The Deception of the Reduced Employee Share of Payroll Tax

I am sure there are many employees who are delighted that the government has decided to make the total 2.0% reduction in the rate of the Social Security tax in the employee's contribution and not in the employer's contribution.  In fact, this is a nearly meaningless distinction, except that it plays well with those who have not thought the problem through.  I can tell you from my experience with mostly quite intelligent employees that very few people have thought this issue through.

In view of this ignorance, the ploy makes great political sense.  First, there are many more employees than there are employers, so it wins more votes for the politicians.  Second, the disappointed Progressive Elitists who so badly wanted to raise taxes on those guilty of being productive enough to earn more than $200,000 or somewhat less or couples earning more than $250,000 together or somewhat less are likely to feel that the reduction of the Social Security tax only on employees making less than $106,800 helps to equalize their disappointment in not getting to soak the rich.  They are also getting even with those rich, exploitative employers by not letting them have a share of the tax break for 2011 offered by this Social Security tax reduction.  Progressive Elitists hate business, profits, and businessmen, so this plays well.  But then this little triumph is entirely based on their own ignorance of employee compensation, which they display in many ways in addition to the present case.

Why is the distinction of employee and employer shares of the Social Security and the Medicare taxes meaningless?  On one level, it is because they are both paid by the employer.  The employee does not take his paycheck home and then send his Social Security withholding of 6.2% and his Medicare withholding of 1.45% in to the IRS.  His employer does that, unless he is self-employed, in which case he sends 12.4% in Social Security tax and 2.9% in Medicare tax.  But while this fact is important, it is not the hard part to understand.  Let us get to that.

An employer hires an employee because he wants the employee to help him produce goods and services and hiring the employee is calculated to produce enough more goods and services that the employer can cover all the costs of hiring the additional employee and make some profit as well.  The employer and the employee make a deal that the employee will be so productive that the employer can rationally afford to keep him employed.  There are two sides to this issue that need to be considered.  What will the employee add in company income and what he costs the employer.  For our purposes here, we will mostly consider what the employee costs the employer.

Adding an employee will generally require more work space and more equipment.  Workman's Compensation Insurance payments will go up.  The company may need to do more advertising to bring in more customers for the employee to provide goods or services for.  There will be an incremental increase in liability insurance in many cases.  There will be generally added expenses for business cards, office supplies, pollution controls and other regulation compliance, and the materials and goods the employee must use to make the company's finished goods or provide services.  There will also be overhead expenses due to the added work in doing payroll and keeping records for the IRS and reporting to them and other government agencies on tax and labor issues, and to provide and keep track of benefits.

Finally, there is the matter of providing the compensation package to the employee.  His compensation cannot rationally be greater than his additions to the company's income minus the many expenses of the previous paragraph.  If they are, for more than a brief training period, he should be fired.  Now every company is also in a bidding war with every other employer and even with the employee's potential thoughts of being self-employed, so that he has little leeway on the downside as to what he can offer in a compensation package.  He may increase that leeway somewhat by providing a nice work environment, good people to work with, good customers to work with, extra freedom in hours worked, and interesting work to do.  But one way or another, he is still in a stiff competition to keep desirable employees, who are likely to be desirable to other employers as well.  But most important of all, the employee's total compensation has a strict upper bound determined by what he adds to the company income minus the expenses associated with his doing so.

The compensation package is usually considered to be his wages or salary plus the costs of his benefits such as health insurance, retirement plans, vacation, sick leave, etc.  One could say that the employer's share of the Social Security tax and the Medicare tax, that state and federal unemployment taxes, and Workman's Compensation costs are all overhead expenses.  But if you do, the employer still needs to consider them as part of the costs of adding an employee and the employee still has to cover those costs or lose his job.  But, unlike added equipment, office or warehouse space, advertising, and other common overhead expenses, these taxes, which Workman's Compensation also is for all intents and purposes, are very easy to attribute to each particular employee and most rational employer's will do just exactly that.  They are part of your compensation package then.  Sure, most employees do not think of them as such, but that is the real case.

