Policy Basics: Federal Payroll Taxes
Updated March 31, 2014
The federal government levies payroll taxes primarily on wages and self-employment income and uses most of the revenue to fund Social Security, Medicare, and other social insurance benefits. In fiscal year 2013, federal payroll taxes generated $947 billion, or 34 percent of all federal revenues (see Policy Basics: Where Do Federal Tax Revenues Come From?).
Main Payroll Taxes Fund Social Security and Medicare
The two main federal payroll taxes levied on wages are known as Federal Insurance Contributions Act (FICA) taxes. Employees and employers both pay FICA taxes: employees usually have them withheld from their paychecks, while employers pay them in addition to any other taxes they owe. However, most economists agree that employees bear the true cost of employer payroll taxes in the form of lower wages. The two FICA taxes are:
- Social Security tax, also known as the Old Age, Survivors, and Disability Insurance (OASDI) tax. It is levied at a rate of 12.4 percent (split evenly between employees and employers) up to a maximum amount of an employee’s wages ($113,700 in calendar year 2013). This wage cap is adjusted annually to take account of increases in average wages. The revenues go toward funding Social Security, which pays benefits to retirees, persons with disabilities, and survivors of deceased workers (see Policy Basics: Top Ten Facts about Social Security and Policy Basics: Social Security Disability Insurance).
- Medicare tax, also known as the Medicare hospital insurance (HI) tax. It is levied at a rate of 2.9 percent of wages (split evenly between employees and employers); unlike the Social Security tax, there is no wage cap. Starting in 2013, married filers’ earnings over $250,000 (and singles’ earnings over $200,000) are taxed at an additional 0.9 percent, for a total of 3.8 percent on this income. Revenues from the Medicare tax support the hospital insurance portion of Medicare, which pays for health benefits such as inpatient hospital care. (There is a 3.8 percent tax on investment income for high-income taxpayers as well, but it isn’t withheld through the payroll tax or reserved for the Medicare Hospital Insurance trust fund.)
People who work for themselves pay a self-employment tax — the Self Employment Contributions Act (SECA) tax — to fund Social Security and Medicare. These taxes are equivalent to FICA taxes; the same basic rates and caps effectively apply.
A third federal payroll tax is the Federal Unemployment Tax Act (FUTA) tax. Employers pay an effective rate of 0.6 percent on the first $7,000 of a worker’s wages, up to $42 per worker per year. The revenues mainly go toward financing the administration of state unemployment insurance programs. Each state collects an additional unemployment payroll tax to further finance unemployment benefits. (For more, see Introduction to Unemployment Insurance.)
Payroll Taxes Have Larger Impact on Lower-Income People
Payroll taxes are regressive: low- and moderate-income taxpayers pay more of their incomes in payroll tax than do high-income people, on average. The bottom fifth of households paid an average of 8.4 percent of their incomes in payroll tax in 2010, according to the Congressional Budget Office, while the top fifth paid 6.7 percent and the top 1 percent of households paid just 2.2 percent.
However, if one looks at the overall impact of Social Security, Medicare, and unemployment insurance — the benefits they provide as well as the taxes they collect — these programs are progressive. For instance, Social Security benefits represent a higher proportion of a worker’s previous earnings for workers at lower earnings levels; and while all Medicare beneficiaries are eligible for the same services, high-income beneficiaries pay more in Medicare taxes and premiums.
History and Recent Policy Changes
As policymakers have strengthened social insurance programs like Social Security over time, payroll taxes have become an increasingly important part of the federal budget. When the Social Security tax was introduced in 1937, it accounted for 11 percent of federal revenues; today payroll taxes as a whole account for 34 percent. Unlike income tax rates, which have generally declined throughout the post-World War II era, payroll taxes have consistently increased.
Late in 2010, to help the economy recover from the severe recession, policymakers temporarily cut the employee share of the Social Security tax from 6.2 percent to 4.2 percent. The measure expired at the end of 2012. The loss of Social Security revenues from the two years of the payroll tax cut was offset with transfers from other government accounts and so did not affect the Social Security Trust Funds.