Tax Withholding and the Size of Government

This paper examines the hypothesis that an improvement in tax collections causally leads to bigger government. We exploit the staggered introduction of withholding of the state personal income tax by U.S. states between 1948 and 1987 and find that withholding led to an increase in tax revenues by about 28 percent. We derive a theoretical model through which we interpret the estimates distinguishing between a mechanical increase in tax collections driven by reduced noncompliance, subsequent adjustments in revenue choices in response to that reduced noncompliance, and an increase in the underlying demand for revenue that may have motivated the adoption of withholding. Governments responded to the improvement in personal income tax collections by shifting the composition of revenues towards a heavier reliance on this tax. States also increased tax rates as they implemented withholding, which suggests that a need to raise more revenue was an important motive for adopting withholding.