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Payroll tax, federal

Originally published in the NTA Encyclopedia of Taxation and Tax Policy, Second Edition, edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle. The encyclopedia is available in paperback from the Urban Institute Press. Order online at www.uipress.org or call toll-free 1-877-847-7377

Edward W. Harris
Congressional Budget Office

A group of taxes levied on the earnings of employees and self-employed persons


Payroll taxes have grown substantially in past decades and are now the second largest source of federal revenues. As a share of total receipts, payroll taxes increased from 10 percent in 1937 to 40 percent in 2003. Over the same period, payroll taxes grew from 1 percent to almost 7 percent of gross domestic product.

Components of federal payroll taxes

Federal payroll taxes, or social insurance contributions, consist of tax revenues from Social Security, Medicare hospital insurance, unemployment insurance, railroad retirement, and other retirements. Social Security makes up the lion’s share of federal payroll taxes-73 percent of the $713 billion collected in 2003. Medicare, the second largest component, makes up 21 percent of payroll tax revenues. The remaining revenue is divided between unemployment insurance (5 percent), railroad retirement (less than 1 percent), and other retirements (less than 1 percent).

Social Security

Social Security (OASDI, or Old Age, Survivors, and Disability Insurance) began in the late 1930s as a mandatory old-age insurance program for most employees in the private sector. Over time, the program was expanded to include disability insurance and mandatory coverage for almost all workers.

The Social Security Act of 1935 provided monthly benefits to retired workers covered by Social Security. In 1939, benefits were extended to the dependents and survivors of covered workers. The program was further expanded to provide disability insurance to covered workers and their dependents in 1956 and 1958, respectively.

Even in its infancy, coverage under Social Security was broad. All workers in commerce and industry-except railroad workers, who had their own retirement plan-were originally covered under Social Security. Beginning in the 1950s, coverage was expanded to include most workers in the private sector not originally covered. Participation was mandatory for some, such as farm and domestic workers and self-employed persons, and elective for others, such as nonprofit workers, state and local government workers, and employees of religious bodies. Additional legislation in the mid-1980s expanded coverage to federal workers hired after 1983 and mandated coverage for employees of nonprofit organizations. In 2002, about 96 percent of all jobs in the United States were covered by Social Security. Workers excluded from coverage fall into four major categories: federal civilian employees hired before 1984, railroad workers, certain state and local government workers covered under a retirement system, and workers whose earnings do not meet minimum earnings requirements.

Benefits earned by covered workers are financed primarily by a payroll tax on a worker’s wages. Both the employee and the employer pay taxes based on the worker’s earnings up to a maximum amount or taxable maximum earnings base. In 1937, both employee and employer each paid a 1 percent tax, levied on all covered earnings up to $3,000. This captured the full earnings of about 97 percent of all covered workers. Since then, both the tax rate and the maximum taxable earnings base have been increased by myriad legislative measures. The most recent increase in the OASDI tax rate occurred in 1990, when the rate was increased from 6.06 percent to 6.2 percent. The tax rate applicable to self-employed persons has varied over the years; since 1990, self-employed persons have been subject to a tax rate of 12.4 percent, which is equal to the combined employee and employer tax rates. The taxable maximum was increased by a series of ad hoc legislative changes until 1975, when Congress tied the maximum earnings base to changes in the national average wage. Since then, the taxable maximum earnings base has been automatically indexed each year. In 2004, the taxable maximum earnings base was $87,900, which is expected to capture the full earnings of around 94 percent of the workforce.

Medicare hospital insurance

The Social Security Act was amended in 1965 to include Medicare hospital insurance (HI). This program, which is financed primarily through payroll taxes, provides hospitalization benefits to eligible persons age 65 or older. Generally, eligible persons have paid HI taxes based on their covered earnings.

For many years, the pool of workers paying HI taxes and the taxable maximum earnings base were identical to those Payroll tax, federal 293 under Social Security. In the mid-1980s, however, the HI pool was expanded to include all federal workers and all state and local workers hired after March 31, 1986. In 1991, the HI taxable maximum earnings base was raised from $53,400 to $125,000, and in 1994 it was eliminated entirely, thereby decoupling it from the Social Security base and making all covered earnings subject to the tax.

The HI tax rate is 1.45 percent on all covered earnings. Both the employee and the employer pay this tax rate, and self-employed persons pay the combined tax rate. While the original tax rate was 0.35 percent in 1966 and increased steadily over the next three decades, no further increases are currently scheduled.

All revenue generated from the HI payroll tax is deposited in the Hospital Insurance Trust Fund. Revenues in that trust fund are used to finance inpatient hospital, skilled nursing facility, home health, and other institutional services.

Unemployment insurance

Unemployment insurance (UI) payroll taxes began in the 1930s; the taxes are used to finance unemployment benefits for workers involuntarily unemployed.

Basically, the UI payroll tax has two parts: the Federal Unemployment Tax Act (FUTA) tax and the state tax. FUTA taxes finance the administrative expenses of the program, the federal account for state loans, and half the expense of extended benefits. State taxes, which are deposited in the U.S. Treasury, finance regular UI benefits and half the expense of extended benefits.

The FUTA program is designed to induce state participation by granting a credit against the federal tax if the state program conforms to federal standards. FUTA generally determines which workers are covered by UI. Originally, coverage was limited to industrial and commercial workers in the private sector. Currently, the vast majority of workers, with the exception of self-employed persons, are eligible for UI benefits.

