However, the new withholding provision was not less painful in practice. Public opposition was profound. By August 5, 1983, one month after withholding was to have taken effect under TEFRA, the Interest and Dividend Tax Compliance Act of 1983 (P.L. 98-67, 97 Stat. 369, 5 August 1983) repealed TEFRA's provision for withholding on interest and dividends. In its place Congress authorized expanded information reporting coupled with ``backup withholding'' of 20 percent in specific circumstances involving taxpayer noncompliance.
The repeal of the TEFRA withholding provision reflects the internal dynamics of determinants of transaction-cost augmentation. While variables discussed above impelled congressmen toward use of transaction-cost-increasing strategies to pass TEFRA, many misjudged the intensity of constituent hostility to the withholding provision. But perhaps the measure served its political purpose nonetheless. Since tax compliance provisions accounted for 21 percent of the additional revenue claimed to be generated by TEFRA, the evanescent authorization of interest and dividend withholding allowed Congress the political benefit without the political cost of claimed budget deficit reduction (U.S. House Report No. 98-120, 1983: 2).
Finally, the 1983 repeal of withholding on interest and dividends provides suggestive evidence regarding the long-term influence of transaction-cost augmentation and the path dependency of institutional change. Absent 40 years' experience of withholding, public opinion in 1983 might have opposed wage and salary withholding with equal intensity.[f19]
Entrenchment of the Machinery of Government
It is now a minimal problem to maintain a withholding system on salaries and wages, which is absolutely at the heart of our self-assessment technique of paying taxes.
--G. William Miller, Secretary of the Treasury
(U.S. House Hearings 1980: 23-24)
The question is, can such long-established and carefully contrived practices be reversed--and, more relevantly, are they likely to be reversed? In a representative democracy, the answer to the first question is unequivocally affirmative. Nonetheless, if the theory and evidence presented here are substantially accurate, the answer to the second question is unequivocally negative. The essence of transaction-cost augmentation is guided deflection of certain types of collective political action in order to facilitate establishment and continuation of policies often initially inconsistent with people's preferences. We have seen that the long-run result of such institutional change is authority-legitimating ideological change that renders policy reversal increasingly unlikely.
One sobering result of the present study is its evidence of key public officials' extensive awareness of the dynamics of transaction-cost manipulation. As their published statements made clear, many officeholders deliberately sought the transaction-cost-increasing results of their income tax withholding policies. Along with the public, other officeholders--such as those in 1943 who did not understand the present-value issue--were targets of those transaction-cost-manipulating strategies.
The history of U.S. income tax withholding documented here is consistent with the theory discussed earlier in this article. We have seen that, on many levels, income tax withholding increases transaction costs to the public of understanding the magnitude of the income tax and of opposing it politically. Government officials always have regarded withholding as a seemingly ``painless alternative'' (U.S. House Hearings 1980: 35). Lacking an understanding of the concept of present value, many taxpayers do not perceive that withholding causes the real burden of their tax liability to be greater. Indeed, the common practice of overwithholding associates the payment of taxes with an apparent financial benefit rather than cost, distorting taxpayers' assessments of the actual costs and benefits of government activity. Consistent with a transaction-cost-manipulation model, the expected return of such overpayments makes people feel ``happier'' about sending in their tax returns on April 15. The very mechanism of withholding deflects blame from the government by requiring employers to initiate and bear the cost of the forcible extraction of people's income. Piecemeal collection each payday from income the taxpayer never sees obscures the magnitude of the annual tax. And, because it is a forcible extraction, it raises the transaction costs to the public of expressing political resistance to taxes by not paying them.
In examining the process of passing the Current Tax Payment Act of 1943, we have seen that key variables identified by the theory as determinants of transaction-cost augmentation played their expected roles. The complexity of the withholding measure, the appealing rationale provided by wartime revenue needs, executive support, constituent support induced by purported tax forgiveness, ideologies shaped by the already expanded role of government, and lack of media publicity regarding the measure's transaction-cost-increasing features all contributed as expected to adoption of the Act. Consistent with the theory, the history of income tax withholding showed institutional experiences born of transaction-cost manipulation in turn influencing predominant public ideologies, thereby building long-run support for expanded government authority buttressed by additional transaction-cost-increasing institutions.
After 50 years of comprehensive withholding at the source of American workers' salaries, people are used to wage withholding; most no longer question it. The relevant institutional machinery is entrenched, both through its administrative apparatus and through its acceptance in the minds of most taxpayers. Some resistance does remain. Representative Bill Gradison (R., Ohio), for instance, stated (U.S. House Hearings 1980: 46) that ``one of the greatest steps we can take toward holding down expenditures and making people aware of the cost to Government would be to reexamine our assumption that wages must be withheld upon.'' More recently (Wall Street Journal 1994), in conjunction with his proposal to replace the existing income tax with a flat tax, Representative Dick Armey (R., Texas) recommended elimination of withholding, calling it a ``crucial, deceptive device'' that has allowed government ``to raise taxes to their current level without igniting a rebellion.'' But such voices are few. As ideologies accommodate altered institutional reality, as citizens' views about what ought to be come more nearly to reflect what is, government manipulation of political transaction costs provides one key part of the explanation of how such politico-economic change has occurred.
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[f100]Cato Journal, Vol. 14, No. 3 (Winter 1995). Copyright ;cW Cato Institute. All rights reserved.
The author is Professor of Economics at Boise State University. She gratefully acknowledges a grant by the Earhart Foundation that facilitated this research. She wishes to thank Robert Higgs and an anonymous referee for helpful comments on an earlier draft.
