Tax Withholding and the Size of Government

• In Event: Tax Policy, Compliance, and Fiscal Capacity

Abstract

This paper investigates whether improvements in tax collection efficiency lead to the growth of government. We examine this question through the lens of U.S. state governments’ staggered adoption of personal income tax withholding between 1948 and 1987. Withholding — which combines third-party reporting and the collection of taxes at the source — significantly improves compliance, as demonstrated in our prior work. In this paper, we estimate the broader fiscal effects of withholding, including changes in tax revenue composition, tax rates, and expenditures.

We find that the adoption of withholding increased personal income tax revenues by approximately 28 percent, exceeding what can be explained by compliance improvements alone. This suggests a political response in the form of higher rates. Changes in corporate income and sales tax revenues, while positive, were modest by comparison. Naturally, given those patterns, the share of revenue raised from personal income taxes rose substantially. Surprisingly, we find no increase in government spending, but we do observe a stabilization of state debt levels, particularly in states lacking strict balanced budget requirements.

Our findings indicate that withholding was not merely a technical reform but was likely adopted in response to growing demand for revenue, with important consequences for tax structure and fiscal capacity. The results underscore the interplay between administrative tools and political economy forces in shaping government size. This paper thus bridges two literatures — tax compliance and the political economy of public finance — and provides new evidence on the causal link between tax efficiency and government growth.

Author

• Sutirtha Bagchi, sutirtha.bagchi@villanova.edu