Policy Basics: Federal Payroll Taxes
Updated April 15, 2013
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. Federal payroll taxes generated $845 billion in 2012, or 35 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, currently $113,700. This wage cap is adjusted annually to take account of increases in average wages (it will be $117,900 in 2014). The revenues go towards funding Social Security, which pays benefits to retirees, persons with disabilities, and survivors of deceased workers.
- 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, earnings over $250,000 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.
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 towards 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 8.3 percent of their incomes in payroll tax in 2009, according to the Congressional Budget Office, while the top fifth paid 7.2 percent and the top 1 percent of households paid just 2.5 percent. There are two reasons why:
- The cap on the amount of wages subject to the Social Security tax means that very high-income people do not face the tax on all of their wage income.
- Low- and moderate-income taxpayers tend to make a larger share of their incomes from salary and wages (which are subject to payroll taxes) than high-income taxpayers do. High-income taxpayers tend to get a greater share of their incomes from capital gains, dividends, and other investment income that is not subject to payroll taxes.
Although payroll taxes are regressive, the programs they support are progressive. That is, if one looks at the overall impact of Social Security, Medicare, and unemployment insurance — both the taxes they collect and the benefits they provide — 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 much 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 35 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.