Payroll taxes are propping up federal revenues

Federal Revenues by Fiscal Year (Trillions of dollars)


Source: CBO http://www.cbo.gov/homepagegraphics/0xx/10/graphic10.gif

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.

Social Security--or convertible bonds--for college students?

Words like "Social Security" and "convertible bonds" understandably make most college students eyes glaze over. I know mine did, when I was your age.

My dear departed and much beloved mother-in-law once had plans to write a book called Convertible Bonds for Teenagers. She had a notion that convertible bonds could be a great investment vehicle for teenagers, if only they knew what she knew about them. I have to admit that I never fully grasped her logic, and since the book never got written, I guess I'll never understand why she thought they were such a good idea for teens in particular.

I often found myself wondering, however, how you would ever get teenagers to read such a book, even if it turned out that her logic was impeccable and convertible bonds were, in fact, the perfect investment for teenagers. (Maybe put a picture of a flashy red convertible car on the cover?)

Although very few college students make the choice to invest in convertible bonds, almost all of them involuntarily "invest" in Social Security and its cousin, Medicare, via the payroll taxes (a.k.a. FICA) paid on their summer jobs and part-time work.

Most college students, like most Americans, pay far more in payroll taxes than they pay in income taxes, but few of them realize how much they are paying.

If your 2009 income consisted entirely of wages totaling $5,700, you won't owe any federal income tax this year, but you and your employer are on the hook for a 15.3% payroll tax bill.

That's $872.

What could you have done with that money if it hadn't gone to pay your payroll taxes?

You could have bought (or rented) a lot of textbooks with that money! Or you could have bought 74 large stuffed crust pan pizzas with that money. Or five Ipod nanos. Or filled up your gas tank about 20 times. Or bought 16 months worth of transit passes for CDTA. (Or other things I'll leave to your imagination.)

Or you could have followed my mother-in-law's advice and invested the money in a convertible bond fund!

But you didn't get to spend it on any of those things, because the money went to the federal government in payroll taxes.

So what are you getting in return?

An entitlement (which is not a legally binding contract, unlike convertible bonds!, but rather an implicit social contract or expectation) that you will eventually be able to collect Social Security and Medicare benefits at some possibly distant point down the road. More concretely, much of your payroll tax money went to pay the current generation of retirees, and a small amount was set aside in a so-called "trust fund" to help pay for future retirees' benefits. (The trust fund is invested in US Treasury securities, and effectively reduces the reported deficit.)

Are those payroll taxes a good deal for you?

For your grandparents' generation--my mother-in-law's generation, it was a very good deal.

For your generation, well, let's just say that convertible bonds might have been a better deal.

But Congress didn't have to write a book to sell you on the idea of "investing" in the Social Security system. They just passed a law mandating participation in 1935, long before you were born. It seemed like a good deal at the time--and it was a good deal for everyone who was alive, especially those old enough to vote at the time Social Security law was passed by overwhelming margins in both houses of Congress.



The graph above accompanies a very readable article in the Washington Post summarizing the tough demographic realities facing Social Security, Deals: A flimsy trust, Why Social Security needs some major repairs. As the graph shows, in 1950 there were 16 workers paying into the system for every retiree collecting. By the time you retire, there will only be 2 workers paying into the system for each retiree. It will indeed take some costly and politically difficult repairs to keep Social Security viable.

The graph below from Chapter 4 of Gruber summarizes the overall intergenerational equity accounting. We'll talk more about this in class tomorrow.

Tax rate trends for the top 400 taxpayers

The graph above shows how effective average tax rates have changed over time for the 400 taxpayers with the highest adjusted gross income each year from 1992 through 2006.

Although the income of this group reached record high levels, their effective average tax rate fell to the lowest level since the IRS began tracking the group.

The top 400 taxpayers clearly face a much lower effective tax rate than many ordinary working Americans of much more modest means. This is largely due to the fact that most high income taxpayers take a large chunk of their income in the form of long-term capital gains and dividends, which are taxed at preferential rates compared to "ordinary income."

Taking payroll taxes (Social Security and Medicare) into account would make the contrast even starker, since most working Americans pay more in payroll tax than in income tax.