millions of ordinary wage earners owed income tax. The number of individual returns jumped from fewer than four million in 1939 to about 50 million in 1945.

That produced an administrative problem. The tax was owed after the year ended. Workers whose incomes had risen with wartime wages would owe a large bill in March of the next year, and many would not have the money. Collecting from tens of millions of new, modest-income taxpayers after the fact looked like a recipe for delinquency and for rising pressure on the government to forgive or delay what was owed. The Treasury wanted the money flowing as the money was earned.

The solution was to put the collection at the source. The employer would deduct the tax from each paycheck and send it to the Treasury, which is how the tax was collected throughout the war and afterward. Paycheck withholding became law in the Current Tax Payment Act of 1943, signed by President Franklin Roosevelt in June 1943, with withholding beginning in July.

Ruml and the forgiveness

The idea had an energetic champion in Beardsley Ruml, who was chairman of the Federal Reserve Bank of New York and also an executive of the Macy's department store. Ruml promoted a "pay-as-you-go" plan, in which taxes would be paid in the year they were earned. The appeal was obvious: it brought money into the Treasury sooner, and it spared the taxpayer a large bill after the fact.

But a pay-as-you-go system raised a transition problem, and it is the part of the story that deserves the most attention. If the government began collecting 1943 taxes during 1943, what happened to the tax owed on 1942 income, which was still due in 1943? Taxpayers would face two years' tax in a single year, a double burden. The solution, in the Act, was to forgive most of one year's tax. Under the 1943 law, a large part of the liability for the earlier of the two years, in broad terms about three-quarters of the lesser of the two years' bills, was cancelled, so that taxpayers could move to the new system without paying twice.

You can see the politics. A reform that begins by cancelling most of a year's tax for tens of millions of people is a reform that will pass. The cancellation was the sweetener. It made withholding popular, so that a measure that has a quiet downside came dressed as a gift. I will not tell you that the forgiveness was a scandal, because it solved a real transition problem. But notice how the sale was made. The public was shown a tax holiday and not the long-term effect of a system that takes the money before it ever arrives.

A young economist at the Treasury

Among the staff who worked on the design at the Treasury was a young economist named Milton Friedman, who worked on tax policy there during the war. In later life, he spoke and wrote about the episode. The gist, which you can find in his memoir and in interviews, is that he helped to develop the withholding system as a wartime necessity, said it would have been introduced whether or not he had been involved, and acknowledged that he had been helping to build machinery for a government he later criticized as too large. In an interview he said he had no apologies for it but wished it had not been necessary and that there were some way of abolishing it. I am paraphrasing, and I would encourage you to read his own account rather than my summary.

Consider what that means. One of the most influential advocates of limited government in the twentieth century acknowledged that he had helped build machinery that made a larger government possible. He did not say the machinery was a fraud. He said it was effective, and that is the problem.

Why a hidden tax grows

Now to the argument. I want to make it in numbered steps, because it is the claim that matters.

1. People respond to what they notice. Economists call this salience. A cost that is vivid gets a response, and a cost that is hidden does not. Studies of consumer behavior have found that shoppers react more to a price they see on the shelf than to a sales tax added at the register, and spend accordingly. A tax that is built into the paycheck before you see it is the extreme case of an invisible price.

1. Withholding makes the cost of government invisible at the moment of decision. A worker sees a net paycheck. The gross amount and the tax withheld are details on a stub. The worker never writes a check for the year's federal income tax unless he underpaid. Nothing in the weekly experience of earning tells him what the government takes.

1. Voters who cannot feel a cost do not resist it. A citizen who had to write a single check each April for his full tax would have a strong reason to ask what the government was doing with it. A citizen who gets a refund, which feels like a gift, has a reason to be pleased. The refund is the most remarkable invention of all: a government that took too much during the year returns the excess in the spring, and the taxpayer thanks it. He has been given back his own money and told it is a prize.

1. A tax that is not felt can rise without a revolt. There is no proof that withholding alone caused the growth of the federal government. A good many other forces were at work, from the Cold War to the entitlement programs. But the mechanism points in one direction, and it is the direction conservatives have always worried about: it lowers the political price of raising the bill.

1. Therefore visible taxation is a safeguard of liberty. The Declaration of Independence lists among the grievances against the King that he was "imposing Taxes on us without our Consent." Consent requires knowledge. A citizen cannot consent to what he cannot see.