[f1]Alternatively, such political transaction costs could be labeled ``constitutional-level'' transaction costs (see Twight 1988, 1992) to emphasize their influence upon the nature and extent of government authority over private decisionmaking tolerated by the public. In this broad sense, to conceptualize them as ``constitutional-level'' implies only that they influence where the line is drawn between the public sector and the private sector; it does not presuppose linkage to or embodiment in a formal constitutional document. Regarding alternative loci of a constitution, see Higgs (1988: 374-75).
[f2]Transaction-cost-manipulation theory thus is concerned with what may be called ``contrived'' political transaction costs, volitionally created by political actors for their own benefit. The residual political transaction costs that exist when all agents are attempting to minimize transaction-cost barriers to political decisionmaking will be referred to as ``natural'' transaction costs.
[f3]For example, U.S. Supreme Court redefinition of the Constitution's interstate commerce clause in ways that previously would have required constitutional amendment.
[f4]The examples in the text are intended to be suggestive rather than exhaustive. For a more complete discussion of political behaviors and policies that exemplify transaction-cost augmentation, see Twight (1994).
[f5]The complexity and appealing rationale variables require further comment. An issue's complexity may be either unavoidable (hence a ``natural'' transaction cost of understanding an issue) or itself a product of transaction-cost augmentation (hence a ``contrived'' transaction cost). Similarly, an appealing rationale may be either false (a contrived transaction cost that in turn facilitates other forms of transaction-cost augmentation) or true. In either case, the direction of impact on an officeholder's decision regarding a transaction-cost-increasing measure is as described in the text. Issue complexity, like the existence of an appealing rationale, makes it harder for citizens to perceive transaction-cost-increasing features of policy proposals. Moreover, both of these conditions allow politicians greater room to credibly claim to have made a ``mistake'' if negative public reaction to the measure's transaction-cost-increasing features does materialize.
[f6]These relationships have proved consistent with actual U.S. policymaking experience in such apparently diverse arenas as off-budget expenditure through the Federal Financing Bank, military base closures, asbestos regulation, and U.S. Social Security legislation (see Twight 1983, 1989, 1991, 1993).
[f7]The emergence and entrenchment of Social Security legislation in the United States has proved consistent with this model's description of the nexus between transaction-cost manipulation, institutional change, and ideological change (see Twight 1993).
[f8]The Supreme Court did not comment on the law's taxation of gains from business and employment, citing ``the instances in which taxation on business, privileges, or employments has assumed the guise of an excise tax [not subject to apportionment] and been sustained as such'' (158 U.S. 635). Later writers and judges interpreted Pollock to mean that the validity of such taxation was recognized and that there was ``no dispute'' about that issue (Brushaber v. Union Pacific Railroad Co., 240 U.S. 1, 17, 1915). For extended discussion of the Pollock case, see Higgs (1987: 99-103), and Arthur Ekirch Jr. (1981: 168-71).
[f9]I found only four brief references to it in thousands of pages of hearings.
[f10]On the widespread use of this rationale during World War II, see Higgs (1987).
[f11]Beardsley Ruml, of R. H. Macy & Co., was at the time chairman of the Federal Reserve Bank of New York.
[f12]U.S. House Hearings 1943: 184. Chairman Doughton incorporated this phrasing in a rhetorical question.
[f13]Two poll questions in May 1942 that described withholding as an idea ``to help the war effort'' found 64 percent and 72 percent of respondents supported the idea (Cantril 1951: 324).
[f14]See Higgs (1985: 2-3 ff.; 1987: 57-74).
[f15]See notes 1-7, supra, and accompanying text.
[f16]Regarding a related matter, Commissioner of Internal Revenue Roscoe L. Egger Jr. explained (U.S. House Ways & Means Comm. Hearing 1982: 19-20) that the IRS advocated a mandatory withholding tax on pensions, but that the IRS was promoting information reporting and, initially, voluntary withholding of taxes on pensions as a first step.
[f17]The Senate Finance Committee, reporting Internal Revenue Service estimates ``that 15 percent of dividend income and 11 percent of interest income is not reported by taxpayers'' while ``99 percent of wage income is reported by taxpayers,'' concluded that ``Withholding improves voluntary compliance'' (U.S. Senate Report 1982: 228).
[f18]Representative Norman E. D'Amours (D., N.H.) noted (U.S. Cong. Rec.-House, 19 August 1982: 22147) that ``One hundred and fifty Members of this body have signed a letter to the Committee on Rules asking for a separate vote. An overwhelming number of our constituents ... oppose withholding of interest and dividend taxes.''
Representative John E. Porter (R., Ill.) remarked the following year (U.S. Cong. Rec.-House, 17 May 1983: 12493) that withholding ``was just one of 96 parts of the last year's tax package, and, unfortunately, we in the House never had the opportunity to vote on the proposal separately. If it had been a free-standing proposal and not part of omnibus legislation, Congress most likely would have overwhelmingly defeated it, just as we did in 1980.''
[f19]In 1982 Representative Daniel D. Rostenkowski (D., Ill.) remarked (U.S. Cong. Rec.-House, 19 August 1982: 6555), ``The debate now in progress on interest and dividend withholding occurred 40 years ago on wage withholding. Now wage withholding is a popular system, and perceived as a relatively painless way to accurately pay taxes. I predict that in a few years, we will be able to say the same of interest and dividend withholding.''
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When and how much were tax rates increased after the 1943 enactment of withholding?