FICA taxes screw the middle class

I previously wrote about about the marginal tax rate graph which showed that those on the borderline of middle class and upper middle class had higher marginal tax rates than the wealthy.

It turns out that I was incorrect in thinking that this had something to do with FICA taxes. There’s a followup post at Marginal Revolution with a link to the assumptions used. It seems that the bump in the marginal tax rate has to do with deductions for things like IRAs (as if anyone with a 401k plan would contribute that) and student loan interest being phased out.

It is a big mistake to ignore FICA taxes when considering tax reform. For people earning less than $90,000/year, the employee must pay a 7.65% FICA tax which he sees deducted from his paycheck, plus there’s a hidden 7.65% tax which the employer pays and the employee never even sees. Of course it’s merely a fiction that the employer pays this tax, because it represents money which otherwise would have been paid to the employee. FICA taxes are really like a 15.3% tax.

After $90,000, the FICA tax drops to 1.45% for both employer and employee (so it’s like a 2.9% tax).

So we see, once you reach $90,000 in income your marginal tax rate plummets by 12.4%.

A flat tax that ignores FICA taxes would screw the middle class because they would be burdened with higher tax rates than the rich. Unfortunately, almost all the flat tax proposals I hear about do ignore FICA taxes.

On the other hand, if FICA taxes and regular income taxes are merged into a single rate flat tax which kicks in once someone earns a threshold amount of income, the final result would be a tax system that’s fairer (assuming all the unfair deductions are removed) and more progressive than what we have now because lower income people would be paying no taxes at all. Under the current system, even the poorest workers still have to pay FICA taxes.

UPDATE 5/11/2005

TaxProf has the exact opposite take of this post. I'm complaining about how ignoring FICA taxes makes our tax system seem more progressive than it really is. But TaxProf complains that the NY Times modified the chart to make it seem more regressive.

Comments

[John Thacker]

Under the current system, even the poorest workers still have to pay FICA taxes.

Yes, but don't forget about the EITC. (Earned Income Tax Credit). If properly claimed (an important caveat), it does change things a bit. BTW, the original graph omitted some parts of the bottom; there's actually negative marginal tax rates at the very low end, thanks to the EITC. See here.

The upper-middle class marginal rates end up being very high because of phase-outs of lots of tax credits in addition to the cap on FICA. Your absolutely right that a true flat tax would be better. As a small counter-benefit with FICA, the "bend points" and effective taxation of Social Security benefits do kick in around that same level, too, so Social Security benefits don't rise that much for making over $90k either. If you believe that your FICA is supposed to pay for your Social Security benefits, then it makes more sense.

Personally, my favored solution would be a true flat tax, Social Security benefits cut along the lines suggested by the President to provide enough to keep any retiree out of poverty, but pay less to the middle and upper class (who should finance their own retirement), and then FICA eliminated and Social Security financed out of the income tax.

[John Thacker]

In fact, if you look at the SSA's documents, you'll see that benefits don't rise at all for making more than the $90k either. Both the tax and the benefits get capped. It's a higher tax on marginal income for the upper middle class that is supposed to be made up for in the long run by higher Social Security benefits. Partially this is because Social Security is sometimes described like a forced-savings retirement plan, and sometimes described like insurance against being desperately poor in retirement, and operates somewhat between the two.

[Terry Piatt]

It is erroneous to assert that the "employer's" FICA tax payment "...represents money which otherwise would have been paid to the employee." Maybe so, maybe not. It depends on market conditions.

If an employee has a good job paying a middle class income, yes, this assertion is most likely valid. If the employee has a menial job earning a low wage (one which is equal to or near minimum wage), the assertion is invalid.

Think about it. If McDonald's did not have to pay "its" 7.65 percent share of FICA taxes, it COULD put the money in employees' paychecks...or it COULD keep the money and pay it to shareholders in the form of increased dividends. Most likely, since customers are more difficult and more expensive to acquire than are hamburger flippers, McDonald's would distribute the money to customers in the form of price reductions, which would in turn lead to higher sales volume and greater profits. But it's just silly to suggest the hamburger flipper will see that money in his paycheck.

[cathyf]

First off, the calling the SS/SE/FICA tax 15.3% because it's 2 times 7.65% is incorrect -- that is 15.3% of 92.93% of your income, so the SS tax rate is really 15.2% not 15.3%. The "medicare" portion (which is a true flat tax with exactly the same rate on your 1st and billionth dollar of income) is 2.72%.

The EITC is minimal if you don't have dependents. You also don't get it if you don't claim it because you can't figure out the rules. (I have 20 years of experience writing pricing models for exotic derivatives, and reading JK Lasser makes my eyeballs bleed. Does the average person who is eligible for the EITC because he wasn't a very good student have a prayer of doing this correctly?)

Just for some data, take a single taxpayer who takes the standard deduction. Using turbo tax, here is his tax rates at different income levels:
AGI tax rate
9293 0.18465511675
18587 0.21853983967
27880 0.24641319943
37174 0.26082746005
46467 0.28910839951
55761 0.30795717437
65054 0.32142527746
74348 0.33134717814
83641 0.34113652395
93211 0.3441868449
103077 0.34059974582
112943 0.33767475629
122809 0.33522787418
132675 0.33313736574
142541 0.33133624711
152407 0.33022761422
162274 0.33173521328
172140 0.33367026839
182006 0.33539004209
191872 0.33693816711
201738 0.33833486998
211604 0.33959660498
221470 0.34074592496
231336 0.34179721271
241202 0.34276664373
251068 0.34365988497
260934 0.34448174634

Paste it into your favorite spreadsheet program and hit "plot". As you can see, this looks a lot like a flat tax once you get past $90K, and it is regressive in the $90K-$150K range.

In addition, I think that TaxProf's comment is not really fair. I took the NYT graph, with accompanying caption, to be making a very specific point about how the marginal rates jump up and down wildly, and that since marginal rates have important behavioral consequences we are not getting the incentives that we think we are when we think that the tax code is "progressive." In other words, the NYT's picture says, "Looky at all tham thar wild ups and downs," and TaxProf's complaint is that they missed a couple jumps at the low income end and that this is somehow evidence of bias.

cathy :-)

[Half Sigma]

Cathy, thanks for the comment! You may note that I used the words "like a 15.3% tax" knowing that it wasn't exactly the same because, as you correctly point out, if you treat the amount the employer is paying as income, then the FICA taxes are slightly lower than the rate you get by merely adding the two components.

Counting the employer's contribution as income also makes every other tax rate slightly lower.