The objection: it works, and people like it

The best defense of withholding deserves its due.

Withholding is convenient. It spares families the pain of saving for a big bill. It reduces non-compliance, since the money never passes through the worker's hands to be spent. It lets the government collect revenue steadily instead of in a lump. Many families like the refund, and use it as a forced savings account. If you took withholding away, many people would fall into debt to the Treasury, and enforcement would be far harsher.

I accept most of that, and I am not proposing to repeal withholding by Friday. Let me answer.

First, convenience is the point. The same features that make withholding convenient make the tax invisible. You cannot have the benefit without the cost. A system that is painless to pay is painless to raise.

Second, the "forced savings" argument is a claim that the government should hold your money without interest so you do not spend it. A refund of $2,500 is an interest-free loan to the Treasury of $2,500, spread across the year. A family that wanted to save could do so on its own terms, and earn something on it.

Third, compliance concerns are legitimate, which is why a sensible reform would not abolish withholding but make the tax visible. Imagine a pay stub that shows, in large type, the total of every federal tax taken in the year to date, including the employer's share of payroll tax, which is a cost of employing you that comes out of what you would otherwise be paid. A transparent system could keep the convenience and restore some of the awareness.

What the Founders would ask

The Founders knew how governments hide their burdens. In Federalist No. 58, Madison wrote that the power over the purse may be regarded as the most complete and effectual weapon with which any constitution can arm the immediate representatives of the people, for obtaining a redress of every grievance. Two ideas run through that discussion. First, the people hold their government accountable through control of its money. Second, that control means little if the people cannot see how much of their money the government is taking. A tax collected before the paycheck is cashed makes the accounting harder.

There is a historical echo worth noting. The revolutionary generation reacted to a tax on tea and to the Stamp Act, taxes that were noticed because they were visible, on goods and documents the colonists handled directly. A modern citizen has a tax that is never handled at all. I do not suggest that withholding is tyranny. I suggest that the tyranny of the Stamp Act was noticed because it was a stamp, and that a government which learns to collect without being noticed is a government that has solved the colonists' problem in its own favor.

What it means now

Here is a modest set of proposals, each one respectful of the need for revenue and each aimed at putting the bill back in front of the people who pay it.

• A full-cost pay stub. Require the pay stub, and the year-end statement, to show total federal, state and payroll taxes, including the employer's share, as a share of total compensation.
• A year-end tax bill in plain English. Every household should see one page that says: you paid this much in tax, and it went to these categories of spending. The budget numbers are public, and the national debt clock shows how much of the spending is borrowed.
• A right to adjust withholding, advertised. The IRS provides a withholding estimator and a form for changing your withholding, the W-4. Most workers never touch it. A taxpayer who sets withholding to come out even, instead of to produce a large refund, keeps his own money through the year and notices what the government takes.
• A debate on moving to quarterly or annual payment for willing households. That has trade-offs, and I would not impose it. Offering it as a choice would be a test of how much people value visibility.

For the same reason, the arguments about transparency run across the rest of the tax code. See tax complexity is a subsidy for lobbyists, and the code shows how it works on how complexity hides costs, and The Sixteenth Amendment and the 1913 bargain that built the income tax for the earlier chapter of the same story, in which a tax sold as a light burden on a few became a mass tax in wartime. Another invisible tax, inflation, is the subject of inflation hurts the poor most, and the arithmetic of a fixed paycheck.

The case in brief

1. Before 1943 most Americans paid income tax after the year ended, in a visible lump sum, and few households owed any.
2. The Current Tax Payment Act of 1943, signed in June, started withholding in July as a wartime measure, and cancelled most of one year's tax to ease the transition, which made it popular.
3. Beardsley Ruml promoted pay-as-you-go, and Milton Friedman, who worked on it at the Treasury, later acknowledged that he had helped build machinery for a government he came to see as too large.
4. A tax taken before the paycheck is received is a tax citizens do not feel, and a tax that is not felt is easier to raise, which sits badly with the Declaration's complaint of taxes imposed without consent.
5. The answer is not to abolish withholding but to make the cost visible: full-cost pay stubs, a plain year-end bill and a withholding setting that leaves no giant refund.

What you can do: pull out your latest pay stub, add up every tax on it including the employer's payroll share if you can find it, and check your W-4 against the IRS withholding estimator so you notice what you are paying.