Payroll Tax
What is Payroll Tax?
A payroll tax is a tax on wages and salaries, usually split between employer and employee, that funds social insurance programs.
A payroll tax applies to earnings from work rather than to all income, so wages are taxed but interest, dividends and capital gains are not. The statutory burden is often split, with half withheld from the worker's check and half paid by the employer, but because labor supply is relatively inelastic, workers bear most of the true burden either way. Many payroll taxes apply only up to an annual earnings cap, so a worker earning far above the cap pays the same dollar amount as one right at it and therefore a smaller share of total income. That cap is why the payroll tax is regressive at the top, while an income tax with rising marginal rates is progressive.
Payroll Tax: a worked example
Take an illustrative payroll tax of 6% on the worker and 6% on the employer, applied only to the first $150,000 of wages. A worker earning $60,000 pays 6% × $60,000 = $3,600, which is 6% of her income. A worker earning $600,000 pays only on the capped $150,000, so 6% × $150,000 = $9,000, which is $9,000 ÷ $600,000 = 1.5% of income. The high earner pays more dollars but a much smaller share, which is what regressive means. The rate and cap here are illustrative, not actual figures.
The mistake students make with payroll tax
Students assume the employer half is a cost the worker never feels. Economic incidence does not follow the legal split: employers respond to their share by offering lower wages, so most of the combined burden lands on labor. A second error is calling the payroll tax progressive because everyone pays the same rate; a flat rate with an earnings cap is proportional up to the cap and regressive above it.
Payroll Tax questions
Is the payroll tax progressive or regressive?
A payroll tax with an earnings cap is regressive, because earnings above the cap are untaxed and high earners therefore pay a smaller share of their income. Below the cap the tax is proportional: every wage dollar faces the same rate. Income that is not wages, such as dividends, sits outside the tax base altogether.
Who really pays the employer's share of the payroll tax?
Workers bear most of the employer's share through lower wages, because labor supply is far less elastic than labor demand. The legal division of the tax sets who writes the check, not who ends up poorer. Economists call this the difference between statutory and economic incidence.
How is a payroll tax different from an income tax?
A payroll tax falls only on earnings from work and usually stops at an earnings cap, while an income tax reaches wages, interest, dividends and other income with rates that rise as income rises. That makes the income tax progressive and the capped payroll tax regressive at the top. Payroll tax revenue is also typically earmarked for specific social insurance programs.
Formula / Example
This is the live Supply and Demand sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
Get AP Econ exam tips in your inbox
Occasional emails with study tips, new interactive graphs, and exam-season reminders. Free, no spam.
No spam. Unsubscribe anytime. Read our privacy policy.
Keep track of what you have studied
A free EconLearn account adds progress tracking, your quiz history, and achievements. Studying here is free either way, and there is nothing to pay for as a student.
Create a free accountAlready have one? Sign in
Last updated