Understanding Payroll Taxes: Tax Cuts

Payroll taxes have been in the news lately, as President Trump mentioned the idea of cutting payroll taxes. However, there are many misconceptions when it comes to understanding payroll taxes! Cutting payroll taxes would enable employees to boost their “take-home pay”. Boosting pay simultaneously creates more spendable income within the larger economic system. More spendable income and consumption means businesses earn more money. Increased income for businesses increases earnings, which are ultimately distributed to investors through dividends. More earnings for investors equates to higher stock prices.

We ultimately arrive at this final equation: (Payroll tax cuts = higher stock prices). THIS is the real reason President Trump is focused on cutting payroll taxes. He wants to artificially boost the stock market in order to increase his likelihood of presidential re-election. We can argue about the political and economic ramifications of this policy, but it is more important to understand payroll taxes!

My First Job

I remember my first day working like it was just yesterday! I accepted a job at Hy-Vee bagging groceries when I was 15. Open interviews were conducted, and the store offered me a position at $8.25. I was bright-eyed, bushy-tailed, and I was ready to go and start making some money! I worked 20 hours my first week, but I was more than surprised when I saw my first paycheck! “This can’t be right”, I thought. What happened? Payroll taxes happened!

See, I was naive, and I believed that my first paycheck should have been for $165 (8.25 x 20). However, as anyone who has ever worked a job knows, the check was for a significantly less amount of money! What had happened? Where did all my money go? Unfortunately, I had lost 6.2% of my pay to Social Security and 1.45% to Medicare.

Social Security

Social Security is the term used for the Old-Age, Survivors, and Disability Insurance (OASDI) program in the United States, run by the Social Security Administration (SSA), which is a federal agency. While best known for retirement benefits, it also provides disability income and survivor benefits.

Social Security is an “insurance” program. I put insurance in quotes because it is not really insurance! Workers pay into the program through payroll withholding where they work. They can earn up to four credits each year. In 2019, every time someone earns $1,360 they receive one credit until they hit $5,440, or four credits. 

That money goes into two Social Security trust funds—the OASI Trust Fund for retirees and the DI Trust Fund for disability beneficiaries—where it is used to pay benefits to people currently eligible for them. The money that is not spent remains in the trust funds. However, all the money gets spent, and the trusts are incredibly insolvent.

Social Security Insolvency

An annual government report on the status of the programs painted a dire portrait of their solvency that will saddle the United States with more debt at a time when the economy is starting to cool and taxes have just been cut.

According to the report, the cost of Social Security, the federal retirement program, will exceed its income in 2020 for the first time since 1982. The program’s reserve fund is projected to be depleted in 16 years. Then, recipients will get smaller payments than they are scheduled to receive if Congress does not act.

Medicare

Medicare is a U.S. federal government program that subsidizes healthcare services for individuals over age 65, as well as younger people who meet specific eligibility criteria. The program encompasses a variety of plans covering different healthcare situations and offered at different premiums. While this allows the program to offer consumers more choice in terms of costs and coverage, it also introduces complexity for those seeking to sign up.

Insolvent System

The hospital insurance fund will be depleted in 2026. This is the same date that was projected last year. At that point, doctors, hospitals and nursing homes would not receive their full compensation from the program and patients could face more of the financial burden.

Lawmakers have been struggling to come to grips with a solution for the country’s eroding entitlement programs, which have for years been at the center of a political tug of war between Republicans and Democrats. A lack of understanding payroll taxes heavily contributes to the problems at election time.

Solutions

The Motley Fool lists 12 options to solve insolvency (6 cuts and 6 income sources).

  • Cut benefits across the board today
  • Raise the full retirement age
  • Freeze the purchasing power of benefits
  • Freeze benefits on a sliding scale
  • Change the cost-of-living adjustment
  • Do nothing and cut benefits later
  • Increase the payroll tax on everyone today
  • Raise the earnings cap
  • Use the estate tax to tax health benefits
  • Transfer start-up costs to general revenues
  • Raise the return on assets by investing in the stock market
  • Do nothing and raise taxes later

Conclusion: Understanding Payroll Taxes

We can continuously debate which policy solution is best, but at the core, we must either slash benefits or increase revenues. There is absolutely no scenario where the answer is cutting payroll taxes and holding benefits constant.

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