If you work for a company, then you probably pay payroll taxes. Payroll taxes are removed from every paycheck and sent to the government. Instead of paying the government a big lump sum in taxes in April, you can pay them smaller sums throughout the year.
Many of us take payroll taxes as an integral part of being a citizen. However, it hasn’t always been that way. Payroll taxes – also known as withholding taxes – are relatively new. Find out everything you need to know about payroll taxes and the history of payroll taxes today.
What Are Payroll Taxes?
First, it’s important to define payroll taxes. The primary responsibility of payroll taxes – at least in the United States – is to finance Social Security and a portion of Medicare. You, as an employee, pay half of your individual burden, while your employer pays the other half.
A payroll tax, like most other types of taxes, is calculated as a percentage of the salaries that employers pay their staff.
There are two broad types of payroll taxes in the world today, including:
-Withholding Tax: Taxes that employers are required to withhold from employees’ wages. These taxes are also known as pay-as-you-earn (PAYE) taxes or pay-as-you-go (PAYG) taxes. They cover your payment of income tax, social security contributions, and other insurances that vary between countries and governments (like unemployment and disability).
-Taxes from the Employer: These taxes are paid from the employer’s own funds and are directly related to employing a worker. This can consist of fixed charges, or it can be proportionally linked to an employee’s pay. These taxes cover the employer’s share of the social security system and other government programs.
Payroll Taxes Around the World
Most first world countries have some type of payroll tax. We’re not going to cover every payroll tax in detail in this article. However, some of the highlights of payroll taxes around the world can be found below:
-Australia: Australia’s federal government requires a withholding tax on employment income. This is considered a pay-as-you-go (PAYG) system (the first type mentioned above). Meanwhile, the individual states impose payroll taxes of the second type mentioned above.
-Brazil: Brazilian employers are required to withhold 11% of their employee’s wages for Social Security along with a certain percentage for income tax (according to the employee’s income tax bracket). Additionally, the employer is required to contribute an additional 20% of the total payroll value to the Social Security system.
-Canada: Canadians pay payroll taxes at the federal level for the Canada Pension Plan and Employment Insurance. Individual provinces add taxes for workers’ compensation premiums. Certain provinces and territories have additional taxes for employees or employers – like Ontario’s Employer Health tax.
-China: China’s payroll tax is paid to provinces and territories by employers. The tax is deducted from each worker’s pay, although individual employees do not specifically pay payroll taxes. The federal Chinese government charges just one single tax, a PAYG tax for medicare premiums.
-France: France has a unique payroll tax system. Employees can opt out of the payroll tax system (in which case they pay their taxes once a year, on their own). Otherwise, employees are billed for income tax prepayments twice a year. The employer pays the majority of the share for social security programs, which include everything from unemployment to child benefits to a “general social tax”.
-Germany: Germans pay payroll taxes only on wages up to a certain threshold. They pay health and nursing care insurance, for example, as well as old age and unemployment insurance, only up to a certain threshold per year (49,500 Euros or 72,00 Euros).
-UK: The UK is well-known for its PAYE tax rate. There are four PAYE income tax bands. Employees have a certain amount deducted from their salary every month. Additionally, employees pay a national insurance contribution of 12%, while employers pay a contribution of 13.8%.
-USA: Payroll taxes are assessed by the federal government and each state (aside from the states that pay no state income tax). These payroll taxes are used to fund Social Security and Medicare.
Payroll Taxes in the Early United States
The first income tax in the United States was introduced by Abraham Lincoln during the US Civil War. It was designed to help finance the rising costs of the Civil War. After the war was over, the tax was repealed.
Later in the 19th century, Congress tried to implement another income tax to fight rising government deficits. However, that income tax was repealed by the US Supreme Court after it was deemed unconstitutional: the US Constitution forbids taxation without proportional representation, and the 1894 income tax didn’t meet that requirement.
The US government faced a problem: it needed more money, and it had an easy source of money in the American people. However, it couldn’t tax these people because of the pesky US Constitution.
