Saturday, December 8, 2012

Short explanation of why the Social Security Tax is a "regressive tax" and negatively impacts lower income people. Kinda important to know when discussing taxes in a larger context...

One of the discussions regarding tax policy pertains to "fairness" in the tax code.  One of the issues is that fact that it is possible for lower income people to have a higher "effective tax" rate on income than someone who makes lot of income.  I will use just one example to show how this works---the Social Security Tax.

The Social Security tax that an individual pays on earned income is 6.2%(note: RIGHT now that rate is 4.2% as a result of recent "stimulus plans" BUT this reduction is considered temporary, so I will just use the  6.2% for our  purposes here).  Also, keep in mind the individuals employer pays the same 6.2% of income on behalf of the employee, but we will ignore that as well.

This 6.2% tax is levied on all income up to $110,000.  The tax is NOT levied on the income ABOVE that amount, nor is it levied on dividends or capital gains from the sale of assets (physical or financial). This is an important point!

So, the maximum amount an individual would have to pay in Social Security Tax in a given year would be $6,820 ($110,100 X 6.2%).  Read that again. 

Let's do the math for someone who earns $50,000 and $200,000 per year and see the impact on effective tax rates for both of these people.

The person that makes $50,000 per year would pay $3,100 in Social Security taxes.  The "effective tax rate" for this individual (just for THIS tax only) would be 6.2% of income ($3,100/$50,000 X 100). Makes sense, right?

The individual who makes $200,000 would have the FIRST $110,100 of that income subjected to the Social Security tax BUT the remaining $89,900 would NOT be subjected to the tax. 

We already established at the outset, this would result in an maximum tax of $6,820.  As a percent of this individuals income, this would represent 3.4% of income earned ($6,820/$200,000 X 100).

So, while the higher income worker pays more in nominal dollars ($6,820 vs $3,100), the lower income worker pays a higher effective tax on their income (6.2% vs 3.4%).

This tax is termed a "regressive tax". Meaning the lower your income, the higher the impact the tax has on your total income (in percentage terms).

Is this "fair"? Not sure, but it IS the way it is---at least for now.

Now you know. Go dazzle your friends, family and teachers with this new found knowledge
View My Stats