Sunday, December 19, 2010

A Primer on the role of Payroll Taxes in the latest Tax Bill set to become law and how it relates to Demand-Side and/or Supply-Side Economics...

Many students work part-time jobs but most don't understand their paychecks, or more specifically, the two primary tax deductions that come out of their paychecks.  It is important to understand these two taxes because the latest tax bill compromise between the President and Congress to stimulate the economy is going to affect YOUR paycheck very soon.

Almost all private sector workers pay TWO mandatory payroll taxes: Social Security and Medicare.  Both of these taxes are targeted to paying benefits to retirees and other designated beneficiaries for living expenses (Social Security) and medical expenses (Medicare). 

The Social Security Tax is 6.2% and the Medicare Tax is 1.45% of your gross pay.  So, for example, if you earn $10 per hour and you work 10 hours a week your gross pay is $100. On this amount you would pay $6.20 in Social Security taxes and $1.45 in Medicare taxes.  Bottom line: you pay $6.20 (Social Security) and $1.45 (Medicare) , or a total of $7.65, for every $100 you earn.

This is not the whole story on these two taxes:

Both the Social Security tax and the Medicare tax must be matched by the employer. This means the employer must remit to the federal government 12.4% of each employee’s first $106,800 of taxable earnings plus 2.9% of each employee’s earnings regardless of amount. (Source)

That is right---your employer matches the amounts that are sent to their respective trust funds in Washington, DC. The Social Security portion has a cap on the amount that is subject to the tax--$106,800. The maximum amount someone would pay into Social Security in any given year is $6,621.06. However, there is NO cap on the earned income that is subjected to the Medicare tax. Keep in mind, the portion your employer pays for these two taxes does not come out of your paycheck BUT is a cost to them to employ you. While you are paid a set wage ($10 per hour) it actually costs more than that to employ you--at this point that would be $10.76 ($10 times 7.65%, the employers portion of the taxes).

Congress and/or the President had two choices: reduce the Social Security tax on workers, a Demand-Side stimulus OR on employers, a Supply-Side stimulus.

The current tax bill will reduce the Social Security tax from 6.20% to 4.20% for 2011.  This is on YOUR portion of the Social Security tax, NOT the employers. The Medicare tax will stay the same. What this means for you, using our example above, is you are going to have an additional $2.00 per $100 you earn in your paycheck.  So, for a worker who earns $500 per week, they will have $10 extra dollars in each paycheck.

Congress and the President opted for a Demand-Side stimulus for the economy.

Here is the reasoning: workers have more money in their paychecks; they will buy more goods and/or services; businesses will sell/produce more goods/services to meet this increased demand; businesses will hire more workers to sell/produce these additional goods/services; newly employed people are now income earners; they will, in turn, buy more goods/services from other businesses that are responding in kind; the economic "pump" has been "primed"...DEMAND CREATES SUPPLY!

Here is the alternative, Supply-Side argument they could have chosen instead: reduce the Social Security portion employers pay for each worker; this reduces the cost of employing labor (which is the largest cost for most businesses); employers "at the margin" of deciding to hire workers will employ more labor; these workers produce goods/services at a lower marginal cost than before; businesses produce more goods/services; the newly employed people are now income earners; they will, in turn, buy more goods/services from other businesses that are responding in kind; the economic "pump" has been "primed"... SUPPLY CREATES DEMAND!

What BOTH ultimately come down to in the current economic climate is this: WHICH path would encourage the hiring of workers by businesses. The lynch-pin is business behavior: Will the Demand-Side policy increase demand enough that businesses collectively hire more workers, or will they see this bump in demand as temporary and make do with existing workers.  Would the Supply-Side policy produce the same result--employers collectively not hiring regardless of the reduction in the cost of hiring workers, because they know the tax relief is temporary and they don't want to take on new employees if they are uncertain about future economic conditions. 

Yikes!! What would you do? Given the current economic conditions, GDP is increasing but hiring is not at a significant level ("a jobless recovery"), which policy option would you choose? Extra credit on the final is at hand!!

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