There are tax breaks, and there are tax breaks. It’s one thing to get an income tax cut – there are lots of ways to do that. Getting a payroll tax cut is a bit more special, and there are only a handful of tax breaks that are up to that task.
Discussions about tax policy are almost always focused on the income tax. Indeed, the individual income tax is the largest source of federal revenue (46.2% in 2012). The payroll tax is the second largest, clocking in at 34.5% in 2012, but it is almost completely ignored in tax reform discussions. When you read about the 47% of Americans who don’t pay taxes, that only refers to income taxes. Most of those people do pay payroll taxes.
It makes sense that the income tax gets all the attention. Lots of important policies are made through the income tax, which is why filing a tax return is so complicated. Americans can take advantage of countless tax breaks, each of which promotes behaviors that the government has deemed important, such as owning a home, donating to charity, or buying a racehorse.
By comparison, the payroll tax only advances two major policy goals: paying for Social Security and Medicare. Like income taxes, payroll taxes are deducted from paychecks by employers. Unlike income taxes, there’s no tax return to fill out for payroll taxes (unless you’re self-employed). The government takes exactly the right amount from your paycheck, and there’s not much taxpayers can do to reduce their payroll tax burden.
But there are two extra-special tax breaks that do cut your payroll tax. The biggest payroll tax break is the exclusion for employer-provided health insurance, which is also the largest income tax break. Employees are not taxed on the premiums that are paid for health insurance they receive through their job. In 2013, this tax break will cost the government $120 billion in reduced payroll taxes, and another $140 billion in reduced income taxes, according to CBO.
The other big payroll tax break is for pension contributions. Employees don’t pay any income or payroll taxes when their employer contributes to their pension. The employee will pay income taxes on their pension when they take the money out for retirement, but the payroll tax is completely avoided. The exclusion for pension contributions will reduce payroll tax collections by $50 billion in 2013.
There are two main policy debates where payroll tax breaks should be part of the discussion. Those issues are the reasons for the payroll tax: Social Security and Medicare. Both programs will likely require changes in the future to remain solvent, meaning either bringing in more tax revenue or cutting benefits. None of those changes will be easy. Reducing payroll tax breaks that support health insurance and pensions would certainly have negative consequences, as would any other tax increase or benefit cut. But if we are considering raising the retirement age or turning Medicare into a voucher program, the big payroll tax breaks should also come under scrutiny.