Sunday, October 11, 2009

Payroll taxes are propping up federal revenues

Federal Revenues by Fiscal Year (Trillions of dollars)

Source: CBO

National income and employment have fallen over the past year. As the graph above shows, personal and corporate tax collections have declined, but payroll taxes (Social Security, Medicare, unemployment taxes) are holding steady, slightly increasing.

It's an interesting mystery as to why payroll taxes are holding so steady, given that overall income is down, employment is down, and other tax collections are down. Looking into those reasons can tell us quite a lot about the structure of our tax system, including aspects most Americans rarely think about.

Income taxes are highly visible--or as behavioral economists would say: "salient." However, for most working Americans, the less visible payroll taxes are a much heavier burden than income taxes. This has been true for quite some time. In 2007, the Urban Institute reported that two-thirds of taxpayers filing tax returns had paid more in payroll taxes than in income tax. This will probably been even more true when the 2009 final numbers come in.

Even though the average working American pays more in payroll tax than income tax, few Americans pay much attention to payroll taxes. Because the payroll tax is so simple, there's no need for wage-earners to file a payroll tax return. The amount of tax doesn't depend on anything other than wages, no need to consider dependents, deductions for mortgage interest, tax credits, etc. Employers simply take the money right out of their paychecks and sends it in to the government, without much fuss or muss visible to the employee.

The self-employed DO notice the payroll tax, because they are responsible for filing and paying their own payroll taxes. Business owners also notice the tax, because they are the ones actually responsible for remitting the taxes to the government on behalf of their employees, but ultimately the burden of the taxes falls on employees because it results in decreased take-home pay for them.

Payroll taxes are regressive, because they only fall on wage income, and many higher income individuals have found creative ways to legally recharacterize what most people would think of as wage income into non-wage income. For example, hedge fund managers are famous for taking much of their employee compensation in the form of "carried interest," which is not subject to payroll taxes, and, in addition, may even qualify for favorable income tax treatment subject to taxation at the preferred rates given to long-term capital gains.

Another reason that payroll taxes are regressive is that the lion's share of the tax rate only applies to the first $106,800 in wage income. Employers--and the self-employed--remit FICA payroll taxes at the 15.3% on the first $106,800 of wage income; wages beyond that are only subject to payroll tax at a 2.9% rate.

The ceiling amount goes up a little bit every year. We'll learn soon what the number will be for 2010. The Social Security Administration website has a history of the ceiling numbers going back to the beginning of Social Security in 1937, when the cap was $3,000. Here are the numbers for recent years:

Year Amount
1996 $62,700
1997 65,400
1998 68,400
1999 72,600
2000 76,200
2001 80,400
2002 84,900
2003 87,000
2004 87,900
2005 90,000
2006 94,200
2007 97,500
2008 102,000
2009 106,800

The gradually increasing cap on wage income subject to Social Security tax could be the reason that payroll taxes have been able to hold steady, despite the decrease in employment and national income in general.

UPDATE: On October 15, 2009, the Social Security Administration announced that the cap for 2010 will remain unchanged at 106,800. This is the first time since the indexation formula went into effect in 1975 that the cap did not increase.

1 comment:

  1. Addendum: I noted above that payroll taxes are regressive, due to the Social Security ceiling and the fact that they only fall on wage income.

    The other side of the coin, so to speak, is those taxes are earmarked for benefits which are generally very progressive. Under the current benefits formula, a retiree who got low wages during his working career will have a relatively greater payback rate ("replacement ratio") than another retiree whose working career paid higher wages.

    There is a big question for workers paying into the system currently, however. The benefit formula enjoyed by current retirees may not be sustainable into the future. So when the current workers paying payroll taxes today retire decades down the road, they may not get such generous benefits.

    In addition, some workers do not live long enough to collect much in Social Security or Medicare benefits. Low income taxpayers have shorter life expectancies on average, which means that the benefit system is less progressive that it might appear at first glance.