It funds Social Security and Medicare.
So, there have been recent suggestions that one way to help the economy during the current stock market slump and the coronavirus pandemic is to reduce the "payroll tax" that nearly everyone pays on earned income. I won't go into the politics of this, but I was curious how the payroll tax (FICA and MDCR on your paystub) contributes to the Social Security and Medicare systems.) So here's the result of my brief research. Enjoy.
The Social Security payroll tax is 6.2% of your gross pay for both employer and employee.
The Medicare tax is 1.45% each. (There is a surcharge for high-income earners, but we'll ignore that here.)
So the totals are 7.65% each for employer and employee (15.30% total for both). Note that this applies only to earned income. So your stock dividends and capital gains don't apply here.
The Social Security payroll tax income cap for 2020 is $137,700 (so neither the employee nor the employer pays the Social Security part of the payroll tax once the employee's gross salary is above this amount). This income cap goes up a little bit every year. In 2020 approximately 6% of all earners have income that is over the income cap amount and hence do not pay the payroll tax on any earned income over the $137,700 cap. (See https://www.ssa.gov/policy/docs/population-profiles/tax-max-earners.html )
There is no income cap on the Medicare payroll tax.
The payroll tax is what funds the ongoing operations of the Social Security Administration and Medicare. It is what provides the funds for my monthly Social Security benefit and my Medicare Part A premiums and some other Medicare costs. How does this happen?
Payroll taxes are used to buy special-issue U.S. Treasury securities for the Social Security Trust Fund. This happens daily. The SSA is paid interest on these securities by the federal government. (These securities are basically a loan from the SSA to the federal government.) In order to make benefit payments, the SSA sells securities from the Trust Fund. In 2017, the SSA bought $2 trillion worth of special-issue Treasury securities using the money it received from payroll taxes. The SSA also sold $1.156 trillion in securities to pay Social Security benefits.
Note that if the total amount of payroll taxes collected in a given year exceeds the dollar amount of benefits paid, then the surplus is retained by the Social Security Trust Fund - and the Trust Fund grows. Conversely, if the total dollar amount of payroll taxes collected in a given year is less than the dollar amount of benefits paid, then the SSA must reduce the amount of money in the SS Trust Fund to make up the difference - and the Trust Fund shrinks. So in 2017, because the SSA paid out less money in benefits than it took in in payroll taxes, the size of the Trust Fund increased. However, starting in 2021 the anticipated amount in benefits paid will be larger than the anticipated payroll tax revenues and the size of the Trust Fund will begin to shrink every year.
See https://www.ssa.gov/OACT/ProgData/fundFAQ.html
and
https://www.ssa.gov/OACT/TRSUM/index.html
It is anticipated that - if nothing is done to reduce or eliminate the rate of shrinkage - the Social Security Trust Fund will be exhausted by 2035 and in subsequent years the SSA will only be able to pay out about 76% of the expected benefits.
There are many ways to fix this, either by increasing income into the Fund, or by decreasing expenditures (aka benefits).
One way to do this is to eliminate the payroll tax income cap. If the payroll tax income cap is eliminated and everyone pays the SS payroll tax on their entire earned income, the Trust Fund will not be exhausted until about 2080. So that's one fix that is doable - make everyone pay the payroll tax on their entire earned income. Note that this only affects the 6% of earners that make more than the current income cap because the other 94% of earners were paying the payroll tax on their entire earned income already. See option E2.1 at https://www.ssa.gov/oact/solvency/provisions_tr2019/payrolltax.html
There are other proposed options that have various effects on the size of the Social Security Trust Fund. Many of them are considered not palatable by most people. The three options mentioned most often are (1) increase the payroll tax amount by several percent (so all people with earned income will pay more in payroll taxes going forward), (2) increase the retirement age by several years (which has the effect of reducing benefits to future retirees), and (3) decrease actual benefit amounts for future retirees by some percentage by changing the formula used to compute the PIA (the Primary Insurance Amount: your full retirement benefit at your full retirement age. See https://www.ssa.gov/OACT/COLA/piaformula.html and https://en.wikipedia.org/wiki/Primary_Insurance_Amount).
None of these options has a lot of support except in certain circles in Congress and some media outlets.
So, to get back to the original question about a temporary reduction in the Social Security payroll tax, here's my opinion, FWIW.
It's a really bad idea, for this reason: It will reduce the income going into the Social Security Trust Fund for this year.
There are a couple of consequences of this.
It will require the SSA to take more money out of the Trust Fund to meet this year's benefit obligations. I know, you say, but John, the Trust Fund is supposed to grow this year. Yes, except that those growth projections assumed the current payroll tax rate and were made before there were 39 million people who are now NOT paying the payroll tax for at least part of the year. At this point, by reducing the payroll tax for everyone else (which, BTW, will not help the 39 million unemployed people at all because they now have no earned income), there is even less money flowing into the Trust Fund, but there is still quite a bit flowing out (part of which is my monthly Social Security benefit payment). This will reduce the overall size of the Trust Fund, which will reduce the amount of interest income the Trust Fund earns - every year going forward.
And that will make the problem of the Trust Fund shrinking to zero even worse.
So, yeah, a really bad idea.
