Although income tax is more salient, most Americans pay more in payroll taxes. These are the Social Security and Medicare deductions you see on each paystub (a.k.a. FICA or OASDI). Income taxes are progressive, meaning taxpayers pay a progressively higher percentage of their incomes as their incomes increase. Payroll taxes, on the other hand, are regressive, meaning taxpayers pay a flat and/or decreasing percentage of their incomes as their incomes increase. This results in an unusual and unfair phenomenon where 76% of taxpaying Americans actually pay more payroll taxes than federal income taxes.
How do payroll taxes work? A fixed percentage of your gross wages are deducted by your employer each pay period, paid to the federal government. This percentage, as of 2018, is 6.2% for Social Security and 1.45% for Medicare, for a combined total of 7.65%. Many employees do not know this, but your employer also must contribute 6.2% for Social Security and 1.45% for Medicare behind-the-scenes, which is another 7.65% bringing your total tax to 15.3%. This means that when a job is advertised for $10.00 per hour, your employer actually is paying $10.77 per hour if we include their share of these taxes, and even more if we also consider unemployment tax, workers’ compensation insurance, and other obligations. Although payroll taxes do not apply to some employees and employers, such as myself as a Graduate Teaching Associate at University of Central Florida, these exceptions are uncommon.
If you are self-employed, you must pay the full 15.3% of payroll taxes out-of-pocket. This is a shock for many sole proprietors, such as freelancers. The IRS expects tax payments on a quarterly basis, rather than a lump sum after the tax year ends (if you were an employee, they would be getting the money in advance from each paycheck). Your business expenses, such as miles driven in a car, may be deducted to reduce the earned income to which payroll and income taxes apply (keeping excellent records and employing an accountant is recommended).
With income tax, nearly half of Americans get all the money back (or more) in their tax refunds. A good chunk of your income is exempt (the standard personal deduction), and tax credits, most notably the Earned Income Tax Credit, soak up whatever other tax is owed and provide a sizable refund for low- and middle-earning people who have children. This stands in stark contrast to payroll taxes, for which there is no refund. (Except in the unusual case where you had multiple employers and earned more than $128,400 [2018 cap] in combination between them, in which case you can get a refund from the IRS for the excess 6.2% Social Security tax you paid on amounts exceeding $128,400.)
The IRS, as directed by existing laws/regulations and the U.S. Congress, makes an important distinction between earned and unearned income. Earned income consists of typical employment wages, including self-employment, and is subjected to payroll taxes. Unearned income includes bank account interest, dividends, capital gains, and Social Security benefits, which are not subject to payroll taxes. With qualified dividends and capital gains, the income tax rates are lower too; about half that of ordinary, earned income. This is an enormous benefit to investors in equities (stocks), who already benefit from the huge capital gains that equities reliably provide over long periods of time. It’s also an enormous disadvantage to most Americans, who work but do not invest, and is a primary contributor to wealth inequality and disenfranchisement.
Although payment of payroll taxes is compulsory and factors into the amount of Social Security benefits you receive each month in retirement, in a U.S. Supreme Court case from 1960, it was decided that paying payroll taxes does not entitle you to anything. The plaintiff in this case was deported for being a communist, and thus his Social Security benefits were revoked despite having paid payroll taxes for 19 years, which the court upheld.
Nonetheless, most Americans can count on receiving their benefits if they survive to retirement age. However, many caution that the system will become unsustainable by the time today’s emerging adults reach retirement age. But, this is a product of tax policy: Social Security tax unfairly rewards high earners by pulling a vanishing act for wages above $128,400 per year. This means if someone earns $200,000 per year at one employer, the government collects 12.4% in Social Security tax on their first $128,400 in wages, but collects 0% on the next $71,600 of wages. Incredible. We could make Social Security solvent by eliminating the cap. Bernie Sanders suggested raising the cap to $250,000 in wages during his 2016 presidential campaign, which has been criticized as extending solvency only from 2034 to the year 2055, but removing the cap entirely would probably do the trick, while maintaining Social Security’s standing as a regressive tax. It would merely be less regressive than it is now.
With Medicare tax, which is 2.9% divided equally between employer and employee, there is already no cap. In fact, for earned income above $200,000, employees have to pay an extra 0.9%, bringing the total tax to 3.8%, and meaning the Medicare portion of payroll taxes might actually be classified as progressive. As we can see here, if removing the Social Security cap proves insufficient, there is already a precedent for having an uncapped payroll tax that also increases with higher earnings.
Because of the grossly unfair tax treatment that earned income receives, coupled with the power of investing in index funds of the whole stock market and the tax benefits one receives for doing so through lower taxes on capital gains, privileged tax treatment for retirement accounts (i.e., 401[k], 403[b], 457, IRA, thrift savings plans, etc.), and other incentives like the Retirement Savings tax credit, relying only on earned income and savings accounts is pretty much hopeless, if your goal is to achieve financial independence. This is why educating yourself (such as by reading Tippyfi) and improving your financial and investing capabilities sooner, rather than later, is critical.