The Hidden Cost Of The Payroll Tax

The best part of the chaotic debate in Washington about the payroll tax is that this wicked institution is finally getting the public attention it deserves. In most debates about taxation, the payroll tax has hardly ever been mentioned, even though it accounts for more than one-third of federal revenue, and even though two-thirds of citizens pay more in payroll than in income taxes.

The current debate about extending the slight payroll tax cut has broken a public silence on this topic, and it provides an opportunity for open discussion of what is really going on here.

The reason for the silence is peculiar. One party rather likes the idea that the workplace would bear an ever-greater burden for the building of the cradle-to-grave welfare state. The other party is not much interested in it because it is already a “flat tax,” and thereby conforms to the supply-side strictures about the difference between good and bad forms of taxation.

Neither party has a clue about what to do about the programs that the tax funds, so they have both mostly tried to ignore its damaging effects.

Think back to the 1980s, when the Republicans were absolutely dead set against increasing taxes. Candidates who were rhetorically open to higher taxes lost elections. And Republicans were given political credit for reducing taxes in an effort to spur economic growth.

But look at the facts. In 1980, the total payroll tax to fund Social Security was 10.16%. By 1990, the total was 12.4%, which is where it has remained to this day. Somewhere in these years, we saw a gigantic tax increase. The reason was something called the Greenspan Commission that took on the task of “saving” Social Security. In 1983, and with little public fanfare, the system was saved by fleecing you.

No one called it a tax increase, even though that’s what it was. Instead, it was sold as an increase in the employee-employer premium paid to the system. This kind of language, taken from the private sector, implies something that is emphatically untrue: that Social Security is some kind of insurance program and what you pay into it is really a contribution of the same form that you pay for car insurance.

The tax burden of just this program went from 2% of a maximum income cap of $3,000 in 1949 to 12.4% of $51,300 in 1990. In the years since 1990, the main form of payroll tax increase has affected the income cap and not the rate itself. Today, the income cap is doubled from the end of the Reagan years. It is now $106,800. Is that an inflation adjustment? No, the increase is well above that. In fact, if the cap were adjusted by inflation alone since 1949, it would only be $28,516 today.

This is an extremely sneaky way to raise taxes without saying that you are doing so. It is like the domestic worker who only steals one piece of silver flatware at a time, once per month. Then he increases that to once per week. Then he increases that to once per day. When caught, he protests that his stealing has not increased: He continued to take only one piece of flatware at a time.

This tax is not a premium for a program that most young people know is not going to provide them anything they can count on in their older years. On the contrary, the purpose of the payroll tax is precisely what we would expect: a coercive program to raise money for the government. In fact, payroll tax revenue as it stands today would have funded the entire federal budget as late as 1982.

By any historical standard, the payroll tax is a gigantic wealth-eating monster. And despite all the money it has raised, the programs that it funds are still said to be broke and doomed to go belly up by demographic trends. Here is a lesson in the truth about government: whereas the private sector always strives to take less and give more, the government always takes more and gives less.

Americans from the earliest years of the republic through the New Deal would have known nothing about such a tax, and they never would have tolerated it. It interferes most directly with the right of the employer and the worker to negotiate terms of employment.

Whereas the individual bears the burden of the income tax, the payroll tax amounts to a direct hit on the fundamental right of association and trade between consenting adults. The state steps in to say: “You guys may not make any kind of deal unless you agree to fork over a portion to your masters. To make this easier to take, we’ll put you on welfare late in life as a form of compensation.”

There are other ways that the payroll tax is hidden. For people who work for wages, the payment is split between the employer and the employee, but this is an accounting fiction, as you discover once you become self-employed and bear the entire burden. The reality is that the worker pays the entire tax; it is only collected by the employer.

There is another aspect of the payroll tax that it is sneaky. This is the withholding aspect of the income tax that is rolled into the government’s take from wages. In this system, most people get “refunds” after they file taxes, leading people to believe that they are getting some kind of gift from the government.

This system began in 1943 with the support of many establishment economists who advised that this would make tax collection easier. Charlotte Twight reports that in 1942, George Lent wrote in the Journal of Political Economy that when government pre-collects payments, “the taxpayer does not have the same consciousness of parting with his income to the government,” making withholding “the most ‘painless’ method of meeting tax liabilities.”

The institution of this system was made possible because employers were already collecting taxes from workers through the Social Security tax. The new withholding tax was merely added on in ways that were not entirely noticeable to taxpayers. The whole effort was helped by a series of propaganda films that came out during the war, one of which featured Donald Duck being told that “your privilege, not just your duty, but your privilege to help your government by paying your tax and paying it promptly.”

One of the major players here was Milton Friedman, who years later told Reason magazine about his experience. “I played a significant role, no question about it, in introducing withholding,” he said. “I think it’s a great mistake for peacetime, but in 1941-43, all of us were concentrating on the war. I have no apologies for it, but I really wish we hadn’t found it necessary and I wish there were some way of abolishing withholding now.”

This year was pretty much the only slight respite in the payroll tax we’ve seen since its introduction. It lessened the burden on workers and employers just slightly, and this is a wonderful thing. The tangle of politics that has come about through this debate now represents an incredible risk to Republicans, who have historically paid scant attention to the payroll tax, and even worked to increase it. As The New York Times mentions in passing, they “now risk the odd political development of being accused of being the impediment to a tax cut.”

At least, this wicked form of wealth extraction is finally being labeled what it is.


Jeffrey Tucker