Every old tax was once young, and it’s easy to forget that taxes don’t arrive on the scene as fully developed fiscal tools, extracting money from a willing populace and delivering it to a hungry government. In fact, tax innovations tend to appear in embryonic form, cobbled together from the vague ideas and clever intuitions of both lawmakers and their expert advisers. The moment of fiscal innovation isn’t really a moment at all — it’s a process.
In his recent book, Figuring Out the Tax, Duke University law professor Lawrence A. Zelenak describes this messy process, exploring how Congress and Treasury tried to hammer out the crucial details of our modern income tax — details that were not, in fact, peripheral to the levy but central to its functioning and long-term survival.
A colleague once reminded me that lawyers are often eager historians, but they come to their subject with a clear agenda: “Lawyers want their history to do something.” He meant, I think, that lawyers are most interested in elements of the past that clearly inform our understanding of the present. Non-lawyer historians tend to sneer at such “presentist” motivations, but almost every student of the past approaches the subject with modern-day concerns in mind.
Zelenak, to his credit, embraces the transparency of present-minded history, approaching his study of the early income tax by looking for specific topics that are (1) “important to a basic understanding of today’s federal income tax, (2) enriched by historical analysis, and (3) just plain interesting.”
In addition to telling a series of discrete but interesting stories, Zelenak also tries to tell a larger, quite important one. “Considered together,” he writes, “the stories told here suggest some insights into how tax laws — and perhaps laws more generally — evolve over time, and into the circumstances which determine whether Congress corrects early mistakes or allows those mistakes to persist.”
The key variable, he concludes, is necessity.
Withholding as Necessity
Among the discrete stories that Zelenak sets out to tell is the early history of withholding. It’s a pivotal issue in the development of the American fiscal state. Absent withholding, the individual income tax would never have become the revenue workhorse that it did during the latter half of the 20th century. A mass income tax simply wouldn’t work without withholding and its close cousin, third-party information reporting.
The story of withholding is partly a tale of this necessity, and modern-day imperatives can give it a sense of near inevitability. But the invention of income tax withholding was anything but certain. Nor, incidentally, was it distinctively American, having begun not in 20th-century America but in 19th-century England.
Withholding arrived in the United States fitfully (like the income tax itself), its history a jumble of administrative necessity, political resistance, and eventual, if only partial, success. However, it tells us something important about how and why lawmakers make durable changes to the tax system.
To understand the origins of modern withholding, it’s useful to supplement Zelenak’s book with a 2016 article by Ajay K. Mehrotra, executive director of the American Bar Foundation and a Northwestern University law professor. In “‘From Contested Concept to Cornerstone of Administrative Practice’: Social Learning and the Early History of U.S. Tax Withholding,” Mehrotra explores the process of “social learning,” by which policymakers study the past to chart a route into the future. (“‘From Contested Concept to Cornerstone of Administrative Practice’: Social Learning and the Early History of U.S. Tax Withholding,” 7(144) Columbia J. Tax Law (2016).)
“Leading tax experts and government officials have relied on the legacy of past policies and the previous social and political responses to pressing problems to understand how best to build an effective tax collection system,” Mehrotra writes. This process explains the development of withholding and information reporting, but it also sheds light on the broader “social, political, and economic conditions that are necessary for effective administrative reform” of all types.
Civil War Withholding
The first American experiment with withholding came during the Civil War, when Congress imposed the first individual income tax, a 3 percent levy on “annual gains, profits, or incomes” exceeding a $600 exemption, and a 5 percent levy on income over $10,000. The Union government cast its net wide, laying claim to a share of that income “whether derived from any kinds of property, rents, interests, dividends, salaries or from any profession, trade, employment or vocation carried on in the United States or elsewhere, or from any source whatever.”
Such a broad tax base demanded the development of some robust administrative capacity. Lawmakers worked quickly to build this fiscal infrastructure, creating a new Bureau of Internal Revenue (BIR) that remains with us even today (albeit under a slightly modernized name). The BIR was endowed with sweeping powers to assess and collect taxes, and it soon hired an “army of officials” to make sure that taxpayers met their obligations. (Prior analysis: T ax Notes, Dec. 24, 2001, p. 1739.)
Lawmakers, however, also delegated some collection responsibilities to nongovernmental entities, including financial institutions and railroads. Such businesses were required to withhold taxes due on interest and dividends paid to bondholders and stockholders, respectively. Moreover, lawmakers required the federal government to withhold taxes on salaries paid to government employees.
