Withholding the Taxpayer Hostage; D. Boudreaux and A. Morris

Withholdingthe TaxpayerHostage by Donald J. Boudreaux and Andrew ~ Morriss H ow often have you heard people say with pleasure, "I got a tax refund this year!"? Americans have grown so immune to income tax withholding that many people regard IRS refunds as gifts. Misperceptions about with holding are widespread. In fact, withholding is a regressive, costly, and furtive system for collecting taxes. Fifty-six years ago Congress approved the current system under which a sum is withheld from each paycheck and deposited with the government, with taxpayers and the govern ment settling accounts once a year when tax returns are filed. According to Milton Fried man, who helped create the withholding sys tem as a young economist in the Tax Research Division during World War II, withholding was justifiable during the war because it raised revenue for the war effort that could not have been raised otherwise.

Is Withholding Justified? What justifies withholding during peace time? Withholding is said to have three advan tages over a system in which taxpayers pay their tax bills annually in one lump sum. First, withholding guards against the threat that people will have too little money on hand to pay their taxes. Some congressmen even Donald Boudreaux is president ofthe Foundation for Economic Education. Andrew Morriss is professor of law and associate professor of economics at Case Western Reserve University. 48 argued in 1942 that withholding was neces sary to protect taxpayers from loan sharks at tax time! Second, because it reduces current disposable income, withholding is said to be anti-inflationary.Third, withholding smoothes the government's revenue stream, making government spending simpler. None of these goals requires that employ ees who have taxes withheld not be compen sated for lost interest. The government could do this simply by paying interest on the money withheld. This is not a new idea. In 1912, the federal government experimented with interest-bearing tax-anticipation notes; the secretary of the Treasury sold the first note to President Teddy Roosevelt. Flaws in the design of these notes doomed them to failure, but the principle remains correct-early pay ment of taxes ought to be compensated by the payment of interest.

Expensive and Regressive Withholding costs taxpayers a great deal of money. With some back-of-the-envelope cal culations based on IRS data, we estimate that since its inception in 1943 withholding has taken over $400 billion (calculated in 1995 dollars) in interest from taxpayers. In a single year withholding costs the average worker over $100 in forgone interest. Not surprisingly, withholding also unfairly penalizes wage income relative to nonwage income. Consider two couples, Ted and Tammy Toiler and Pierre and Priscilla Pluto crat. Both couples have annual federal tax lia bilities of $10,000, and both structure their withholding and estimated tax payments so that they legally minimize the amounts they pay to the IRS before April 15. The only dif ference between these couples is that the Toil ers just have wage income and the Plutocrats live exclusively on investment income. Thus the Toilers have taxes withheld from their biweekly paychecks while the Plutocrats make four estimated tax payments a year.

Using a 4 percent interest rate, at the end of the year the Toilers' lost interest from with holding (about $273) is 17 percent higher than the Plutocrats' lost interest (about $234). This disparity in tax treatment is caused by the government's holding more of the Toilers' money for a longer time than it holds the Plu tocrats' money. Such disparities are rampant in our tax sys tem. Procedural quirks and unintended conse quences result in radically different tax rates for similar amounts of income based on the source, the taxpayer, and, for all we know, the phases of the moon. There is no rational basis for applying a higher implicit tax to wage income than to nonwage income. A business that behaved in a like fashion, randomly charging some customers higher prices for example, would quickly go out of business. The great "advantage" of government for the tax and spend crowd, of course, is that it short circuits the market forces which penalize irra tional behavior by private businesses.

Deceived Taxpayers The withholding tax is also a potent cause of fiscal illusion among taxpayers. Rather than write an annual check to the government for the full amount of their tax bills, most tax payers on April 15 either send in a claim for a refund or pay only a small fraction of their taxes. In his 1989 book, A Law Unto Itself: Power, Politics and the IRS, David Burnham recounts a Harvard Medical School faculty member's confession that he hardly notices his paycheck deductions. Burnham reports 49 that accountants and tax lawyers now find that large numbers of taxpayers no longer view the IRS "as a hard-nosed tax collector" but rather as "a benevolent bureaucracy that gives away money to the needy middle class." Thus, because taxpayers have become immune to the full magnitude of the tax bite, government growth is greater than it would be if there were no withholding or if withholding were less clandestine.

A Proposal for Reform The best plan would be to abolish the income tax altogether. Until we can do so, however, the government ought to pay interest on money withheld as well as on estimated tax payments from the date of deposit of these sums with the Treasury. Short-term T bills provide a market rate of interest that can be easily used; a few lines of computer code can perform the calculations necessary to credit this interest to the "Amount Withheld" boxes on the W-2 forms employees receive at the end of the year. Moving one step further to cure the problem of the disguised cost of government is almost as easy. Employers can deposit withheld tax payments (income and Social Security) into interest-bearing tax escrow accounts from which the government can borrow at T-bill rates. These accounts could then be released to employees before taxes are due. The govern ment would be assured that individual taxpay ers have the funds available to pay their taxes, while taxpayers would experience the full cost of Washington's operations. Adoption of this proposal might significantly restrain the growth of government spending by erasing the fiscal illusion caused by the current withhold ing scheme.

Genuine fairness requires reform of the regressive and deceptive system of tax with holding. Championing reform of the existing withholding system promises to be a good first step for politicians who regard fairness as something other than a slogan for use in class warfare. D Economic Notions 'Economies Opportunity Cost and Hidden Inventions by Dwight R. Lee F ew people think about opportunity cost as systematically as economists do, but all of us are constantly guided by the opportunity costs we face. If, as you are reading this arti cle, you learn that someone a few blocks away is giving $1,000 to anyone who comes by, I predict with confidence that you will quickly stop reading because of the cost of continu ing. Unfortunately, we commonly accept arguments that would make sense only if people ignore the opportunity costs of their decisions. Hidden Inventions A persistent claim is that in market economies where the profit motive reigns supreme, extremely valuable inventions are hidden to prevent their sale. Supposedly,if the inventions were available they would destroy the profits of big corporations by making their products obsolete. So these corporations buy up wonderful inventions to make sure we can't buy them.