A tax is a mandatory levy by government on tax payers as a contribution towards a wide range of government public expenditure. Taxes are the main stream of income for any government for upkeep of the country’s public systems. The money collected through the means of taxation is used by the government to fund its expenses, be it from infrastructure to social causes to welfare benefits etc. Taxes can be bifurcated into several types on several parameters such as nature of levy, taxpayer the levy is applicable to and the purpose of the tax imposed etc.
This article looks at meanings of and differences between two types of taxes – payroll tax and income tax.
Definitions and meanings
Payroll tax is the tax levied on employers and employees as funding to the government for public and employee welfare programs. These taxes include taxes imposed towards social security, medical insurance programs and unemployment benefit programs etc.
Payroll taxes are generally calculated as a specific percentage of the employees’ salary and may often be capped up to a certain limit (upper limit of tax or upper limit of salary). Amounts of these taxes, in most cases, are contributed equally by both employer and employee.
The employer arranges the collection and payment of payroll taxes in the following manner:
- Employee’s contribution is deducted every month from his salary by the employer.
- Employer’s contribution is consolidated with the employee’s contribution and the total amount is deposited with the dedicated government authorities within the specified time frame.
Mr. Steward is employed with John Inc. at a monthly salary of $5,000. The prevailing social security contribution rate is 6.20% for each employer and employee. Accordingly, every month the social security contribution by both Mr. Steward and John Inc. to the government would be:
- Employee contribution = 5000 × 6.20% = $310 (to be deducted from the salary of Mr. Steward)
- Employer contribution = 5000 × 6.20% = $310 (to be contributed directly by John Inc.)
- Total contribution = 310 + 310 = $620
Income tax is a direct tax that is levied by the government on the income earned by individuals and business entities. These taxes are often levied at both the federal and state level, making income tax a combination of federal and state taxes. Individuals and business entities are required to file an income tax return each year which declares the income earned by them as well as calculates the income tax due. The taxes are paid to the government on the basis of this return.
Every jurisdiction also has tax withholding rules, whereby income tax is deducted at source on various financial transactions and thereafter deposited with the government authorities. For example, employers are required to calculate and withhold income taxes from their employees’ monthly salary. Similarly, banks may be required to withhold tax on interest income that depositors earn on their deposits.
Difference between payroll tax and income tax
The key points of difference between payroll tax and income tax have been detailed below:
- Payroll tax is the tax levy on employers and employees towards funding of employee and public welfare programs.
- Income tax is a direct tax levy on individuals and business entities for income earned by them.
- Payroll tax includes taxes towards social security, national level medical insurance programs, unemployment wages funding etc. It includes component of employer and employee contribution.
- Income tax includes federal, state and local taxes which are in the nature of direct taxes on income.
3. Levied on – entity type
- Payroll taxes are levied only on employers and employees as their contribution towards welfare programs.
- Income taxes are levied on various type of entities like individuals, corporates etc. that earn income.
4. Levied on – nature of income
- Payroll taxes are only levied on salary income.
- Income taxes are levied on several sources of income such as business income, salary income, interest income, dividend income and rental income etc.
- As the levy of payroll tax is on limited persons and limited types of income, the scope of these taxes is narrower.
- As the levy of income tax is across several types of taxpayers and across sources of income, its scope is wider.
6. Responsibility to pay to the government
- The employer is responsible to collect and deposit payroll taxes with the government.
- The income earning entity i.e., the individual or corporate taxpayer is responsible for paying income tax. In case of withholding of income tax, the payer of the income is responsible for withholding and depositing tax with the government.
7. Manner of calculation
- Payroll taxes are calculated as a percentage of salary earned by the employee. Generally, both employer and employee contribute equally. Payroll tax may also be capped and applicable only on salary upto a certain limit.
- Income tax is calculated as per jurisdictional rules on the net income earned by individuals and business entities. Several expense and other deductions are available from gross income to arrive at net taxable income on which income tax is calculated. There is no maximum cap; usually, higher the income, higher the income tax.
- Payroll taxes are considered to be regressive in nature as they are typically applicable with maximum capping conditions.
- Income tax is progressive in nature; as a taxpayer’s income rises, his income tax also rises.
9. Manner of collection
- Payroll taxes are collected through monthly withholding from salary by the employer.
- Income taxes are collected through annual filing of tax return and are also often collected periodically via tax withholding provisions.
- Payroll taxes are utilized towards specific programs devised primarily for employee welfare such as medical insurance, unemployment wages and retirement social security etc.
- Income taxes are used for general government funding. They can be applied for a plethora of government projects like infrastructure, public health and welfare and subsidy programs etc.
Both payroll taxes and income taxes are an important source of income for any government. Thus, it is imperative that these taxes are correctly collected from the responsible taxpayers. Governments across the world thus have several compliance procedures in place to enforce correct determination and collection of various taxes. They also have designated government agencies such as the Internal Revenue Service (IRS) in USA that monitors the collection and payment of such taxes by various taxpayers.