Union lawmakers turned to withholding after studying the British version of an income tax, which had introduced a withholding feature in 1803. Mehrotra quotes a key lawmaker to make the point. “I think it is a pretty safe rule to follow the practice of older nations who have had this tax for fifty years,” observed Sen. James Simmons of Rhode Island.
Withholding promised to make the income tax not just more collectable, but more palatable as well. American taxpayers, like their British counterparts, were inclined to view the income tax as intrusive, and critics complained constantly about the “inquisitorial” methods needed to collect it. BIR officials were empowered to explore the intimate financial lives of recalcitrant taxpayers. Assessed taxes, moreover, were a matter of public record, as were the incomes from which they were derived. Anyone with an inclination could wander down to the local BIR office and ask to see the return of any taxpayer they wished.
Withholding did not eliminate these intrusive elements of the new tax system, but it did tend to limit the use of more irritating (and aggressive) collection techniques. Withholding seemed to keep the tax man removed, if only notionally.
20th-Century Withholding
By most accounts, withholding proved to be a success during the Civil War. By 1865 nearly 40 percent of total income tax receipts were collected at the source, which was impressive since it only applied to the “normal” tax due on income above the exemption, not to the graduated surtax rates that applied to wealthier taxpayers. Successful or not, however, withholding was a creature of the income tax, and when the tax disappeared in the early 1870s, so did this collection innovation.
In 1913, however, the Civil War was pivotal in shaping a new version of the individual income tax, including a new withholding regime. As Zelenak recounts, tax experts of the early 20th century were convinced that withholding was the best way to guard against rampant tax evasion. Economists like Edwin R.A. Seligman understood the limitations of withholding, especially its uneasy relationship with graduated rates. In the economy of early 20th-century America, using withholding to collect anything more than a flat rate of tax was practically infeasible, even if it was theoretically possible.
However, the efficiency of withholding was worth the sacrifice of graduated rates, Seligman argued: “We could well afford to be content with a successful income tax, even if it be a proportional one.”
American lawmakers — including Rep. Cordell Hull, a Tennessee Democrat often described as the father of the income tax — followed Seligman’s advice, incorporating an ambitious withholding feature into their nascent plan for an income tax. Hull, like his Civil War predecessors, looked hopefully at British precedent. “Stoppage at the source is the chief cause of the great success of the English income tax,” he declared in a 1914 speech.
The 1913 levy did, in fact, feature graduated rates, but Hull and his colleagues kept things simple by requiring that only the flat rate normal tax of 1 percent be currently withheld; surtaxes would be paid through an annual return filed after the end of the tax year.
This same expedient had been used to good effect during the Civil War. Similarly, the 1913 legislation followed Civil War precedent by enlisting the efforts of private sector entities to help collect tax on “interest, rent, salaries, wages, premiums, annuities, compensation, remuneration, emoluments, or other fixed and determinable annual gains, profits, and income.”
The limitation of withholding to the amount of the normal tax was necessary but costly — and not just in terms of revenue. “The failure of the withholding mechanism to collect the surtax at the source was to play a crucial role in the congressional decision to abandon withholding just four years later, in 1917,” Zelenak writes. As surtax rates began to climb in the years leading up to the American entry into World War I, the percentage of total income tax revenue generated by the normal tax continued to fall. In 1914, not quite 20 percent of individual income tax revenue was collected through withholding. Two years later, that figure had fallen to less than 10 percent. Clearly, withholding was not crucial to the administration of the new levy, even if it did curb underpayment at the low end of the income scale.
Meanwhile, private entities required to do the withholding were none too pleased with the administrative burden foisted on them by Congress. For many companies, the task was probably not especially onerous because corporate financial controls were developing rapidly in these boom years of the industrial economy. For other companies, however, especially in the financial sector, withholding was proving to be a heavy burden. And those companies were quick to voice their complaints.
Impressed by the outcry on Wall Street and reassured by the low percentage of total revenue being collected through withholding, lawmakers moved in 1917 to repeal stoppage at source requirements. As a substitute, they moved to a system of reasonably comprehensive information reporting, which drew far fewer complaints from the private sector and seemed to satisfy Treasury.
