Tax Analysts Blog

Singing the Payroll Tax Blues

Posted on Aug 9, 2009

I've promised to stop ranting about how most people -- roughly half the country -- don't pay any income taxes. If we're serious about broadening the tax base and lowering rates, then everybody ought to have some skin in the game. Enough said. As many of you have pointed out, our country's poor do pay other types of taxes, most notably the payroll tax. In fact, the poor pay more in payroll taxes than they should. That's a design feature of the payroll tax system that also screams out for base broadening.

If you don't understand how payroll taxes work, you should. Confusion is entirely understandable. The topic merits some explanation.

For the majority of us, the mechanism by which we pay payroll taxes is virtually identical to how we pay income taxes. Our employers withhold from our paychecks. As we earn salary or wages, the government takes a cut. We see it in those pesky details at the bottom of our pay stubs. Because they're collected at the same time, it's tempting to lump payroll taxes and income taxes together. This post attempts to refute that perception. In fact, payroll taxes and income taxes are very different.

The income tax is progressive. The rich pay more tax than the poor, not only on a net-outlay basis but also in terms of marginal rates. Bill Gates -- our token rich guy -- not only pays more income tax than the average Joe, but he also pays at a higher rate. The top income tax rate is currently 35%. As David Brunori recently explained, that rate historically has been significantly higher, making today's figure look like the mother of all bargains. [This top rate, BTW, is scheduled to revert back to 39.6% on January 1, 2011. That's because in the earlier part of this decade Congress chose to make tax cuts temporary.]

Payroll taxes, in contrast, are regressive. The two main components of our payroll tax regime are the social security tax, which is imposed at a fixed rate of 6.2%, and the medicare tax, which is imposed at a fixed rate of 1.45%. Employers must pay matching amounts, meaning the government's combined take for social security and medicare taxes is 12.4% and 2.9%, respectively. Collectively, these social security and medicare taxes are known as FICA taxes; the combined FICA rate is 15.3%. FICA is a reference to the Federal Insurance Contributions Act. The name is deceptive. FICA payments are in no sense "contributions" (i.e., voluntary). They are taxes which, by definition, are involuntary payments. The FICA regime isn't really "insurance" either, but that's a topic for another day. [One should never underestimate Congress' penchant for statutory titles that are misleading at best, or wholly inaccurate at worst.]

Here's what makes FICA regressive. The medicare tax rate does not increase as an employee earns more money. Somebody making $20,000 per year pays the same rate (1.45%) as Bill Gates. Ditto for the matching employer's share. That's regressivity. Next time you hear somebody express a sentimental longing for a flat tax, kindly inform them we already have one. Nor does the social security tax rate increase as an employee earns more money. Somebody making $20,000 per year pays the same rate (6.2%) as somebody earning $100,000. Ditto for the employer's share. Again, that's regressivity.

The social security tax also has no zero-bracket for lower incomes. The tax applies to the very first dollar earned. Ironically, a zero-bracket exist under the social security tax for higher incomes. Under current law, the marginal rate falls to zero for incomes above $106,800. In other words, the tax goes away completely for anyone over that threshold, which is regularly adjusted for inflation. So Bill Gates pays exactly the same social security tax -- to the penny -- as somebody earning $107,000. That's $6,621.60 for those who don't care to do the math. Not only are the wealthy not subject to higher rates of social security tax, they actually receive preferential treatment. This is regressivity on steroids.

So there you have today's musing on payroll taxes, which poor people pay by the truckload. My mantra remains 'broaden the base, lower the rate.' That applies to the regressive payroll tax as well as the progressive income tax.

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