On Nov. 19, the New York Times published a very interesting front-page story about a growing movement among businesses to stop withholding income taxes for their employees. Reporter David Cay Johnston cited some 14 businesses with as many as 76 employees that have now abandoned withholding. He says that the Internet is facilitating the spread of non-withholding and that it threatens the foundation of the federal tax collection system.
Business opposition to withholding is not a new story. When the income tax was first introduced in 1913, it included a withholding provision. But business opposition forced its abandonment in 1917, after the Treasury Department decided that simply requiring businesses to report wages and other forms of income paid was sufficient to ensure compliance.
World War II led to a vast expansion of the government's need for revenue. Tax rates were increased sharply, and millions of Americans previously exempt from taxation now found themselves ensnared in the government's tax net. As early as 1941, before the U.S. was even a formal belligerent, the Treasury was asking Congress for authority to require withholding of taxes at the source. It did not act, and Treasury renewed its request in 1942. Congress finally agreed the following year, passing the Current Tax Payment Act of 1943.
Between 1917 and 1943, taxpayers simply paid their income taxes in a lump sum, due on March 15 each year on the previous year's income. For those unable to meet this obligation, the IRS allowed them to pay their tax in four quarterly payments. Compliance was generally considered to be high.
But government officials understood that the vast expansion of taxation during the war was going to severely strain the lump sum payment system. They also understood that taxes were unlikely to fall to prewar levels after the end of hostilities and that withholding would be necessary to maintain compliance. Moreover, they understood that there would be strenuous resistance to withholding and that the government needed to take advantage of the window of opportunity presented by war to get it implemented.
Even with broad patriotic support for sacrifices necessitated by the war, however, opposition to withholding was intense. Taxpayers were rightly concerned that initially they would have to pay their taxes twice: once in a lump sum for the previous year and again in the form of withholding for the current year.
What ultimately made withholding palatable was a scheme devised by business executive Beardsly Ruml. He reasoned that the value of withholding was so great that it was worth forgiving a substantial amount of tax revenue to get it. At his instigation, Congress provided forgiveness of 75 percent of a taxpayer's tax liability in either 1942 or 1943 as part of the withholding legislation, which became effective in July 1943. In short, taxpayers were induced to take the medicine of withholding through the sugar of a one-time tax cut of 75 percent.
In the short run, of course, the government lost a lot of revenue. But in the long run, it has come out way ahead. Withholding constituted a significant tax increase in and of itself, as well as making more effective high rates of taxation in the future. Economist Charlotte Twight notes that while the idea that withholding would constitute a tax increase was not advertised, it was "candidly acknowledged in congressional hearings."
The biggest way in which taxes are raised by withholding is that the government gets the use of a taxpayer's money long before his tax liability is due. In 1998, the IRS withheld almost $1 trillion from the paychecks of American workers, $120 billion more than their actual tax liability. While taxpayers received a refund on the amount overwithheld, they did not receive interest on it. With the Treasury Bill rate at about 5 percent in 1998, taxpayers therefore lost at least $6 billion in income just on the taxes that were overwithheld. The loss of income on all taxes withheld would be several times greater.
Although taxpayers were mollified by the clever strategy of combining a tax cut with the implementation of withholding in 1943, businesses were not. They took the view, quite correctly, that much of the burden of tax collection had been shifted from the government to them. Henceforth, employers would have to expend their own resources to withhold taxes from their workers, account for them properly and remit them to the Treasury in a timely fashion. Failure to do so invited severe penalties from the IRS.
In spite of IRS threats, one employer, Vivien Kellems of Connecticut, stopped withholding taxes for her workers once World War II ended. She explained that withholding had been instituted as a temporary war measure. With the end of war, therefore, it was no longer justified. Kellems fought the IRS over withholding for years, publishing a book on the subject in 1952, "Toil, Taxes and Trouble."
Now it appears that the spirit of Vivien Kellems continues to live. And tax officials clearly recognize the threat that failure to withhold represents. Says former IRS Commissioner Sheldon Cohen, "The system simply cannot work if they (employers) get away with it."
However, a growing number of legal scholars now
believe that withholding has outlived its purpose. One is Emory law professor Richard L. Doernberg, who has published an article, "The Case Against Withholding," in the Texas Law Review (December 1982). He concludes that withholding is no longer necessary for compliance because computers make full matching of income sources and tax returns possible. Hence, businesses should no longer be forced to be de facto IRS agents, collecting the government's revenue for it without compensation.
Elimination of withholding would constitute a significant tax cut for individuals because they would once again have full use of their money until their taxes are due on April 15. Perhaps this is a tax cut both Republicans and Democrats can agree upon.