A Brief History of Payroll: Withholding in America

November 21, 2022
Ian Zapolsky

Head of Partner Engineering

by 
Ian Zapolsky

Ian Zapolsky is the Head of Partner Engineering at Check, and joined us in 2019 as the company’s first engineer. When he’s not reading up on the history of how people pay each other, he’s probably helping one of our partners launch and scale their payroll business. As a certified payroll nerd, Ian volunteered to share what he’s learned in a blog series about the history of payroll in the US.

This post is Part 1 of a 3-part series. You can find Part 2 here.

What is tax withholding, and where did it come from?

The modern payroll industry exists in large part because the U.S. Government requires employers to withhold taxes from employee wages, and then pay them to the government in a timely manner. This requirement creates a very real administrative burden for employers, and compliance is enforced through fines and penalties. While we may take withholding for granted today, it's a practice whose widespread adoption in America is less than 100 years old. The history of withholding is worth a closer look, because the primary job of a payroll company is to shoulder the administrative burden and abstract away the complexity the system creates for employers.

The first taxes on individuals' earnings (or payroll taxes) in America were not withheld by employers. Instead they were paid in lump sums directly to the government by the individuals themselves. This method of tax administration put the burden on employees to track and report their income, which both inconvenienced the employees, and led to a higher percentage of wages going unreported. However, because early payroll taxes applied to only the top few percent of earners, the burden was not widely felt and the government was not sufficiently incentivized to change the system. As late as 1939, less than 4 million individual tax returns were filed out of a total population of approximately 140 million people, and the total tax owed by the filers amounted to less than 4% of their income.1 With such a small number of participants, and such small sums of money at play, the system was not scrutinized.

Withholding expands with the Underwood-Simmons Tariff Act

The first attempt at a broad institution of employer withholding of payroll tax was passed in 1913, just after the ratification of the 16th Amendment as part of the Underwood-Simmons Tariff Act, which also introduced the first constitutional income tax in America. The income tax sections of the law, initially drafted by Cordell Hull (who would go on to become the longest-serving Secretary of State ever under President Franklin Delano Roosevelt), abruptly introduced a complex system of employer tax withholding.2

Cordell Hull, co-author of the Underwood-Simmons Tariff Act and longest-serving Secretary of State ever under F.D.R.

In his paper What a History of Tax Withholding Tells Us About the Relationship Between Statutes and Constitutional Law, law professor Anuj C. Desai details many of the complex withholding regulations that suddenly applied to all employers when this act was passed. He follows his description with the following:

I give such detail not to bore you with the minutiae of a century-old law that was repealed in 1917, but rather to give a taste of the way in which the law introduced administrative burdens—primarily, though not exclusively, on corporations—burdens that were dramatically greater than those imposed during the 1860s and the likes of which no one in the United States had ever seen before....

The federal income tax of 1913 attempted to install the system without fully laying the groundwork necessary to ensure that such a complicated system, one demanding the compliance of large numbers of entities that had to expend significant resources, could work. The fact that the law attempted to bring withholding into this brand new income tax system so abruptly had its costs. Initial estimates were that the withholding provisions would yield two-thirds of income tax revenue, but in 1916, less than 5% came from withholding.3

In addition to simple lack of compliance, there was a groundswell of corporate opposition to the new withholding system, such that by 1916 it had become so politically unpopular that even Secretary of the Treasury William McAdoo advocated for its removal. In the War Revenue Act of 1917 the withholding rules passed in 1913 were officially repealed and replaced with a softer set of rules for employers — they were now only required to furnish information about wages paid to employees throughout a year, but not actually withhold or pay taxes on those wages.4

Withholding returns with the New Deal

However, withholding would return 18 years later as a core component of one of the most important pieces of New Deal legislation passed by President Franklin Delano Roosevelt: the Social Security Act of 1935.

President Franklin Delano Roosevelt signing the Social Security Act into law on August 14, 1935.

Books have been written about this act, so we'll avoid diving into the details of the programs it created here, but one of its effects was the institution of "old-age insurance" taxes on employee wages that are paid by both employers and employees. These are the employer and employee Social Security taxes we know and love today. The question worth asking here is why this 1935 attempt at a broad institution of employer withholding worked, when the 1913 attempt failed. Desai suggests three reasons:

  1. Employer opinion was solicited early on and was taken into account by the government bodies charged with creating the system for collection and bookkeeping of Social Security taxes. For example, the design of the system of quarterly returns that was established to track and facilitate employer payments to the government for these taxes was influenced by employer feedback on alternatives.
  2. The Social Security Act instituted taxes on both the employer and the employee that were calculated as a percentage of wages paid to employees. Because employers were already mandated to calculate, pay, and report tax on their employees' wages, it was seen as a relatively lower lift to do the same for employees as well.
  3. The fight over withholding in 1913 - 1917 took place in the context of a larger dispute over the constitutionality of the income tax itself, as well as the practice of withholding in general. Both of these were ultimately deemed constitutional by the Supreme Court, so in the late 1930s further opposition to withholding was perceived to be futile and failed to gain political momentum.

