Whereas an income tax is levied on all sources of income, a payroll tax applies only to wages and salaries. Employers automatically withhold payroll taxes from employees' wages and forward them to the government. Payroll taxes are the main sources of funding for various social insurance programs, such as those that provide benefits to the poor, elderly, unemployed, and disabled. In 1994 payroll taxes accounted for about 26 percent of all tax revenues in the United States; in Canada, the figure was 17 percent. For most people, payroll taxes are the second-largest tax they must pay each year, after individual income taxes.
The U.S. federal government levies the social security payroll tax at a flat 12.4 percent rate on employees' annual gross wages up to a certain limit. The limit, which was $68,400 in 1998, rises each year at the same rate as the growth in average wages. The government imposes no payroll tax on earnings above the limit. Employers pay half the tax and employees pay the other half. The Medicare payroll tax is 2.9 percent of all earnings, with no cap. Again, employers and employees split the cost of the tax. Self-employed individuals must pay the entire payroll tax.
Although the legislators who set up payroll taxes intended to divide the tax burden equally between employers and employees, this may not occur in practice. Some economists believe that the tax causes employers to offer lower pretax wages to employees than they would otherwise, in effect shifting the tax burden entirely to employees.