But three factors caused the government to need more money: first, the massive debt caused by New Deal spending programs; second, future obligations created by entitlement programs; third, the Second World War. Needing more money, the government raised income tax rates significantly.
The new rates were publicized, yet people didn’t understand that, on March 15 of each year, they would be forced to send thousands of dollars to the government. There was a big problem in the making. What would the government do when the majority of its citizens didn’t pay their taxes — or were unable to pay their taxes.
Historian Amity Shlaes recounts the looming problem facing government bureaucrats:
As March 15, 1943 neared, though, it became clear that many citizens still were not filing returns. Henry Morgenthau, the Treasury secretary, confronted colleagues about the nightmarish prospect of mass tax evasion: “Suppose we have to go out and try to arrest five million people?”
Clearly, a new system was needed. It wouldn’t work simply to present each individual America, once a year, with a bill for thousands of dollars.
Enter Ruml, man of ideas. At Macy’s, he had observed that customers didn’t like big bills. They preferred making payments bit by bit, in the installment plan, even if they had to pay for the pleasure with interest. So Ruml devised a plan, which he unfolded to his colleagues at the Federal Reserve and to anyone in Washington who would listen. The government would get business to do its work, collecting taxes for it. Employers would retain a percentage of taxes from workers every week — say, 20 percent — and forward it directly to Washington’s war chest. This would hide the size of the new taxes from the worker. No longer would the worker ever have to look his tax bill square in the eye. Workers need never even see the money they were forgoing. Withholding as we know it today was born.
The new tax system had several advantages. First, the government would get money in a steady stream all year long instead of one big amount once a year. Second, the government could collect interest on some of that money before it was spent. Third, the government could collect excess money from each individual, and then give an annual refund — meaning that the government had gotten an interest-free loan from each citizen. Fourth, the ordinary taxpayer would never really understand how much money the government was taking.
Workers received their pay, but before they got it, the government had already taken a cut. The government could steal their money without the workers feeling the pain. There was also no consent requested from, or given by, the worker. The money simply disappeared into the government.
This was a revolution in politics and economics, both of which depend more on perception than reality, more on psychology than mathematics. Amity Shlaes explains:
This was more than change, it was transformation. Government would put its hand into the taxpayer’s pocket and grab its share of tax — without asking.
The transfer of the concept from a department store to the government made sense: both institutions could make life more palatable for the individual by offering a “pay as you go” program.
The differences, however, were significant: the department store still required a deliberate volitional act of payment from the consumer monthly. The government required neither consent nor willingness, nor even awareness, on the part of the worker.
Ruml hadn’t invented withholding. His genius was to make its introduction palatable by adding a powerful sweetener: the federal government would offer a tax amnesty for the previous year, allowing confused and indebted citizens to start on new footing. It was the most ambitious bait-and-switch plan in America’s history.
The advantage of the withholding tax was that it made the process more comfortable for the taxpayer. But comfort is not freedom. By analogy, one might add sugar to poison to make it easier to consume, but it remains poisonous. The withholding tax was easier to endure, but in the end, the government still confiscated a worker’s money.
Taxpayers were faced with painful choices. In the absence of a withholding plan, some taxpayers took on debt in order to pay the massive annual tax bill. Withholding would avoid this debt. It also helped the war effort, and in 1943, as Amity Shlaes writes, that was loyal thing to do:
Ruml advertised his project as a humane effort to smooth life in the disruption of the war. He noted it was a way to help taxpayers out of the habit of carrying income tax debt, debt that he characterized as “a pernicious fungus permeating the structure of things.” The move was also patriotic.
The mechanism for orchestrating a withholding tax at all would have been technically daunting. To orchestrate it in a short period of time would have been impossible. But something made it possible: the government had already put in place a similar system to collect taxpayer’s money for the Social Security system.
Implementing the withholding program was very possible, even in a short period of time, because of the organizational infrastructure of the Social Security program. The IRS could simply piggyback on Social Security collections.
Ruml had several reasons for wagering that his project would work. One was that Americans, smarting from the Japanese assault, were now willing to sacrifice more than any other point in memory. The second was that the federal government would be able to administer withholding - six successful years of Social Security showed that the government, for the first time ever, was able to handle such a mass program of revenue collection. The third was packaging. He called his program not “collection at the source” or “withholding,” two technical terms for what he was doing. Instead he chose a zippier name: “pay as you go.”
In addition to a more palatable name, the new withholding system had advocates and fans among the economic experts of the day. John Maynard Keynes saw taxes, not only as a method for collecting needed revenue for the government, but as a method for regulating the macroeconomy. Keynes advised that, in some circumstances, governments should collect taxes even if they don’t need the money.
The withholding system allowed the government to easily and quickly change or increase the amount of taxes it was collecting, and so respond in Keynesian fashion to changes in the economic environment.
Ruml’s plan went from paying the government’s bills to managing the entire economy by increasing, suddenly and at will, the amount of money being taken from each worker’s paycheck.
The policy thinkers of the day embraced the Ruml arrangement. This was an era in which John Maynard Keynes dominated the world of economics. The Keynesians placed enormous faith in government. The one thing they liked about the war was that it demonstrated to the world all the miracles that Big Government could work. The Ruml plan would give them the wherewithal to have their projects even, they sensed, after the war ended. Keynesianism also said high taxes were crucial to controlling inflation. The Keynesians saw withholding as the right tool for getting those necessary high taxes.
After a few years, some of the experts began to question the wisdom of the withholding plan. One of them, Milton Friedman, later regretted promoting the withholding program, and contended that it should be dismantled, as Amity Shlaes reports:
Among withholding’s backers was the man who was later to become the world’s leading free-market economist, Milton Friedman. Decades after the war, Friedman called for the abolition of the withholding system. In his memoirs he wrote that “we concentrated single-mindedly on promoting the war effort. We gave next to no consideration to any longer-run consequences. It never occurred to me at the time that I was helping to develop machinery that would make possible a government that I would come to criticize severely as too large, too intrusive, too destructive of freedom. Yet, that was precisely what I was doing.” With an almost audible sigh, Friedman added: “There is an important lesson here. It is far easier to introduce a government program than to get rid of it.”
Milton Friedman said, in an interview:
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.
One may note the general principle that wartime allows governments to take drastic actions which would not be countenanced in peacetime. People are willing to tolerate decisions made as necessary emergency actions during war. The sad lesson is that, with the advent of peace, the wartime controls often remain in the hands of the government.
