Taxes, Contributions, and Social Insurance

With most Americans focused on taxes this month, it’s a good time to take a look at the relationship between federal income taxes and social insurance contributions.

Overview of Federal Taxes and Distributional Effects

The latest report by the Joint Committee on Taxation, Overview of the Federal Tax System As In Effect for 2019, provides a comprehensive starting point. This report breaks out the current federal tax system into four elements:

• Income taxes on individuals and corporations
• Payroll taxes on wages and self-employment income
• Estate, gift, and generation-skipping transfer taxes
• Excise taxes on selected goods and services

The Joint Committee on Taxation’s analysis indicates that, while individual income taxes are projected to account for half of all federal receipts in 2019, social insurance contributions will account for over one-third of those receipts.

Its analysis also projects that, while wages and salaries will account for 66.6% of all gross income received by individual taxpayers in 2019, 12.1% will come from Social Security, pensions, and individual retirement account distributions.

Finally, and quite significantly, the analysis also indicates that 67.8% of taxpayers will pay more in “employment taxes” than in individual income taxes. The highest percentages of such taxpayers are those with incomes between $10,000 and $100,000.

(Tax credits play an important role in determining the net tax burden on low- and moderate-income workers, in particular. More on these below.)

What the FICA?

FICA stands for Federal Insurance Contributions Act. While FICA has some characteristics of a “tax,” (e.g., it is compulsory and collected by the Internal Revenue Service), it differs significantly from federal income taxes in that it is earmarked for one exclusive purpose, namely the payment of Social Security and Medicare benefits and associated costs. Revenues generated by FICA are therefore not directly available for other federal purposes.

This earmarking was famously justified by President Franklin D. Roosevelt, who said, “with those taxes in there, no damn politician can ever scrap my Social Security program” (Dewitt, Larry. “Research Note #23,” Research Notes and Special Studies by the Historian’s Office, Social Security Administration, 2005).

Referring to FICA as a “payroll tax” raises concerns about the regressive nature of the FICA rate, if it is perceived simply as a tax. A preferred alternative term is “contribution.” This characterization recognizes that FICA payments are dedicated, and directly related to, both eligibility for future Social Security and Medicare Part A benefits, and the amount of Social Security benefits. Describing the payments this way also connects FICA with the certainty of those benefits.

Moreover, FICA payments are more like premiums than taxes, since they provide insurance protection for those who pay into the system. The term “contributions” also captures the relationship between the past earnings, on which FICA is based, and future Social Security benefit amounts, in which those who earn more get higher benefits. Social Security’s progressive benefit structure, along with the availability of the EITC, mitigate the apparent regressivity of the flat FICA rate and capped wage base.

Additionally, emphasizing the contributory nature of Social Security implies that it would be unfair to introduce eligibility conditions, like a means test, which would keep benefits from people who have paid toward their own protection.

Contributions to Social Insurance

The primary source of revenue to finance Social Security (Old Age, Survivors, and Disability Insurance – OASDI) and Medicare (Hospital Insurance – HI) is FICA, which is paid by employers and employees. For employers, FICA is based on their payroll. For employees, it is based on their individual earnings in covered employment.

The OASDI rate is 6.2% of covered wages up to the taxable wage base, or cap, which is $132,900 in 2019. The HI rate is 1.45% of covered wages with no wage cap.

The employee portion of the HI rate is also increased by an additional 0.9% on wages received in excess of specific threshold amounts ($250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately, and $200,000 for all other taxpayers). The employee’s FICA is generally withheld and, along with the employer’s share, remitted to the federal government by the employer.

Self-employed individuals are treated in effect as both employees and employers. The Self-Employment Contributions Act (SECA) applies to net income from self-employment. The SECA rate equals the combined employee and employer OASDI and HI FICA rates.

Proposed Changes to Social Security Contributions (and Benefits)

It is important to understand Social Security through a social policy lens, as well as a tax and federal budgetary lens. From this perspective, there are some critical social policies to address:

1. The extent to which a smaller share of total U.S. wages is subject to FICA due to widening wage inequality;
2. The growing disparity in life expectancy between higher- and lower-income individuals.

As the Academy stated in our 2017 Report to the New Leadership and the American People on Social Insurance and Inequality: “Some observers note that there is reason to increase the progressivity of Social Security to compensate for two trends in equality: 1) growing inequality in the distribution of income; and (2) growing inequality in longevity by income.”

Proposals to expand Social Security, such as Rep. John Larson’s “Social Security 2100 Act” address the first issue by increasing the extent to which wages are covered by FICA. As average wages have been growing at a far slower rate than higher wages, only approximately 83% of total wages are currently subject to FICA, down from 90% in 1982. The Larson legislation, which would apply FICA to wages above $400,000, would affect only the top 0.4% of wage earners.

A proposal by William Gale of The Brookings Institution would increase the percentage of wages subject to FICA to 86% by the end of 2024 and then index the wage base cap for growth in the average wage index plus 0.5 percentage points. (Gale, William. Fiscal Therapy, 2019, p. 157)

The second issue affects proposals to increase the Social Security Normal Retirement Age, which is already set to reach age 67 for those born in 1960 or later. As noted by William Gale: “Divergent trends in life expectancy make Social Security less progressive because they raise the total lifetime benefits that the rich receive as opposed to the poor” (Gale, William. Fiscal Therapy, 2019, p. 159).

Last but not least – Refundable Tax Credits

While not a form of social insurance, tax credits are also based on earnings (and work). Similar to social insurance, tax credits protect millions of Americans from falling into poverty.

Among the most significant tax benefits provided to many Americans are refundable tax credits. “Refundable” means that, if the amount of a credit exceeds a taxpayer’s tax liability, the excess may generate a refund to the taxpayer. Two of these refundable tax credits are the Child Tax Credit and the Earned Income Tax Credit (EITC).

Taxpayers may claim a tax credit for each child under age 17. The amount of the credit per child is $2,000 in 2019. The aggregate amount of child credits that may be claimed is phased out for those with incomes over certain threshold amounts.

The EITC is available to low-income workers who satisfy certain requirements. The amount of the credit varies depending on the taxpayer’s earned income and the number of qualifying children. For 2019, the maximum EITC is $6,557. The credit amount begins to phase out at various income levels.

If the EITC were treated like earnings, it would have been the single most effective antipoverty program for working-age people, lifting about 5.8 million people out of poverty, including 3 million children in 2018 (Center on Budget and Policy Priorities). While four out of five eligible workers take advantage of the EITC, millions miss taking it because either they do not claim it, or they do not file a tax return, which is a prerequisite.

As we continue to look at the future of the nation’s social insurance programs and assess various policy options, we welcome your questions and comments on taxes and contributions.