Who pays the payroll tax?
Tax laws divide the statutory burden of the payroll tax between employers and employees, each of whom pays 6.2 percent for Social Security and 1.45 percent for Medicare, or 15.3 percent in all. Starting in 2011, Congress cut the employee portion of the Social Security tax to 4.2 percent. At the end of the year, it extended that temporary reduction for two more months.
In one of the great frauds embedded in our tax system, Congress chose this pattern of statutory rates to make it look like the government is going easy on workers. The arrangement may fool a few people, but statutory rates are not what matter. The important thing is who actually bears the economic burden of the tax—what tax wonks call the question of tax incidence.
The incidence of some taxes is deeply controversial. For example, as I discussed in a recent post, experts have argued for decades about how the burden of the corporate income tax is split among shareholders, workers, and possibly other corporate stakeholders. By comparison, the payroll tax is an easy case. Economists are as close to unanimous as our contentious profession ever gets in placing the economic burden of the payroll tax 100 percent on workers.
It is not hard to understand why. The number of workers a firm is willing to employ depends, from the employer’s side, on the total cost of hiring and, from the employee’s side, on take-home pay after all taxes. How the total tax is split between the lines labeled “employee’s share” and “employer’s share” makes absolutely no difference for either party. What matters is the total gap between employers’ labor costs and workers’ take-home pay.
What happens when the government raises the total tax rate? In principle, employees could force employers to absorb part of any increase by cutting back their hours worked, withdrawing from the labor force, or moving to some country where payroll taxes were lower, but past experience suggests that they do none of those things. They supply just as much labor after a tax increase as they did before. As a result, once things settle down following a few rounds of wage negotiation, employers manage to shift the whole burden of any payroll tax increase to workers.
The payroll tax is regressive
Once we know that the whole burden of the payroll tax falls on labor income, we can go about measuring its distribution among income classes, that is, its progressivity or regressivity. Two features make the payroll tax one of the most regressive parts of our entire tax system. One is the income cap, which means that wages and salaries are subject to the payroll tax only up to $106,800 per year. The other is the exemption of non-labor income, which makes up a disproportionately large share of income for wealthier households.
Consider these numbers: The top 1 percent of taxpayers, whose average income is just over one and a half million dollars a year, derive 54 percent of that income from capital gains, dividends, and business profits. No payroll tax is due on any of that. Wage and salary income for the top 1 percent averages $690,000, of which only the first $106,800 is subject to tax. By comparison, the middle 20 percent of taxpayers have an average income of $36,451 per year, of which 93 percent is wage and salary income, all of it subject to payroll taxes. (Data from this source.)
The payroll tax is not only regressive; it has become more regressive over time. The following chart from the Congressional Budget Office shows that while the federal income tax became slightly more progressive between 1979 and 2007, the payroll tax became more regressive. As a result, the federal tax system as a whole became less progressive.
Increasing dependence on the payroll tax
The regressivity of the payroll tax would not be a big issue if it were only a small part of all federal taxes, as it once was. In the early post-World War II period, as the following chart shows, payroll taxes contributed just 10 percent of all federal tax revenue. Now that share has grown to 40 percent. Depending on exactly how you measure it, something like 85 to 90 percent of working families pay more in payroll tax than income tax.
Some observers think that the consequences of heavy dependence on the payroll tax go beyond simple economics. Charles Murray’s recent book, Coming Apart, has raised a storm of controversy by calling attention to the social breakdown of lower-income white American families—drugs, crime, single-parent households, and more. Writing in the New York Times, Ross Douthat makes these observations:
[If] we want the poor to be industrious, we should do everything possible to make their industry pay off. The current tax-and-transfer system imposes a tax on work — the payroll tax — that falls heavily on low-wage labor, and poor Americans face steep marginal tax rates because of how their benefits phase out as their wages increase. Both burdens can and should be lightened. There are ways to finance Social Security besides a regressive tax on work, and ways to structure benefits and tax credits that don’t reduce the incentives to take a better-paying job.
How to fix it?
There are a lot of ideas floating around about how to reform the payroll tax. The simplest ones just tweak the current system a bit while retaining the link of payroll taxes to Social Security and Medicare trust funds. For example, it would be possible to rebate the first $500 or $1,000 of payroll taxes to workers and make up the loss of revenue by increasing the income cap by an appropriate amount.
A more ambitious approach to reform would abandon the idea of funding Social Security and Medicare with a dedicated tax. Instead, the current payroll tax could be fully integrated with the income tax. The resulting tax system would resemble that of New Zealand, which, alone of OECD countries, has no separate payroll tax. The Urban Institute-Brookings Tax Policy Center has simulated the effects of one version of an integrated system, which would exempt the first $5,000 of income from the employee portion of payroll taxes and, at the same time, remove the cap. Doing so would produce tax cuts for most households with less than $100,000 annual income balanced by tax increases for higher earners.
Still another idea would be to replace all or part of the payroll tax with a value added tax. Eric Toder and Joseph Rosenberg of the Tax Policy Center have published a paper discussing various ways to introduce a VAT into the U.S. tax system. One option they explore is using VAT revenue to reduce payroll tax rates. The authors calculate that revenue from a broad-based 5 percent VAT would be sufficient to cut the Social Security portion of the payroll tax roughly in half. The VAT itself is sometimes criticized as regressive but, as Toder and Rosenberg explain, it could be implemented in a way that was less regressive than the current payroll tax.
It would be possible to undertake reform of the payroll tax in isolation, but it would be best to do it as part of a comprehensive restructuring of the tax system that broadened the base, closed loopholes, and lowered marginal rates across the board. There is probably no such thing as a perfect tax system, but any of numerous reform proposals would be an improvement over what we have.
The real problem with tax reform is not designing a better system, but finding the political courage to implement it. The administration’s 2013 budget proposal, to its credit, does endorse the broad principle of tax reform. It urges Congress “to undertake comprehensive tax reform to cut rates, cut inefficient tax breaks, cut the deficit, and increase jobs and growth”. Unfortunately, the specific tax proposals contained in the budget are few and weak. Highlights include:
- The 10-month extension of the 2 percent payroll tax cut
- A small reduction in the rate at which the wealthiest taxpayers can make use of itemized deductions
- Taxing carried interest (but not other forms of capital gains) as ordinary income
- Eiminating special tax breaks for corporate aircraft.
Beyond these timid reform-minded measures, the budget promises to end the Bush tax cuts for top earners. Even granting the administration’s wish to restore some of the lost progressivity of federal taxes, raising top marginal rates is a poor approach. It would be better to accomplish the same thing by closing loopholes more aggressively.
Some say we should not expect much because it is an election year. Instead, we should expect more. If Congress is going to reject most of the administration’s tax reform agenda anyway, why not let them reject a bold program rather than a timid one? Putting a credible program on the table would increase the likelihood that the next Congress might actually take it up.