Why Withholdings?

March 4, 2009 11:10 AM

Taxfilter: Why does the (US) federal government bother with payroll deductions?

Assuming that each year, the vast majority of the taxpayer population either owes a tax payment or gets a tax refund, why does the federal government bother deducting taxes from our paychecks? Why don't we just get a statement of our earnings, a tax table, and a bill every year? That approach would seem to save a lot of money and bureaucratic layers (from the administrative aspects of overseeing withholdings).

I've done a little searching for the answer, but most of what I'm finding devolves into libertarian theories of "why the Federal government shouldn't be taxing us at all" or "flat tax" arguments. Outside of that, what I've come up with so far is that maybe:

1) By and large, people couldn't be trusted to save enough for an annual bill, so it's more productive for the Fed to just oversee taking small amounts from earnings (the "pay as you earn" system).

2) If everyone paid a total tax bill each year, the revenue cycle would be thrown off; relatively large amounts of revenue would flow in at certain times of the year (tax season), with relatively little coming in otherwise.

3) There are so many variables and caveats to taxation, with so much corresponding paperwork, that overseeing payroll deductions is the easy part of collecting taxes.

4) There's more room for fraud (from you and your employer) if the Fed isn't keeping tabs on your weekly earnings.

IANAA (accountant), so I'm sure I'm missing something here. What's the deal?

posted by Rykey to work & money (25 comments total)

I'm also not an accountant- but I've made estimated quarterly payments before (i.e. no withholding) so not everyone has withholding on their paychecks.
posted by jourman2 at 11:14 AM on March 4

Majority of people won't voluntarily pay / attribute their taxes properly. That's why various governments are cracking down on the definition of what a consultant/contractor is - they're guaranteed their money when it's withheld as the business has to cough up, even if the individual doesn't.
posted by Vantech at 11:17 AM on March 4

It's #1. because of #4.
posted by GuyZero at 11:19 AM on March 4

Withholding hides/obscures the burden of taxation. People would be a lot less enthusiastic about government if they actually had to write a big check to the IRS once a year. It's amazing how effective it is -- think about people's attitudes towards receiving tax refunds.
posted by Perplexity at 11:19 AM on March 4

1. Easier to get money from large entities than from lots of individuals.
2. They get to collect interest on the money all year.
posted by king walnut at 11:20 AM on March 4

If you live paycheck to paycheck, as a lot of people do, then finding the money for your tax payment once a year is going to be a problem.
posted by MadamM at 11:30 AM on March 4 [2 favorites]

It used to be done like that. In some countries, some of the older crowd may remember it first-hand. It's a crappy method. They all say the new way is much better.

Method 1. At the end of the year, you get a bunch of tax work to do and a HUUUUUGE bill.
Method 2. At the end of the year, you get a bunch of tax work to do and a little bit of money in return.

Method 2 goes down MUCH easier with people. We don't hate losing money we never had.
posted by -harlequin- at 11:43 AM on March 4

With the current system, procrastinators like myself merely owe the government paperwork, rather than paperwork + money. I think both they and I prefer it this way.
posted by ryanrs at 11:53 AM on March 4

#1 all the way. Can you imagine Joe Six-pack getting a bill for a few thousand dollars every January? The government would never see that money. They're smart- they get their piece before you do, just to make sure they get theirs at all. Perhaps you could handle paying a tax bill at the end of the year, but many Americans live paycheck to paycheck.

I'm sure the cost of dealing with refunds is more than mitigated by the additional revenue gained by actually getting that tax money, and less cost of "going after" people.
posted by JuiceBoxHero at 11:56 AM on March 4

Google "Milton Friedman withholding." You'll get a wealth of information on the Nobel Prize-winning economist who invented income tax withholding, his reasons for favoring it during WWII (despite being a free market, low tax sort of guy generally), and the difficulty getting rid of it now that it's entrenched.
posted by decathecting at 12:12 PM on March 4

You've missed the most important consideration: the time value of money.

Yeah, the IRS probably doesn't trust most Americans to plan their finances in such a way that would enable them to fork over double-digit percentages of their annual income every spring, but that aside, the government would much rather have your taxes today than each April 15, because it means they get to spend that money now rather than later. So they take taxes out of each paycheck, ensuring that they get their money as soon as possible.

The fact that they have to give most taxpayers a refund doesn't bother them at all; in fact, the system is set up such that most Americans will drastically overpay unless they deliberately adjust their withholdings. Why? Because unless you do, you're essentially loaning the government money interest-free. This is why you should always adjust your withholdings such that you never get a significant refund. That's money you could have earned interest on--or spent--instead of letting the government have it for a few months. You can even get away with under-withholding a little, enabling you to earn interest on taxes you owe rather than paying it to the government immediately, though the IRS gets annoyed if you do this with too great a percentage of your income. IANA(tax)L, or tax consultant, so I make no guesses as to what this percentage is, but a qualified professional would be able to tell you.
posted by valkyryn at 12:19 PM on March 4 [1 favorite]

I think Perplexity and -harlequin- have it spot on. Even assuming everyone would be diligent and save up to pay their taxes (which they wouldn't), people would howl when they had to write giant checks to the government every year. This way most people don't really think about what they are truly contributing.

With respect to the beaurocracy, most of the burden of withholding is borne by businesses rather than the government, so in addition to maximizing payment compliance it also theoretically shifts administrative expense away from government.

I'm a fairly libertarian fellow, but I must confess that I much preferred the year I screwed up my withholdings and got a $6,000 refund to the year I screwed up my withholdings and owed $4,000.
posted by AgentRocket at 12:26 PM on March 4

I'm a fairly libertarian fellow, but I must confess that I much preferred the year I screwed up my withholdings and got a $6,000 refund to the year I screwed up my withholdings and owed $4,000.

