Most people don't give a second thought to today's tax withholding system, but taxes haven't always been withheld at the source, and there are compelling criticisms of the withholding system. In general, tax withholding is good for the government and bad for taxpayers.

Key Takeaways

  • Most full-time employees in America are familiar with the tax withholding system - where a portion of a pay period's gross income has been deducted for tax purposes.
  • The benefits of this process include ensuring workers have enough money to pay their taxes, making it harder to evade taxes, and a steady flow of income for the government.
  • Drawbacks include over-paying taxes that create opportunity costs for workers, as well as encouraging a disconnect or apathy between employment income and taxes that can fuel unchecked government spending.

Benefits of the Tax Withholding System

The tax withholding system was implemented to help the government raise money to finance various wars and to make it easier for the government to increase taxes without citizens protesting. Here are a few of the benefits of collecting taxes at the source - and notice that most of these benefits go to the government, not the taxpayers.

People don't notice the missing money

People tend to focus on their take-home pay, which makes sense since that's the amount of money they actually have to work with. And when they do look at the tax withheld, it may not seem like a significant amount, since it's divided among the 24 or so paychecks most people receive each year. Since most people don't ever touch all the money they've earned and they only see a number for the total amount of federal tax they've paid once a year on their tax returns (which don't show how much they've also paid for Social Security and Medicare, or how much their employers have contributed to Social Security and Medicare on their behalf) it's easier for the government to collect taxes under a withholding system, even at relatively high rates. (To learn more, read Avoid The Social Tax Trap.)

There's no need to save up for or make a gigantic payment in April

It's true that some people are bad at saving and wouldn't be able to pay their tax bills if they had to pay them in a lump sum or even in quarterly installments. Americans who live paycheck to paycheck, when faced with a credit card bill now or a tax bill in nine months, would probably put the money toward their immediate concerns. Thus, tax withholding is said to be convenient for taxpayers because it allows them to make small, seemingly affordable payments throughout the year. Some people, however, might say it's paternalistic of the government to decide when and how you'll pay your taxes instead of allowing you to make the payments yourself. (Despite tax withholding, some people are still caught off guard in April. Read Top 9 Solutions To An Unexpected Tax Bill to learn how to handle this problem if it happens to you.)

Withholding decreases evasion and underpayment

Because of the aforementioned savings dilemma, withholding makes it more likely that the government will receive all the taxes it is due. Withholding also makes it more difficult for tax protesters and tax evaders to keep their money out of the IRS's hands.

Withholding decreases collection costs

Since most people have all or most of their taxes remitted to the government by their employers, the IRS theoretically has a smaller pool of people to go after for unpaid or underpaid taxes. Lucky you - this means that fewer of your tax dollars are needed to fund the IRS's collection efforts. (For more, see Surviving The IRS Audit.)

Government uses the money sooner & steadily throughout the year

If this point is truly a rationale for withholding, it would seem that government is admitting that its own employees aren't very good at managing the budgets for their programs, either. If they were, it wouldn't matter if programs were funded in a lump sum in April or with steady payments all year long.

W-4

An employee who starts a new job must fill out IRS Form W-4, which the employer typically provides in order to elect the amount of tax withholding from their paychecks.

Criticisms of the Tax Withholding System

The tax withholding system is something that most of us take for granted, but the concerned citizens, politicians and economists who have analyzed it have many criticisms of the system.

Taxpayers have no idea how much they pay and are apathetic about tax rates

If taxpayers had to make one large payment, they would know exactly how much they were forking over for federal taxes, Social Security taxes, Medicare taxes and state taxes. Since the money is taken gradually, many people never pay attention to the full amount, which makes it easier for high tax rates to persist and for the government to increase tax rates. For example, the state of California in 2009 decided to use the tax withholding system to take a large, interest-free loan from its taxpayers. It increased the withholding tax by 10%, and even journalists didn't seem to notice until the days before the rate hike was implemented. The government says it will refund the borrowed money in April.

Taxpayer apathy contributes to high levels of government spending

As we all know, the government has a knack for not only spending every single tax dollar it collects, but for running large budget deficits. To continue the previous argument, critics say that when taxpayers don't realize how much of their income is going to the government, they aren't likely to make the connection between their income and the money that is needed to fund new government programs and expand existing ones. Thus, they are likely to support ever-bigger programs without understanding that they're also supporting higher taxes.

Taxpayers think that tax refunds are gifts from the government

They don't realize the money was theirs all along and that they've made an interest-free loan to the government all year.

Taxpayers don't use their refund money wisely

A tax refund isn't really a windfall - it's money that you earned that you should have had access to during the year. But when it arrives in a lump sum in the form of a tax refund, it seems like a good excuse to do some extra spending. It's possible to adjust your withholding so you don't receive a large refund. You can use the extra money in each paycheck to help meet your savings goals throughout the year.

(For more on this topic, read Don't Waste Your Tax Refund.)

Taxpayers suffer opportunity costs from withholding
An opportunity cost is a missed opportunity - and if you already "spent" some of your income on future taxes, you can't use them for consumption today. For example, taxpayers lose out on the interest they could be earning on their tax dollars all year if they could hold on to the money until April. Over the course of a year, let alone a lifetime, this lost interest really adds up.

Taxpayers can't protest by refusing to pay taxes

Citizens who want to withhold their support for certain types (or all types) of government spending or who believe that the income tax is unconstitutional can have a difficult time keeping their money from the government under the tax withholding system.

The system penalizes wage earners

Because taxes aren't withheld from investment income or self-employment income (and a few other less common types of income), the withholding system is said to penalize wage earners, or those whose taxes are collected at the source (from each paycheck). They have to pay up sooner, which means that their opportunity costs from the withholding system are higher.

The system imposes costs on employers

The employers who protested tax withholding in 1913 and got it revoked in 1917 had good points that are still true today. Businesses have to hire additional staff to deal with tax withholding and spend time and money on tax compliance that could be spent on improving their businesses or paying workers more.

The Bottom Line

It's important to understand where that money coming out of your paycheck goes and why - after all, you earned it, and someone else is deciding what happens to it. Instead of taking the tax system for granted as a simple way to pay your taxes, consider what it really means for your finances.