Q&A with Lilian Faulhaber on increase of payroll taxes
As part of the fiscal cliff negotiations, Congress decided not to renew a temporary payroll tax deduction. The “payroll tax holiday” was enacted in late 2010 as a way to help taxpayers get through the recession and to help boost an economic recovery.
Lilian Faulhaber, an associate professor of law at Boston University’s School of Law, is an expert in tax law, with a special focus on federal income taxation. In a Q&A with Professor Voices, Professor Faulhaber explains what the payroll tax increase means to Americans:
Professor Voices: What are payroll withholding taxes?
Lilian Faulhaber: There are two main types of taxes that are withheld from your paycheck. FICA taxes (named for the Federal Insurance Contributions Act) include Social Security and Medicare contributions. These include employer and employee contributions, so your employer pays an amount directly to the government, while you (the employee) have a portion of your paycheck withheld. Federal and state income taxes are often also withheld from employees’ paychecks, but payroll taxes generally refer to the employee’s portion of FICA taxes.
FICA taxes are calculated on a base of wages (meaning that your wages, rather than other forms of income, make up the tax base), and the Social Security portion of FICA taxes are only applied up to a certain amount of compensation. In 2013, for Social Security, employees must pay 6.2% of their wages up to $113,700 of gross compensation; above that amount, employees do not have to pay any Social Security taxes. (Employers also pay 6.2% of the employee’s wages up to $113,700.) For Medicare, both employees and employers pay 1.45% each of gross compensation, with no limit on the amount of wages subject to the tax. So employees will pay 7.65% of their wages up to $113,700, and then they will only pay 1.45% of any wages above that cut-off.
PV: Are people imagining it if they think their first paycheck in 2013 was smaller than their last paycheck in 2012?
LF: No, they’re correct that their first paycheck in 2013 had more taxes taken out than their last paycheck in 2012. In 2011 and 2012, there was a payroll tax cut that reduced the employee’s share of Social Security taxes to 4.2%. This tax applied to all wages up to $106,800 in 2011 and $110,100 in 2012. This tax cut was not extended as part of the fiscal cliff deal, so employee contributions to Social Security have now returned to 6.2%. This means that, if you make $5,000 per month in gross compensation, you owe $100 more per month in FICA taxes than you did last year. ($100 is 2% of $5,000.) If, however, you make $10,000 per month, this will be even more noticeable because you exceeded last year’s Social Security threshold in December 2012, when you only had to pay $4.20 in Social Security taxes. (This is because you made $110,000 in wages in the first 11 months, so your final paycheck only had $100 that was subject to the Social Security tax of 4.2%.) In January 2013, you are both paying taxes on your full monthly compensation and paying at the pre-2011 rate. So you have gone from having about $4 taken out of your paycheck (along with Medicare contributions and federal and state withholding) to having $620 taken out of your paycheck. For most employees, that is a noticeable increase.
PV: What was the percentage of the tax increase?
LF: This was a return to the pre-tax cut rate of 6.2%. The Medicare tax rate remained the same (1.45% for both employees and employers), but the employee’s Social Security contribution returned to 6.2% from 4.2%.
PV: Who will be most affected by the tax increase?
LF: Anyone who has wage income. FICA taxes do not directly affect taxpayers who do not receive paychecks, so taxpayers who have only investment income will likely not be affected by this.
PV: What impact does the tax increase have on consumer spending?
LF: This is the big question, and we won’t know for sure until we have more data. The initial reason for the payroll tax cut was to encourage consumer spending. The general idea was that, since it was a tax cut that directly increased consumer take-home pay (rather than a lump sum that was part of a tax refund, for example), consumers would be more likely to spend the difference than save it. A recent NBER paper suggests that employees spent between about a quarter and a half of their payroll tax savings, which was a higher percentage than the employees themselves predicted, so a takeaway from that is that the payroll tax cut increased consumer spending, at least in the short-term. Whether the end of the payroll tax cut will decrease consumer spending in the long-term remains to be seen. Data from January 2013 suggests that, even if it decreased consumer spending, it did so less than economic models had predicted.
PV: How much of an impact does the tax increase have on the earnings of major retailers like Walmart & Target?
LF: If it can be shown that the end of the payroll tax cut caused a reduction in consumer spending, then it will likely reduce the earnings of major retailers. There are many other reasons that consumer spending may be decreased, however, including concerns about sequestration, a slowdown in the ability of the IRS to process returns due to the lateness of the fiscal cliff negotiations, and an overall lack of consumer confidence. Given that at least some statistics suggest that consumers have not responded as much as expected to the end of the payroll tax cut, the effect of this change on consumer spending remains to be seen, as does the impact of the overall economic climate on the earnings of major retailers.
PV: What is the impact of the tax increase on the economy? Will a higher payroll tax decrease economic growth?
LF: Again, this depends on whether people change their spending habits because of the end of the payroll tax cut. The purpose of the initial cut was to jumpstart the economy by putting more money in consumers’ pockets. Consumers do seem to have spent a large portion of this money, so reversing this tax cut may then shrink consumer spending – but that could happen for reasons apart from the payroll tax, it could not happen, or it could only be a short-term change. This latter argument means that, even if consumers react in the first few months by cutting spending, they may return to spending more as they acclimate to the payroll tax. The takeaway is thus that there are many factors that can contribute to economic growth, and, while the payroll tax cut may have been one of them in 2011 and 2012, we do not yet know if ending this tax cut will be enough to negatively affect economic growth in the long term.
Contact Faulhaber at 617-358-6192; firstname.lastname@example.org.