This is a great example of how withholding tricks even smart people. You should be much happier in the second case, when you owe -- in the first case, you gave the government an interest-free loan for no benefit.
posted by Perplexity at 12:53 PM on March 4

It's the interest free loan the goverment is getting. Not only do they not give you inerest on the withholding; they get free use of your money until you actually submit your return and cash your check.

Also the majority of the paperwork burden for withholding lies with employers.
posted by Mitheral at 12:55 PM on March 4

That approach would seem to save a lot of money and bureaucratic layers (from the administrative aspects of overseeing withholdings).

That saved money? It and MUCH more would be spent tracking down and getting payment plans of $5/month for eternity from all the deadbeats who didn't, couldn't, chose not to, didn't feel like, wanted to buy a car instead of, and so forth, pay their taxes. This was a big problem, which as I recall was SOLVED, and money saved, by requiring businesses to withhold from earnings.
posted by bunnycup at 1:05 PM on March 4

I think you are overthinking this.

You owe taxes when you make the income, not on April 15th of the next year. Withholding is the way to make that happen. The other option is to make estimated quarterly payments.
posted by smackfu at 1:19 PM on March 4 [1 favorite]

I think you are overthinking this.

Or underthinking it ;)

Thanks everybody.
posted by Rykey at 2:16 PM on March 4

Don't want to hi-jack but this question got me wondering, I always assumed you all got a big bill at the end of the year because there is so much talk of filing taxes etc. But if they're taking money out of your wages every month, why do you have to file taxes? Also, why are refunds so common, do they purposely take more tax that you owe?
posted by missmagenta at 3:12 PM on March 4

I take it you've never filed a tax return. There are lots of deductions, credits, etc, as well as really crazy stuff like the Alternative Minimum Tax (AMT). There's really no way to know with 100% accuracy what you own for taxes until you close your books for the year and tally everything up. people also tend to accumulate deductions as opposed to losing them - getting married, having a kid, buying a house and getting deductible mortgage interest, etc. Also, not every form of income has mandatory withholding - if you sell assets (e.g stocks or a house) for a capital gain there's no mandatory withholding (to my knowledge). So you have to report that on your taxes and you may owe extra tax, unless you have capital losses to offset them, etc, etc, etc.

Tax is half about collecting revenue and half about the government implementing social policies so it ends up being really complex.
posted by GuyZero at 3:22 PM on March 4

They probably do take more, but another big reason, for me at least, is because they take the money at the rate they calculate if you earned that money consistently over the whole year.

When I took a couple month leave from work, my yearly pay and hence my tax rate went way down, but all the withholding from my job assumed I was going to be making more.

Conversely if you start working a second job your yearly salary is higher, so then even though there was withholding at each job, your total yearly salary has gone up enough to push you into a higher tax bracket. And now you would owe them more taxes.
posted by Iax at 3:26 PM on March 4

missmagenta, filing tax returns serves two purposes:

1) It ensures that the withholdings for the year actually equal the taxes you owe. Most people either overpay or underpay, and there needs to be a fixed time to settle accounts.

2) It gives a fixed time when taxes that are due that are not subject to payroll taxes are to be collected, i.e. interest, dividends, capital gains, etc. No withholdings are assessed on these sources of income, but they're still taxed just like everything else, so again, there needs to be a time when accounts are settled.

This second point also explains in part why most Americans overpay with withholdings. The biggest part is that the government likes free loans, but part of the official justification is that it's intended to account for those sources of income on which you don't pay taxes as you go.

smackfu, you're wrong about when taxes are owed. Taxes are not actually owed until April 15 of the following year. Getting behind on your withholdings raises red flags for the IRS because it suggests that you aren't going to pay come April 15--so get prepared for an audit if you push it--but does not constitute being late with your taxes. Besides, there isn't any way of telling how much tax you owe until the end of the year, as your deductions, exemptions, etc. cannot be determined until then. Many people make large charitable contributions at the end of the year for exactly this reason: a dollar given in December gives just as big a deduction as one given in January, but you have the use of that dollar all year if you give it at the end rather than the beginning. Thus your estimated tax liability grows with every paycheck, but your actual liability is only fixed at the end of the year.
posted by valkyryn at 3:29 PM on March 4

I've never really understood the charitable angle. Yes, it's a deduction, and december is the best time to contribute if you plan to, but people seem to sell it like "save money on taxes, contribute to charity", as though your deduction will be equal to or greater than the dollar you just gave away.

Or maybe I'm just uncharitable.
posted by pwnguin at 3:38 PM on March 4

I take it you've never filed a tax return.

Actually I have, as a self-employed invdividually I file yearly because I don't pay tax monthly.

In the UK PAYE don't generally file tax returns, the tax man knows how much you owe him and he takes his cut monthly (and automatically adjusts as necessary if you monthly income varies). Tax on savings interest is also deducted automatically.
posted by missmagenta at 4:46 PM on March 4

you're wrong about when taxes are owed. Taxes are not actually owed until April 15 of the following year

I agree that all your taxes for the prior year are due on April 15th. That does not imply that none of your taxes are due prior to April 15th. The IRS certainly thinks some are due, because there are penalties for underpayment, not just red flags.
posted by smackfu at 10:10 PM on March 4

valkyryn: You owe as you earn. The IRS is nice to the self employed and lets them pay quarterly instead of monthy, weekly, or daily.

The only times you can not pay enough estimated tax and not pay a penalty are if you either owed no tax in the previous year, in which case you can pay it all on April 15th, or you paid in at least a certain percentage of last year's tax bill in your quarterly payments, in which case you get to settle up without penalty.
posted by wierdo at 11:39 PM on March 5