So what did the US government do? It passed the 16th Amendment, which allowed for Americans to be charged an income tax.
The early income tax was similar to modern income tax: Americans were charged a certain tax rate based on their income. However, in the early days of the income tax, fewer than 10% of Americans were required to pay income tax. The vast majority of the country earned less than $3,000 USD per year (a modest sum at the time), which means their tax burden was 0. Taxes were largely a problem for the wealthy classes.
In any case, the 16th Amendment paved the way for the payroll tax we know today.
Early Withholding Tax in the United States
In the early 20th century, people generally called payroll taxes “withholding taxes”.
Taxpayers were required to file tax returns and self-assess tax. Taxes were withheld from “payments of income” (your salary or wages). If any of your tax burden was not covered by withholdings, then taxpayers were required to make estimated tax payments every quarter.
At the end of each fiscal year, tax returns were subject to review and adjustment by taxing authorities – like the Internal Revenue Service (which wasn’t actually called the Internal Revenue Service until the 1950s).
During this phase, taxable income was considered to be your gross income minus all exemptions, deductions, and personal exemptions. Gross income included “all income from whatever source”. Certain income was subject to tax exemption, including both personal exemptions and business deductions.
Federal Insurance Contributions Act Tax
Today, most of your payroll taxes fall under FICA. FICA stands for the Federal Insurance Contributions Act.
The act is imposed on both employers and employees to fund Social Security and Medicare, two programs that provide basic social services for America’s retirees, the disabled, and children of deceased workers.
This tax also provides funding to America’s health care system, including to healthcare organizations that provide basic healthcare coverage to those without insurance and are unable to afford health care.
Meanwhile, the social security portion of your payroll taxes goes towards old age security benefits, survivors benefits, and disability insurance (which falls under OASDI).
The amount that you pay into social security throughout your working career is linked to the amount you receive in benefits as a retiree. The more payroll taxes you pay, the more social security benefits you’ll get when you retire.
Why Did the United States Institute Payroll Taxes?
Payroll taxes (at least, payroll taxes under FICA) were introduced because America needed a social safety net for its citizens. Prior to the Great Depression, most Americans had no social safety net to fall back on. FICA was a way to fix that problem.
FICA was seen as a way to solve the following problems:
-The US had no mandated retirement savings program. That means anyone who didn’t voluntarily save money throughout their working career had no income after they retired.
-The US had no disability income insurance, which means those who were disabled and unable to work received no income or compensation.
-The US had no social programs in place to those who were born with disabilities, or anyone who was born with a cognitive disorder.
-There was no government-mandated health insurance for elderly citizens, which means that many elderly citizens were unable to pay for medical care at the end of their working careers.
Ultimately, all of these problems led to America’s most disadvantaged citizens – the elderly and the disabled – left even more disadvantaged due to a lack of income. These people were dying due to lack of medical care, lack of housing, and lack of food. America needed to change – which is why it implemented payroll taxes.
Payroll Taxes and FICA Throughout the 20th Century
In the 1930s, FDR’s New Deal introduced Social Security to fix the first three problems listed above (the lack of protection for retirees, injured individuals, or those with congenital disabilities).
It took America another 30 years, however, to solve the last problem on the list above – the lack of health care for elderly citizens. Medicare was introduced in the 1960s, and FICA was increased in order to pay for that expense.
History of Payroll Tax Rates
Today, the average American’s payroll tax sits at 12.4%. Half of that is paid by you (the employee) and is deducted from your paycheck. The other half is paid by your employer. Those who are self-employed need to pay the full 12.4% (because they’re considered both the employer and the employee).
