It’s Time to End Tax Code Prejudice Against the Self-Employed

Whether it’s ride-sharing firms like Uber and Lyft, or accommodation-sharing firms like Airbnb, or job-sharing firms like Task Rabbit, the sharing economy may soon reverse a trend of declining self-employment.

Yet there are many other self-employed Americans beyond the sharing economy. According to federal government statistics, 15 million people — more than 10 percent of all U.S. workers — were self-employed in 2015. Unfortunately, that vast economic potential is under attack.

For a start, consider the fact that self-employed Americans pay 7.65 percent more in taxes than formally employed Americans. Where formal employers pay half of an employee’s social security and medicare taxes (amounting to 6.2 percent and 1.45 percent respectively), self-employed Americans must pay everything themselves: 15.3 percent (12.4 percent Social Security tax and 2.9 percent medicare tax).

This marginal difference matters.

It means significantly less money for savings, bills, socializing and anything else. And although taxes are not supposed to be popular, they should be fair and they should encourage economic activity. On both counts, the additional 7.65 percent marginal tax on the self-employed fails those tests.

On the fairness count, while self-employment is a choice, it is also often a requirement for those who cannot find formal employment. Consider ride-sharing drivers trying to earn a living after becoming unemployed. But that’s not the only issue. Of all unincorporated self-employed workers, after the management sector, most are in the construction, services, and sales sectors. Jobs in those sectors are often unreliable in duration and earnings, and dependent on big contracts.

Still, while a company can offset its taxes if it loses money in a bad year, or offset capital costs, self-employed individuals have no such luck. They must pay federal and state taxes, and a 15.3 percent payroll tax on their earnings, regardless of circumstances. To cope with these risks, self-employed Americans must save early and save considerably. Failing to do so, they may find themselves broke in a year of bad earnings. The payroll tax is thus inherently regressive.

Another problem with the tax code’s approach to self-employment is its hidden effects on health care. Where formal employees are often offered tax-mitigated health insurance plans by their employer, self-employed Americans are less fortunate. While self-employed health care plans are also tax deductible, employer-provided health plans are more generous in coverage. The costs in these plans are pooled to the advantage of the corporation. The costs in self-employed plans are pooled entirely to the individual. This discrepancy needs to go.

Of course, some defend the self-employment tax code. They point to its generous solo-401(k) options for saving tax-free retirement income. But while this element is positive, its impact is qualified by the unpredictable nature of self-employed earnings. If you touch the 401(k) account too early, it becomes taxable. Others say that self-employed Americans should simply form their own S-corporations. Doing so allows for some earnings to be taken as non-taxable dividends. But again, this is often easier said than done.

First, the filing and other bureaucratic requirements involved with establishing and maintaining an S-corporation are extensive and expensive. Second, dividends cannot be disposed of at will. If that were the case, every S-corporation would simply designate a super-majority of its earnings as dividends. It is for these reasons that around 65 percent of all U.S.-based self-employed workers were unincorporated in 2015. Oh, and forget the lie that self-employment offers great opportunities for deductions. It does not. The rules for those deductions are very strict.

Still, the self-employment tax code’s core weakness is in its broader economic impact.

For one, it deters talented individuals from innovative activities. And if, like the vast majority of economists, one accepts that innovation drives economic growth, discouraging entrepreneurial pursuits is a bad idea. By imposing higher fixed tax rates on the self-employed than on formally employed individuals, the tax code encourages those with risky ideas to choose the safe option. The code pushes them to accept formal employment and mitigate the risks of self-employment.

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For a country defined by its entrepreneurialism, this represents grievous lost opportunities. Indeed, it’s the perfect partner to the tax code’s investment-killing approach to corporations. What great inventions has the tax code caused us to lose out on? We’ll never know.

As time goes on, the need for self-employment tax reform will be a growing concern. Millennials and Generation-Z-ers support the self-employment opportunities and service options born of the sharing economy. But regardless, as global economic competition grows and as more employers seek to offset increasing regulatory costs, the number of self-employed Americans is likely to grow.

Managing fairness with maximal economic productivity, it’s time for reform.