Impose a New Payroll Tax

Background

Payroll taxes are levied on the earnings, primarily wages and salaries, of people who work for an employer and on the net earnings of people who are self-employed. Unlike the individual income tax, payroll taxes are not applied to other sources of income, such as interest, dividends, or capital gains. The individual income tax also includes many deductions, exemptions, and credits; by contrast, payroll taxes are generally more straightforward and have few, if any, adjustments. A payroll tax can be paid by an employer or an employee, or by both. Typically, payroll taxes are set at a single uniform rate.

In the United States, payroll taxes are used to finance social insurance programs and are the second-largest source of federal revenues after the individual income tax. The two largest sources of payroll tax revenues are Social Security payroll taxes and Medicare payroll taxes. Social Security payroll taxes are the primary source of financing for Old-Age and Survivors Insurance and Disability Insurance. Only earnings up to a statutory maximum are subject to Social Security taxes. (That maximum amount is $147,000 in calendar year 2022.) The Social Security tax rate is 12.4 percent of earnings: Employees have 6.2 percent of earnings deducted from their paychecks, and the remaining 6.2 percent is paid by their employers. Self-employed individuals generally pay 12.4 percent of their net self-employment income. The primary source of financing for Hospital Insurance (HI) benefits provided under Medicare Part A is HI payroll taxes. The basic Medicare payroll tax rate is 2.9 percent of earnings. For employees, 1.45 percent is deducted from their paychecks and 1.45 percent is paid by their employers. Self-employed individuals generally pay 2.9 percent of their net self-employment income. Unlike payroll taxes for Social Security, the 2.9 percent Medicare payroll tax is levied on all earnings, and no taxable maximum applies.

Option

This option consists of two alternatives. The first alternative would impose a new payroll tax of 1 percent on earnings. The second alternative would impose a new payroll tax of 2 percent on earnings. For both alternatives, the income subject to the tax would match that of the Medicare payroll tax, so there would be no taxable maximum. The new tax would be paid entirely by employees. Self-employed individuals would face the same tax rates as those who work for an employer.

This option would not make any changes to existing payroll taxes. Further, unlike existing payroll taxes, the taxes described in the option would not be tied to the financing of a specific social insurance program.

Effects on the Budget

If implemented, the first alternative—imposing a new payroll tax of 1 percent—would reduce the deficit by $1.1 trillion from 2023 through 2032, according to estimates by the staff of the Joint Committee on Taxation (JCT). JCT estimates that the second alternative—imposing a new payroll tax of 2 percent—would reduce the deficit by $2.3 trillion over the same period, roughly double the effect of the first alternative.

The higher payroll tax would create an incentive for employers and employees to seek to change the composition of compensation, shifting from taxable compensation, such as wages and salary, to forms of nontaxable compensation, such as employment-based health insurance. The estimates account for that behavioral response.

Uncertainty About the Budgetary Effects

The estimates for this option are uncertain primarily because the underlying projections of earnings are uncertain. The estimates rely on the Congressional Budget Office's projections of the economy over the next decade, particularly projections of wages and employment. Those projections are inherently uncertain. However, CBO's projections of wages are typically less variable than its projections of other sources of income, such as capital gains realizations or corporate profits.

Distributional Effects

Under this option, the share of income owed in taxes would rise more for lower-income workers than for higher-income workers. That is because households toward the bottom of the income distribution typically receive a larger share of their income in the form of earnings, which would be subject to the new payroll tax, as opposed to other forms of income, such as capital gains, which would not. As a result, the additional payroll tax would represent a greater proportion of the income of lower-income households than would be the case for higher-income households.

Economic Effects

In addition to having the behavioral effects reflected in conventional budget estimates, such as the ones shown above, a new payroll tax would also affect taxpayers' incentive to work. All people who work would face an increase in their marginal tax rate on earnings. (The marginal tax rate is the percentage of an additional dollar of income that is paid in taxes.) When marginal tax rates increase, there are two effects. First, people have an incentive to work fewer hours because other uses of their time become relatively more attractive. Second, increases in statutory tax rates can cause people to work more hours, because having less after-tax income requires additional work to maintain the same standard of living. CBO estimates that, on balance, the former effect would be greater than the latter effect, and people would reduce the average number of hours they work.

Other Considerations

This option would be easier to implement than most other types of tax changes. Employers already deduct existing payroll taxes from employees' paychecks and remit payments to the federal government. As a result, the administrative burden of imposing a new payroll tax with a single rate and without a taxable maximum would be minimal.

Although the payroll tax in this option would be levied on employees, additional payroll taxes could be levied on employers instead. In CBO's assessment, employers would reduce their employees' earnings over time to leave the cost of those employees' compensation unchanged. Consequently, a tax levied on employers would reduce employees' after-tax earnings in the same way that a tax levied on the employees would. The budgetary effect of a payroll tax levied on employers would be different, however, because the reduction in employees' earnings would reduce the income base for individual income and payroll taxes. That effect would partially offset the increase in payroll taxes. Therefore, a payroll tax split between employers and employees would be estimated to result in less additional revenue than a payroll tax paid entirely by employees.