This system of information reporting may well have been effective at improving compliance, but as Zelenak points out, policymakers had no way to know for sure. To say that compliance research was in its infancy during the late 1910s would be to exaggerate its stage of development. In hindsight, at least, modern-day research on information reporting suggests that it was probably getting the job done — or at least mostly done.
In any case, withholding disappeared in 1917 and did not reappear in the nation’s fiscal system until the 1930s, when New Deal policymakers made it a cornerstone feature of the new payroll tax used to finance Social Security. The use of withholding for this new, flat rate wage tax was widely considered a necessity by fiscal experts of the era because the levy would apply to millions of new taxpayers, many of them quite unsophisticated in terms of managing their financial lives. Expecting low-wage workers to pay the new tax using a system of annual returns was unreasonable, they believed. Current collection through stoppage at the source was the only plausible solution.
As Mehrotra observes, the reintroduction of withholding was another example of social learning among policymakers. Many aspects of the New Deal were developed with a close eye on Progressive-era precedent, and the financing regime for Social Security was just one more example. As Treasury officials pointed out, the comprehensive system of information reporting instituted after 1917 could serve as a model. The new system of payroll tax withholding — while much broader in scope — would build on this existing system, as well as the pre-1917 experiment with actual withholding. At its core, the new payroll tax would simply require an elaboration of past practice, not a wholesale reinvention. As one Treasury official quoted by Mehrotra declared at the time, “Little more would be required of the employer than he already does.”
Withholding Writ Large
Withholding for Social Security proved successful — and a useful trial run for the wholesale return of income tax withholding in 1943. Policymakers worked feverishly in the early years of World War II to build a workable revenue system adequate to the mammoth task at hand. Chief among their innovations was a dramatic expansion of the individual income tax. Between the late 1930s and the mid-1940s, the income tax went from being a narrow tax paid by the rich to a mass tax shouldered by nearly all working Americans. As Zelenak notes, the share of American households paying the tax increased from 5 percent in 1939 to 74.2 percent in 1945.
Withholding was crucial to making this expansion workable. Withholding of tax payments on a current basis (rather than waiting for end-of-the-year return filing) would allow for more effective control of rising prices. By withdrawing consumer purchasing power quickly, it could help prevent a ruinous upward surge in prices.
Moreover, withholding would spare new taxpayers from their presumed inability to manage their cash flows. Taxpayers of modest means were unaccustomed to setting aside money for end-of-year tax payments, or even quarterly estimated tax payments. If policymakers hoped to forestall a compliance crisis, they would need to collect tax payments on a current basis. Once again, withholding seemed like the right tool at the right time.
The Current Tax Payment Act of 1943 returned income tax withholding to the federal revenue system for the first time since 1917 — and it has remained a fixture of national finance ever since. However, its reincarnation in 1943 was not a moment of wholesale innovation but, rather, an example of social learning within a context of exigent circumstances.
In trying to distill lessons from the history of withholding, including this final act in the 80-year drama, both Zelenak and Mehrotra have important points to make. Zelenak emphasizes the importance of necessity in the development of the federal income tax. Policymakers tend to make taxes more functional only when those changes are necessary.
In this sense, withholding was a useful but dispensable innovation when it was enacted in 1913; its nonnecessity made it vulnerable to motivated arguments from its more ardent opponents, who managed to get it repealed in 1917. By 1943, however, withholding was widely understood to be a crucial, indispensable feature of a mass-based income tax. As such, lawmakers made it a centerpiece of the federal tax system, and it has remained that way ever since by virtue of its undeniable necessity.
Mehrotra, meanwhile, reminds us that good ideas have a history. In fiscal policy, if necessity is the mother of invention, past experience is its father. Durable tax innovations rarely spring fully formed from the minds of farsighted lawmakers, or even the brainy experts who advise them. Rather, they are the product of a gradual process marked by invention and experimentation — not to mention both failure and success.
The lesson for today’s policymakers includes both bad news and good news. On the one hand, radical innovations are unlikely to stick around permanently. But on the other, their short-term failure can pave the way for long-term success. As Mehrotra points out in his conclusion, the 1917 repeal of withholding was a constructive moment for the longer-term process of developing a durable withholding regime, because it strengthened the new system of information reporting that later featured prominently in the revival of withholding. “Current failures,” Mehrotra concludes, “may turn out to provide the foundation for future success.”
That’s a hopeful upshot for anyone discouraged by the numerous, and regular, failures of administrative tax reform.