Are Efficient Taxes Responsible for Big Government? Evidence from Tax Withholding

Abstract

The paper examines the claim that more efficient taxes lead to bigger government by studying the effects of income tax withholding, a particular technological shock to tax efficiency. We exploit the variation in the timing of the adoption of withholding by state governments in the United States during the 1940’s through 1970’s. Due to improved compliance and other factors, withholding immediately and permanently increased income tax collections by 24 percent at given tax rates. We find that this efficiency shock caused a large increase in income tax revenues, although much of the increase occurred through a shift in the composition of revenues towards a heavier reliance on the income tax. We also find that the revenue from other taxes increased when withholding was adopted, which we intepret as evidence that the adoption of withholding was motivated by higher demand for government spending. We use the theory to disentangle the causal effect from withholding to higher taxes and the reverse causality from higher demand to withholding. The causal effect accounts for at most one half of the 8 percent increase in total revenue. Contrary to claims that withholding was the thing that enabled the post-war explosion of income taxation, we conclude that it accounts for approximately 9 percent of the growth of state income taxes during the period in question.