FUTA imposes some other guidelines on state programs, but states are generally free to determine the amount and duration of benefits, the tax rate, and eligibility requirements. FUTA currently imposes a 6.2 percent gross tax rate on the first $7,000 paid annually by covered employers to each employee. Employers in states with programs approved by the federal government and with no delinquent federal loans may credit 5.4 percentage points against the 6.2 percent tax rate, making the minimum, net federal tax rate 0.8 percent. Currently, all states have approved programs, so the relevant rate is 0.8 percent. Included in these rates is a 0.2 percent surtax, which was originally enacted in 1976 and extended several times since then. The surtax is currently set to expire at the end of 2007.

Originally, the FUTA tax applied to total annual wages. In 1939, however, a $3,000 taxable wage base was established that exceeded the annual wages of 98 percent of the workers subject to the tax. The taxable wage base was increased three times: to $4,200 in 1972, to $6,000 in 1978, and to $7,000 in 1983.

States must impose a payroll tax on employers for at least the first $7,000 paid annually to each employee to be eligible for the 5.4 percentage point FUTA credit. In 2003, 42 states had taxable wage bases greater than $7,000; Hawaii has the highest base, at $30,200. All state laws have experience ratings that vary individual employers’ tax based on their previous unemployment experience. In 2003, the national average of state tax rates was 0.6 percent of total wages, or 2.1 percent of taxable wages.

Railroad retirement

Federal involvement in providing and financing railroad retirement began in the mid-1930s, when declines in the railroad industry imposed tremendous financial hardships on the railroads. The current system was established in 1974, and substantial modifications were made to the program in 2001.

The retirement system has two tiers that are financed by federal payroll taxes on the wages of railroad employees. The tier 1 tax rate is equivalent to the combined Social Security and Medicare HI tax rate. Under tier 1, both employee and employer pay taxes on covered wages up to the applicable maximum taxable earnings base for Social Security and all covered wages for HI. Under tier 2, the wage base is equal to what the Social Security tax base would have been without the ad hoc increases in the taxable wage base provided by the Social Security amendments of 1977. In 2004, the tier 2 taxable wage base was $65,100. Unlike tier 1 and Social Security, where both the employer and employee tax rates are 7.65 percent, tier 2 employers’ contributions are much greater; in 2004, the tier 2 employer and employee tax rates were 13.1 percent and 4.9 percent, respectively. Under the 2001 legislation, the tier 2 rates automatically adjust, beginning in 2004, based on the financial status of the retirement system. The employer rate varies from 8.2 percent to 22.1 percent, and the employee rate ranges from 0.0 percent to 4.9 percent.

Other retirements

Basically, revenues classified as “other retirements” in the federal budget are the retirement contributions of federal government workers. [Employer and employee payroll taxes for District of Columbia government employees are also included as other retirement revenues in the federal budget.] Federal government workers are covered under one of two retirement programs. For decades, all workers were covered under the Civil Service Retirement System (CSRS). Under this program, most employees contribute 7 percent of wages to finance retirement benefits. (A higher tax rate is levied on workers in special groups, such as law enforcement officers and congressional staff.) CSRS employees are not covered by the Social Security system. In 1984, a new retirement program for federal workers, the Federal Employees’ Retirement System (FERS), was introduced. FERS is mandatory for workers hired in 1984 and later. FERS replaced the defined benefit program under CSRS with a smaller defined benefit program, but added Social Security coverage for FERS employees. The defined benefit portion is financed by employee contributions of 0.8 percent of wages. Under both programs, the federal government also makes an employer contribution based on the workers’ wages; this, however, is considered an intergovernmental transfer and not included in the revenue totals.

Incidence of federal payroll taxes

Unemployment taxes are statutorily levied on employers only, while Social Security and Medicare taxes are levied on both the employer and the employee. Economists generally believe that the burden of payroll taxes is borne by workers in the form of lower wages, regardless of whether the tax is levied on the employer or the employee.

Payroll taxes are less progressive than individual income taxes because payroll taxes tax only earned income, and most payroll taxes include a maximum taxable earnings base. Effective or average federal payroll taxes rates increase across the bottom of the income distribution, since the lowest-income people generally have little income from wages. Average rates are virtually flat across the broad middle of the income distribution, and decline at the top of the income scale, where people often have earnings above the taxable level. (Including both payroll taxes and the benefits financed by those taxes would show a more progressive system.) In an effort to increase the progressivity of payroll taxes and to create incentive to entering the labor force, the earned income tax credit (EITC) was introduced in 1975 to lighten the burden on working people below certain incomes. Since then, the EITC has been expanded several times, including the Omnibus Budget Reconciliation Acts in 1990 and 1993.

ADDITIONAL READINGS

  • Burman, Leonard E. "Is the Tax Expenditure Concept Still Relevant?" National Tax Journal 56 (September 2003): 613-27.
  • Musgrave, Richard A., and Peggy B. Musgrave. Public Finance in Theory and Practice. 5th ed. New York: McGraw-Hill, 1989.
  • Pechman, Joseph A. Federal Tax Policy. 5th ed. Washington, DC: Brookings Institution Press, 1987.
  • Rosen, Harvey S. Public Finance. 6th ed. New York: McGraw-Hill/Irwin, 2002.
  • Sammartino, Frank, Eric Toder, and Elaine Maag. "Providing Federal Assistance for Low-Income Families through the Tax System: A Primer." Tax Policy Center Discussion Paper no. 4. Washington, DC: The Urban Institute, 2002.
  • U.S. Congress, Congressional Budget Office. The Economic and Budget Outlook: Fiscal Years 2005-2014. 108th Cong., 2d sess., 2004.
  • U.S. Congress, House of Representatives, Committee on Ways and Means. 2004 Green Book: Background material and Data on the Programs within the Jurisdiction of the Committee on Ways and Means. 108th Cong., 2d sess., 1996.