An end to withholding?

Could the states’ failure to pay tax refunds end income tax withholding?

States from New York to Hawaii that have been hard-hit by the economic downturn say they have either delayed refunds or are considering doing so because of budget shortfalls.

Income tax withholding, was deemed too controversial at the time of the 16th amendment.

The 1913 statute authorized withholding of income taxes “at the source”–that is, extraction of income taxes from taxpayers’ pay envelopes before salaries were paid. Precedent existed in the income tax withholding for government employees during the Civil War (Bopeley 1943). However, the 1913 law’s withholding provision proved to be a great irritation to taxpayers, a fact downplayed in later discussions of withholding. Based on public criticism, Treasury Secretary William G. McAdoo reported that “it would be very advantageous to … do away with the withholding of income tax at the source” because it would “eliminate a great deal of criticism which has been directed against the law” (U.S. Treasury Department 1916: 19). The following year the commissioner of Internal Revenue, in a report also signed by McAdoo, formally recommended that “the provisions of law requiring the withholding of the normal income tax at the source of the income be repealed” (U.S. Treasury Department 1917: 674). The authority for withholding was withdrawn in 1917, not to be resurrected until the 1940s.

Unfortunately, in 1943 withholding was implemented as a crisis measure.

Conventional wisdom suggests that withholding became advantageous to the public with the vast expansion of income taxation that occurred during World War II. In fact, the military crisis facilitated establishment of institutional mechanisms that served long-run interests of government and its functionaries rather than the public, with crisis providing an essential ingredient and cover for all manner of misrepresentations used to secure passage of the withholding act. As Higgs (1987), Forsythe (1977), and others have noted, real or purported crisis often provides a carte blanche for expansion of government authority. In the more general framework employed here, crisis facilitates transaction-cost augmentation by influencing its determinants–providing an appealing rationale for transaction-cost-increasing measures, stimulating executive and party support for such measures, prompting favorable media coverage, and shortening the public’s time horizon so as to focus attention on the emergency at hand and deflect attention from transaction-cost-increasing features of proposed legislation.

In other words, “You don’t ever want a crisis to go to waste; it’s an opportunity to do important things that you would otherwise avoid”..

So as the steadily increasing tax was in effect hidden from the taxpayer, a bit of carrot was also created in the form of the tax refund. Since almost everyone overpays their taxes (I wonder why? Hmmmm…) most people get “money back” from what is effectively an interest free loan to Uncle Sam.

Until now.

Granted, this is a problem at the state level now, mostly because states can’t print money. But anyone want to bet that the US Treasury doesn’t decide to issue IOUs at some point with all those billions in refunds just sitting there? After all, you’re just going to waste it, right?

If people learn that the government won’t refund “their” money, they will figure out how to not pay it in the first place.