Do More Efficient Taxes Lead to Bigger Government?: Evidence from the Introduction of Withholding for the State Personal Income Tax

Abstract

This paper examines the claim that adopting more efficient taxes leads to bigger government by studying the introduction of withholding of the state personal income tax. We exploit the staggered adoption of withholding by individual states in the U.S. between 1948 and 1971 to construct a difference-in-differences style estimate and find that withholding immediately and permanently increased income tax collections by about 30 percent at given tax rates. Governments responded to this efficiency shock, the major response being a shift in the composition of revenues towards a heavier reliance on the personal income tax. States also increased revenues from other taxes as they implemented withholding, which suggests that a need to raise more revenue was an important motive for adopting withholding. The evidence we obtain suggests that withholding resulted in a one-time increase in personal income tax revenues but did not change the growth rate of revenues by itself.