The Liberty Papers

Brad Warbiany’s post about income tax withholding reminded me that, while the income tax came about in 1913, payroll withholding did not come into existence until the Second World War. Ironically, one of the people who came up with the idea was Milton Friedman, as Linda Chavez learned when she visited with him several years ago:

“I have to write a check every quarter to pay my taxes because I’m self-employed,” I said. “If more Americans had to do that instead of having the money automatically deducted from their paychecks, people would quit thinking of taxes as the government’s money rather than their own. We’d have a huge tax revolt,” I asserted.

Suddenly I heard Rose’s voice from the kitchen. “See, I told you what mischief you were causing,” she hollered, as Milton broke into a deep-throated laugh.

“The withholding tax was my fault,” he explained. Apparently, as a young economist working for the Treasury Department, Friedman helped design the federal withholding tax. It was not a totally indefensible act though, he said. “Without it, we would not have had a steady flow of money into the Treasury to fight World War II.”

Friedman also discussed his role in creating the withholding system we live with today in a Reason Magazine interview:

Reason: You were involved in the development of the withholding tax when you were doing tax work for the government in 1941-43?

Friedman: I was an employee at the Treasury Department. We were in a wartime situation. How do you raise the enormous amount of taxes you need for wartime? We were all in favor of cutting inflation. I wasn’t as sophisticated about how to do it then as I would be now, but there’s no doubt that one of the ways to avoid inflation was to finance as large a fraction of current spending with tax money as possible.

In World War I, a very small fraction of the total war expenditure was financed by taxes, so we had a doubling of prices during the war and after the war. At the outbreak of World War II, the Treasury was determined not to make the same mistake again.

You could not do that during wartime or peacetime without withholding. And so people at the Treasury tax research department, where I was working, investigated various methods of withholding. I was one of the small technical group that worked on developing it.

One of the major opponents of the idea was the IRS. Because every organization knows that the only way you can do anything is the way they’ve always been doing it. This was something new, and they kept telling us how impossible it was. It was a very interesting and very challenging intellectual task. I played a significant role, no question about it, in introducing withholding. I think it’s a great mistake for peacetime, but in 1941-43, all of us were concentrating on the war.

I have no apologies for it, but I really wish we hadn’t found it necessary and I wish there were some way of abolishing withholding now.

In the context of World War II, and considering the vast amount of money needed to fight and win that war, withholding does make sense. However, payroll withholding has outlasted that war by more than 60 years now and its impact has been felt far and wide.

Because of payroll withholding and the fictional “refunds” that people look forward to every April, the true cost of government is never revealed to the public. Yes, you see small amounts of money being taken out of your paycheck, but the impact of having to write a check every year, or every quarter, would be far greater and, as Brad points out, go a long way toward making people more aware of just how much money the government takes from them every year.

More importantly, though, payroll withholding is yet another example of a program adopted during a crisis, that far outlives the crisis for which it was created. Payroll withholding has lasted six decades.  Does anyone think the PATRIOT Act is going away anytime soon ?