CAN CONGRESS DISTRIBUTE THE BURDEN OF PAYROLL TAX

If you have ever received a paycheck you probably noticed that taxes were deducted from the amount you earned. One ot these taxes is called FICA an acronym for the Federal Insurance Contribution Act. The federal government uses the revenue from the FICA tax pay for Social Security and Medicare the income support and healthcare programs for the elderly. FICA is an example of a payroll tax which is a tax on the wages that firms pay their workers. In 2005 the total FICA tax for the typical worker was of earnings.

Who do you think bears the burden of this payroll tax firms or workers. When Congress passed this legislation it tried to mandate a division of the tax burden. According to the law half of the tax is paid by firms and half is paid by workers. That is half of the tax is paid out of firms revenues and half is deducted from workers paychecks. The amount that shows up as a deduction on your pay stup is the worker contribution.

Our analysis of tax incidence however shows that lawmakers cannot so easily dictate the distribution of a tax burden. To illustrate we can analyze a payroll tax as merely a tax on a good where the good is labor and the price is the wage. The key feature of the payroll tax is that it places a wedge between the wage that firms pay and the wage that workers receive. The outcome when a payroll tax is enacted the wage receive by workers falls and the wage paid by firms rises. In the end workers and firms share the burden of the tax much as the legislation requires. Yet this division of the tax burden between workers and firms has nothing to do with the legislated division. The division of the burden I is not necessarily fifty-fifty and the same outcome would prevail-if the law levied the entire tax on workers or if it lived the entire tax on firms.

This example shows that the most basic lesson of tax incidence is often overlooked in public debate. Lawmakers can decide whether a tax comes from the buyer’s pocket or from the seller’s but they cannot legislate the true burden of a tax. Rather tax incidence depends on the forces of supply and demand.

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