Why is this?  It is because the employer would have been just as happy to have given these tax monies to you as to give them to various governments or insurance companies.  If you are employed, you are worth the sum of these taxes, your take-home pay, the other taxes fictionally paid by you though he pays them for you, and all of your benefits.  In fact, if the employer could hand all of this money to you he should be happier.  He probably likes you and he would surely be very happy not to have go to all the trouble of separating the amount you are worth into separate piles with all the associated record keeping, report filings, and payments needed to

• Withhold income taxes for the state.
• Pay unemployment insurance to the state.
• Withhold income taxes for the federal government.
• Withhold Social Security taxes for the federal government.
• Withhold Medicare taxes for the federal government.
• Pay unemployment insurance to the federal government.
• Pay Workmen's Compensation insurance.

I can certainly vouch for the fact that I would love to give all this money to my employees and if any of these taxes had to be paid, I would be delighted if they would relieve me of all the tedious work involved and do it themselves.  Of course, I have a devious motive.  I know that that would create so many very angry voters that we would soon have a much simpler tax system and much smaller governments.  Many more people would pay more attention to how much they were paying in taxes.  The present system is designed to fool them into underestimating the amount of taxes they pay.  That deception works with most people.

Now, let us consider the case of a tax increase.  It does not matter a bit whether the tax increase is designated as paid by the employer or the employee.  The employer is still the one who is actually going to make the payments, though the employee is involved in some minor adjustments on the income tax.  Let us suppose that either the Social Security or the Medicare tax goes up.  If it does, the employer will have to do one of a few things:

• If he has many employees, he can easily fire one or more of the least productive employees to compensate for the cost increase.
• He may crack the whip and say all employees must work harder.
• He may defer pay increases until increases in worker productivity match the increased tax cost.
• He probably will be loathe to take on new workers who will not be able to match their cost of employment for an initial period of time as they learn the job.
• He may cut back on benefits.
• He might have to decrease wages or salaries, though this is usually psychologically a tough choice for everyone.

The employer has options and he will have to exercise them.  Losing money is not a choice he can handle for long.  But, you should note that such compensatory actions are harder on small businessmen than on big companies.  If your costs go up 2% and that wipes out your profit, but you have four employees, firing one causes you to lose 25% of your income.  That is most often not an option.  So you have to use the remaining options or go out of business altogether.  The going out of business option is very frequently exercised by small businesses, especially since they are usually already working very hard and productivity increases are often harder for them to come by.

Now let us return to the 2% decrease in the employee share of the Social Security tax.  Each employee gets to now take that 2% home and spend it as he wishes.  But, what would have happened if the 2% decrease had been in the employer's share of the Social Security tax?  Well, perhaps for a few weeks the employer might have had a few extra dollars to reinvest in his company or to call net income and to be taxed, but there would be a very rapid readjustment in the marketplace in which employers found that they must offer employees 2% more to retain them or to get them to come to work for them.  Why?  Because the worker in question has already proven that his labor is worth that extra 2%.  That is why he had a job in the first place.

Good, productive employees are a scare resource.  There is always an active bidding process for their services, just as there is a market for plumbers, accountants, gold, wheat, pork, televisions, and other goods and services.  The inescapable Law of Supply and Demand applies here as it generally does in life.  Governments often pretend that they are above the Law of Supply and Demand, but all they do is shift the equation is some way, usually some bad way, but some new Supply and Demand equilibrium ensues.

In the case of the 2% reduction from 6.2% to 4.2% in the employee share of Social Security, there will be more money available in the short run for people to spend.  Generally, I favor reductions in taxes.  However, this reduction is going to make the financial straits of the Social Security system all the worse.  The Baby Boomers are about to start retiring in large numbers.  The politicians have been unwilling to face that program's severe underfunding.  The Ponzi scheme is about to collapse upon us all.  The best solution is simple, but few will yet accept it.  The problem is the size of the Baby Boomer wave and the fact that retirees are living a long time.  The life expectancy of the 65 year old in 2006 was 18.5 years.  That is a long time in retirement, particularly given that many people aged 70 are now in good enough health to be working.  The retirement age should be at least age 70.  I expect to work at least until I am 75 and longer if my health allows, which it probably will.

Given that the federal government has long been using Social Security tax revenues to generally pay for the obscenely excessive spending of the government, either major retirement age increases or major tax increases will be required.  Taxes are already much too high and they are already very much degrading the health of the private sector.  What we generally need are massive government spending decreases.  They are coming because the People will not put up with higher taxes and they are coming to understand the fatal nature of government deficit spending.  The process by which the necessary spending decreases will occur is going to be very interesting to observe.  Because a simple problem has so very long been ignored, its solution will now be all the tougher and may be catastrophic for some.