In any case, the specific amount of payroll tax has varied throughout US history. Interestingly, payroll tax rates have only gone down once since they were introduced. Here’s the timeline of payroll tax rates in America:
-1937 to 1949: 2% on maximum taxable earnings up to $3,000
-1950: 3% on maximum taxable earnings up to $3,000
-1951 to 1953: 3% on maximum taxable earnings up to $3,600
-1954: 4% on maximum taxable earnings up to $3,600
-1955 to 1956: 4% on maximum taxable earnings up to $4,200
-1957 to 1958: 4.5% on maximum taxable earnings up to $4,200
-1959: 5% on maximum taxable earnings up to $4,800
-1960 to 1961: 6% on maximum taxable earnings up to $4,800
-1962: 6.25% on maximum taxable earnings up to $4,800
-1963 to 1965: 7.25% on maximum taxable earnings up to $4,800
-1966: 7.7% on maximum taxable earnings up to $6,600
-1967: 7.8% on maximum taxable earnings up to $6,600
-1968: 7.6% on maximum taxable earnings up to $7,800
-1969 to 1970: 8.4% on maximum taxable earnings up to $7,800
-1971: 9.2% on maximum taxable earnings up to $7,800
-1972: 9.2% on maximum taxable earnings up to $9,000
-1973: 9.7% on maximum taxable earnings up to $10,800
-1974 to 1977: 9.9% on maximum taxable earnings up to $16,500
-1978: 10.1% on maximum taxable earnings up to $17,700
-1979 to 1980: 10.16% on maximum taxable earnings up to $25,900
-1981: 10.7% on maximum taxable earnings up to $29,700
-1982: 10.8% on maximum taxable earnings up to $32,400
-1983: 10.85 on maximum taxable earnings up to $35,700
-1984 to 1987: 11.4% on maximum taxable earnings up to $43,800
-1988 to 1989: 12.12% on maximum taxable earnings up to $48,000
-1990 to 2010: 12.4% on maximum taxable earnings ranging from $51,300 (in 1990) to $106,800 (in 2010)
-2011 to 2012: 10.4% on maximum taxable earnings up to $110,100
-2013 to 2015: 12.4% on maximum taxable earnings up to $118,500
You can view this data in chart form at Urban.org here.
The “maximum taxable earnings” refers to the amount of your salary that gets charged the payroll tax. For example, if you earn $200,000 per year, then only your first $118,500 is charged a payroll tax.
This is why payroll taxes are considered a “regressive tax” – they have a higher burden on lower income classes than they do on higher income classes. Some people also earn a lot of money despite paying 0 payroll taxes, because payroll taxes are not charged on investment income like rental income, interest, or dividends.
Are Payroll Taxes Really a Tax?
You might naturally assume that payroll taxes are a form of tax. But that’s not exactly certain. There’s some controversy over whether or not FICA – your Social Security and Medicare contributes deducted from your payroll – are considered a tax.
The reason is this: the amount you pay into Social Security throughout your working career corresponds to the amount you receive through Social Security benefits after you retire. Because the collection of the “tax” is tied to a benefit, payroll taxes may not truly be a tax.
This issue went all the way to the United States Supreme Court in 1960 in the case of Flemming v. Nestor. The US Supreme Court decided that nobody has an accrued property right to benefits from Social Security. In other words, Congress reserved to itself the power to amend and revise the schedule of benefits.
The case emerged after Ephram Nestor was denied Social Security payments as a deported member of the Communist Party. Nestor argued that there was a contract between himself and the United States government (because he had been paying into the system for 19 years), while the Secretary of Health, Education and Welfare (led by Arthur Flemming) argued that no such contract exists.
The US Supreme Court eventually ruled that no such contract exists between the United States and its citizens in terms of an obligation to be paid Social Security.
In other words, you can pay into Social Security every year of your life, only to be denied Social Security benefits at the end of your career because you were a member of the communist party. Fortunately, issues like this are rare, and most people have no trouble receiving their Social Security payments.
The American Government is More Reliant on Payroll Taxes Than Ever Before
In 1969, payroll taxes and corporate income taxes accounted for an equal share of the federal government’s tax revenue. In 2009, payroll taxes generated more than six times as much revenue for the federal government.
That’s why some people say we should get rid of payroll taxes. Owen Zidar, writing for The New York Times, says that,
“We’ve become reliant on payroll taxes, and a goal of a tax overhaul should be to reform and reduce them, permanently.”
We take payroll taxes for granted today. However, the future of payroll taxes is far from certain.