Ultimately, the Social Security Act laid the instrumental groundwork that paved the way for full adoption of withholding, and in large part the payroll tax system as we know it today. To support what was outlined by the bill, the government created the infrastructure needed to track employee wages throughout the year (including the Social Security Number), efficiently accept tax payments and associate them with employees and employers, and monitor activity so that employers who were out of compliance could be penalized.

Income taxes expand to fund World War II efforts

With all this infrastructure now in place, it might be painted as somewhat inevitable that the U.S Government of the 1940s, faced with massive costs associated with a burgeoning global war effort, would try to put it to good use to collect income taxes as well. Federal spending grew throughout World War II from $9 billion in 1940 to more than $98 billion in 1945.5 Although more than half of this spending was financed by borrowing, huge increases in tax collections also took place both in terms of the percent collected, and also in terms of the number of citizens who were required to pay income tax. What once had been a tax primarily on the richest 1% of Americans was now a tax that everyone was responsible for paying. In contrast to the 4 million filers in 1939, 50 million individual income tax returns were filed in 1945, and the filers owed more than $19 billion, nearly 20 times the amount that was paid five years earlier.6

The system of individuals tracking and reporting their own income tax did not scale to meet this new reality. Everyday Americans lacked the ability and willingness to save up large sums of money to pay their income tax the following year. This is illustrated by a wartime film produced by Disney called The Spirit of '43, starring none other than Donald Duck, which strongly encourages citizens to be thrifty and put their money away so they can pay taxes to help the U.S. prevail in the war.

Ultimately no amount of Disney-produced content would override basic human nature, which is to spend what one earns and not willingly give it up. As a result, Congress passed the Current Tax Payment Act of 1943, which required employers to withhold employee income tax, much like they were already doing for Social Security taxes. There was little opposition to the law at the time, largely because the policy was framed as essential for the guarantee of the nation's security in the fight against Nazi Germany and the rest of the Axis powers. In such times of fear and war, the government has wide political authority to expand its power. In the case of income tax withholding, the system introduced in 1943 has been in constant operation ever since.

One other interesting fact about withholding: it was viewed both as a vastly more efficient system for collecting taxes by the government, which is certainly the primary reason it was instituted, but also as a powerful mechanism to depress the rampant inflation created in the 1940s by the injection of billions of new dollars into the economy to fund the war. By withholding some of this money from employees before it entered their wallets, the government was able to dampen discretionary spending by the citizenry and rein in prices.

Tax withholding is likely here to stay

What's most fascinating about the practice of withholding is the psychological impact, recognized or not, that it has on the nation. Whereas before withholding, tax day was viewed with malice and ill will by many, today most Americans look forward to it because they often receive refunds from the government.

For many Americans, their tax refund is the single largest sum of money they receive in the year. But in reality, this refund is simply the return of a loan made to the government at a 0% interest rate. One wonders if government spending would receive more scrutiny from average Americans if they had to painfully part with their income tax money at the end of every year, instead of having it more or less silently siphoned out of their wages by their employers.

In any case, withholding is likely here to stay — it generates revenue for the government so effectively, and there's been so much time invested in the system by both the government and employers, that it seems extremely unlikely that it would be changed in any near term future.

Sources

  1. Wartime Origins of Modern Income-Tax Withholding - Foundation for Economic Education
  2. What a History of Tax Withholding Tells Us About the Relationship Between Statutes and Constitutional Law - Anuj C. Desai
  3. What a History of Tax Withholding Tells Us About the Relationship Between Statutes and Constitutional Law - Anuj C. Desai
  4. What a History of Tax Withholding Tells Us About the Relationship Between Statutes and Constitutional Law - Anuj C. Desai
  5. Wartime Origins of Modern Income-Tax Withholding - Foundation for Economic Education
  6. Wartime Origins of Modern Income-Tax Withholding - Foundation for Economic Education
  7. How Tax Withholding Became the Norm for American Workers - Marketplace.org

More from the Check blog

February 1, 2023

The ins and outs of worker misclassification, a guide.

Worker misclassification lawsuits are on the rise. In our latest eBook, we provide some background on the state of worker misclassification today, and identify five key considerations for employers.

Read more >

January 19, 2023

The Unlikely Story of a British Tea Company, the First Business Computer, and Payroll

The development of the electronic digital computer was hastened dramatically by World War II and the accompanying need to quickly and efficiently do things like calculate the trajectories of bombs and rockets, or decode encrypted messages sent by the enemy. The first computer of this kind, dubbed “Colossus,” was developed at Bletchley Park in the U.K. between 1943 and 1945 to help crack Nazi codes.

Read more >