Why does my paycheck look small today?

Today's topic is a reader request.  Jory O. asks:

“A lot of people after seeing their paycheck today seem to be confused about the social security tax increase they're seeing. Maybe this would be a good topic for the Economystified blog??”

I couldn’t agree more, Jory!  What is going on with our pay right now…?

                                                                     

 

Many readers in the US might have noticed something odd about their recent paycheck.  It looks a bit small.

No, its not a mistake.  No, its not just you’re check.  And, yes – it a permanent change.

What happened?

Ok, so go back to late 2010.  The Great Recession is in full swing.  Unemployment is high, and people’s wages are stubbornly low.

The national government had already tried a handful of economic stimulus programs, and at that point people were still unsure if they were really doing much.  Whats more, each measure was pretty politically complex.  Everyone had big ideas about what those programs should look like, and how they would be administered.  Things got messy.

So when the national govt decided it was time to try something new for in 2011, it wanted something quick, simple and direct.

What the Obama administration suggested – and Congress eventually approved was a temporary reduction of Federal taxes, specifically payroll tax (this tax is sometimes called “FICA” or “Social Security” tax). 

The thinking was this would be an, easy way of increasing everyone’s take home pay in one fell-swoop, and hopefully encourage some spending to kickstart the sluggish economy. 

The payroll tax reduction was set to last from 1/1/11 until 12/31/11.  Then in December of 2011, Congress decided to roll it over for an additional year.  So in the end, this temporary reduction ran for all of 2011 and 2012.  They called this 2 year reduction in payroll tax a “tax holiday.”

What is the “payroll” tax, anyway?

The payroll tax is a special tax paid by all workers in the US.  Every time a paycheck is issued – no matter where, no matter for what line of work - 6.2% is taken out (before any other taxes) by the national government. 

That is until the recent tax holiday, when that rate was cut from 6.2% to 4.2%.   

You’re seeing a drop in your pay today because, at long last, Congress has decided to let the tax holiday expire.  We’ve reverted back to the old (pre-2010) rate.  On 1/1/13, the payroll tax rate jumped from 4.2% to 6.2%. 

You’re paying an additional 2% of your gross pay in taxes, that’s why your check looks weirdly smaller.

This tax (the FICA-payroll-Social Security-whatever tax) serves a special purpose.  It’s revenue is used exclusively to pay Social Security – a type of welfare/pension for the elderly and disabled.

Take a look at your paystub.  You probably have a line on there that says “Social Security” or “FICA.”  That amount is the contribution you made to the US Social Security coffers this pay period.  (Aren’t you so generous!)

How does “Social Security” work?

Basically, as long as you are retired, disabled, or otherwise unable to work, you can collect Social Security.  It’s a simple lump sum of cash paid out to you on a regular basis. 

Now, I think a lot of people operate under the assumption that somehow or another they are guaranteed to receive the money they pay in to the Social Security system once they retire.  That is not correct. 

Social Security is a “pay-as-we-go” scheme.  If $50 was taken out of your check today through the payroll tax, that $50 is getting transferred to the bank account of some retiree somewhere else in America.  That 50 bucks is Florida bound.

When you retire, and begin to draw Social Security payments, your money will be coming directly out of the paycheck of the generation still working.

Why do we do it this way?

The first Social Security check was issued in 1935, right in the middle of the Great Depression.  At the time, there was huge national concern about the welfare of the elderly, disabled, widowed – those were least like to be hired or couldn’t work at all.

When the system was created, we wanted to tap into it LIKE NOW.  So Congress began collecting tax from workers immediately back in 1935, and just turned around and paid out what was collected to those who weren’t working.

If Social Security was set up to collect from workers today, hold on to the money, and just return it to the individual after retirement, no retirees alive when the program began would have been able to collect a cent.  It got started that way, and now we’re stuck with it.

Why not keep the tax holiday permanent?

Believe me, there were folks out there who wished they would keep this reduction permanent.  The tax holiday coming to an end is a real bummer. 

For example, I started my current job only 8 months ago.  I started here during the tax holiday.  So I never saw a paycheck for my current position with the pre-2010 rates being applied to it before.  For me, all this doesn’t feel like “my taxes are going back up to where they used to be.”  To me, this just feels like a plain and simple pay cut.

But we can’t keep the payroll tax holiday indefinitely simply because we can’t afford it.  Looking back, economists calculated that the Social Security scheme missed out on somewhere to the tune of $200 billion in revenues as a result of it.

Now that isn’t $200 billion down the drain.  That was $200 billion left in the pocket of ordinary workers, hopefully giving the economy a bit of a pick-me-up. 

However, we didn't decrease the payments outgoing to retiree's during the tax holiday.  So even though the govt didn’t collect as much from workers through payroll taxes, their expenses remained unchanged.  

The SS system made up the shortfall caused by the tax holiday by spending more out of its savings, something it calls the “Social Security Trust Fund.”  When that things gets depleted, we’ll eventually have to borrow money to pay our obligations to our retirees, which will add to the already uncomfortably large national debt.

So that tax holiday – it was fun while it lasted, but it couldn’t have lasted forever.

So is this really a tax hike?

Every time some one on the news calls this a new "tax hike," I flinch.

Ok, yeah, duh, this clearly is not a tax decrease for anyone. 

But I’m hesitant to call this a “tax hike” per se.  Our taxes were temporarily  reduced, and now that party is over.  That’s not really really a tax hike, you know?

Say a store puts everything on sale for a day, then reverts back to the original pricing the following day.  Is that the same as the store just jacking up the prices of their wares?

Or let’s say your boss announces on a Monday that he’s bringing in donuts for everyone for a week.  Free donuts for five days! 

But next Monday morning, just as promised, he comes in to the office empty handed.  Now is it fair to say: “My boss took my donuts away from me”?  I don’t think so.  (But feel free to disagree!)

Last thing I want to mention is that you should always keep in mind that the Federal government isn't the only govt you pay taxes to.  You pay taxes to your city, your county, and your state.

I think taxes collected by the national govt tend to go under more scrutiny because we get most of our news from national sources, not local ones.  Even if you live in New York state, for example, you'll probably get bombarded with more info about national taxes then state ones.

Personally, I pay about 40 cents in state taxes for every dollar I pay to the Federal govt.  Add in the sales taxes I pay every day (which mostly go to the county I live in), and I probably pay almost as much in tax to the state and county as I do to the nation.

So from a purely rational standpoint, I should hear just as much about my local taxes as I do the national ones.  But that's really just not the case.  C'est la vie, I suppose...