Origin of Payroll Tax and How it Works Today

DISCLAIMER: This article was written in 2020 and has not been updated. For more up to date information about small business funding products and options, please browse our recent articles.

Taxes are as much of a part of the United States’ identity as apple pie, baseball, and the 4th of July. But just because Americans know that tax withholding is a given on every paycheck and that, come tax time, they’ll have to file a tax return with the Internal Revenue Service, that doesn’t necessarily mean that they understand what all of those taxes are for or where they came from—and that includes payroll tax.

Let’s take a deeper look at payroll taxes—what they are, where they come from, and what’s going on with payroll taxes today:

What is payroll tax?

First things first—before we jump into the origins of payroll taxes and how they work today, let’s quickly cover what, exactly, payroll taxes are.

Payroll tax is a type of tax that both employees and employers are responsible for paying to the federal government. The amount of payroll tax owed is determined by the employee’s compensation (including salary, wages, and tips). To cover the employee’s tax responsibility, the employer withholds their portion of the payroll tax and remits it to the IRS on their behalf—and the employer pays their portion directly. 

Federal payroll taxes are used to fund Social Security and Medicare—also known as the Federal Insurance Contributions Act tax, or FICA. The FICA tax rate (which, again, covers Medicare taxes and Social Security payroll tax) is currently 15.3 percent, half of which is covered by the employee and half of which is covered by the employer. (Self-employed individuals are considered both employer and employee—and, as such, they pay the entire 15.3 percent tax.)

Employers are also responsible for paying additional payroll taxes for Federal Unemployment Insurance, or FUTA (which is 6 percent on the first $7,000 paid to an employee) and State Unemployment Insurance, or SUTA (which varies by state).

What’s the history behind payroll tax?

Now that you know what payroll taxes are, let’s dig into their history—which starts with the passing of the 16th Amendment.

The 16th Amendment, which was passed by Congress in 1909, made it legal for the federal government to impose income tax on Americans. But, as mentioned, income tax is used to fund a variety of programs—and federal income tax wasn’t necessarily earmarked to directly fund the American people.

But then the Great Depression hit, and millions of Americans were left without jobs, without income, and without any source of support. It was then that the government realized that they needed to fund social programs to support the American people; in response, they passed the Federal Insurance Contributions Act (FICA) in 1935—and, from there, what we now know as payroll taxes were born.

Originally, FICA only covered social security tax; it wasn’t until Medicare was launched in the 1960s that federal payroll taxes were increased to fund the program.

Why is payroll tax separate from general income tax?

The biggest reason that payroll tax is separate from income tax is because payroll taxes are used to fund specific social programs—Social Security, Medicare, and unemployment insurance, both at the state and federal level. The idea is that individuals and employers pay into these social programs while the individual is still working—and then the individual can access those programs if and when they need them (for example, accessing Medicare or Social Security benefits when they hit old age or collecting unemployment if they’re laid off or otherwise lose their job and source of income.)

Federal income tax functions differently. Once federal income taxes are collected, they’re funnelled into a general fund at the Treasury—and, from there, those taxes are used to fund a variety of federal programs, including education, defense, infrastructure, and other public services. Most state governments and local governments also collect income tax—which they then use to fund similar programs, just at a state or local level.

The current state of payroll taxes: Coronavirus and the payroll tax holiday

Today, employers must withhold payroll tax on behalf of their employees in addition to covering the share they owe as an employer—and those taxes continue to be used to fund Social Security, Medicare, and, on the employer side, FUTA and SUTA.

But the COVID-19 pandemic could change all of that. On August 8, 2020, President Donald Trump signed an executive order that called for a payroll tax deferral on the employees’ side. This new tax policy would defer the employee portion of payroll taxes for employees making less than $100,000 per year from September 1, 2020 through December 31, 2020.

There are some questions surrounding the specifics of the executive order—namely, whether those payroll tax deferrals will be forgiven or if individuals will be responsible for paying those taxes next year, after the deferral period ends. If the policy dictates the latter, that could leave a large percentage of Americans with a large tax burden in 2021. In order to avoid that kind of widespread financial burden in the upcoming year (particularly during a time when many Americans are facing challenges with job and financial security), the U.S. Chamber of Commerce and other trade organizations have called on Congress to pass legislation that would make the payroll tax deferred in 2020 forgivable—meaning individuals would not be responsible for repaying those deferred taxes in 2021.

There are also questions around how, exactly, this policy change should be implemented. Making changes to payroll taxes is complicated—and with the deferral period set to start in less than two weeks, businesses and payroll companies are unsure if they’ll be able to implement the necessary changes and change the withholdings before the September 1 deadline.

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Ultimately, we’ll have to wait and see how President Trump’s executive order impacts payroll tax today and in the upcoming years. But now that you understand the history behind payroll tax and what the taxes cover, you’re equipped with the information you need to follow the evolving story—and fully understand its long-term impact.