Payroll tax

Payroll tax is the percentage of an employee's pay that an employer is required to withhold or pay on behalf of that employee, and which is usually used to fund government programs and services.

While all countries use payroll taxes to support various forms of social security, healthcare, and other public services, the details and amounts can differ significantly. 

In addition to national government withholdings, local governments may also collect payroll taxes to support area services and infrastructure.

Components of payroll tax

Payroll taxes are usually broken down into different areas, each of which are collected at varying rates. In the US, for example, the tax authorities collect:

• Social security

• Medicare (healthcare contributions)

• Unemployment insurance

• Workers' compensation

• Disability insurance

• Family and medical leave

• Education or training levies

How is payroll tax calculated?

Payroll taxes are set by each country’s tax authorities and, in most cases, can be raised — or reduced — at any time. They are often split between the employer and the employee.

Example: The US

In the US, federal payroll taxes are calculated based on a fixed percentage of an employee's gross income. Employers withhold their employees’ taxable wages according to the Federal Insurance Contributions Act (FICA), comprising social security and Medicare taxes. 

Some taxes, such as social security and Medicare, are split between the employer and the employee. Other payroll taxes, such as the federal unemployment tax (FUTA) are paid by the employee.

State payroll taxes can vary. For example, California deducts state disability insurance (SDI) from employees’ taxable wages, while Illinois has flat rates for levying income tax. Some states, like Florida, have no state income tax at all. 

State unemployment insurance rates are also employer-funded, and can vary based on the employer's industry and experience.

In addition, some localities — such as New York City — impose city-level payroll taxes. These can be either employee or employer-paid.

Note that, in the US:

• Employers don’t pay any portion of an employee's federal, state, or local income tax.

• Businesses are required to deduct the correct income tax amount from employee paychecks based on W-4 Form information.

• Income taxes are determined through a progressive tax system, with gross annual income and filing status as key factors.

• Income taxes vary based on the resident’s state and local governance.

Other examples

The UK: In the UK, most employers must calculate and remit payroll taxes through the national Pay As You Earn (PAYE) system. Employers pay National Insurance contributions at a rate of 15.05% on earnings above a certain threshold, with employees also contributing a portion of their earnings — typically around 12% — depending on their income level.

Germany: In Germany, payroll tax includes contributions to health, unemployment, pension, and nursing care insurance. The total is split evenly between employer and employee, with each paying about half of the total 40% average rate.

Mexico: Employer payroll tax rates in Mexico range from 1% to 3% and are issued by each state, with the percentage applied to the business’s total payroll. Federal rates vary from about 2% to 35% based on the employee’s income level, and are directly withdrawn by the employer.

Are there any other payroll costs or requirements?

In addition to standard payroll taxes and income tax, business owners have other costs and administrative responsibilities related to payroll.

Consider using payroll analytics to inform your process. Beyond traditional payroll reporting, they can help you better understand your payroll costs, maintain compliance, and reduce the likelihood of errors.

Mandatory payroll costs

In some cases, employers may have additional payroll costs to keep in mind, such as:

• Employer benefits contributions

• Unemployment insurance

• Workers’ compensation insurance

• Court-ordered wage garnishments

Optional benefits

Optional benefits are left to the employer’s discretion, although some of those listed below may be mandated depending on the employer’s location.

Depending on your country’s laws, optional benefits include the following:

• Retirement plans

• Pension plans

• Paid sick or holiday leave

• Additional health benefits, including vision and dental

• Bonuses and stock options

• Life and disability insurance

• Mental health support

• Wellness initiatives, such as gym memberships or life/career coaching

• Work-life balance supports, such as childcare or transportation subsidies