The government shutdown and our antiquated tax code
By Jeff Wald
Nine days into the first government shutdown in 17 years, and the debate rages on about the budget, debt ceiling, and whether the U.S. has become a global laughingstock. As the days progress, everyone — from politicians to furloughed workers – is wondering how long the shutdown will continue and what the damage will be in the near and long term.
Though disputes over Obamacare were initially at the heart of the economic debate, the potential for default on the $16.7 trillion debt has now moved front and center. This debt is due to a persistent government deficit, whereby U.S. spending exceeds revenue. According to the Congressional Budget Office, the projected deficit for 2013 is approaching $700 billion.
Notably, the IRS thinks it can solve more than half of the deficit by addressing the tax gap; the gap between what the IRS believes it is owed and what Americans have actually paid. According to the Government Accountability Office this tax gap is estimated to be $450 billion. A significant portion of that gap (pdf) is attributed to the misclassification of workers as independent contractors, rather than as full-time employees.
However, the real problem is not actually worker “misclassification.” The problem is an antiquated tax code that does not address the reality of the American employment landscape. This shutdown should serve as a wake-up call to both the IRS and the government that we need to adjust how we tax labor — and fast.
When businesses employ full-time workers, taxes are withheld directly from those salaries and paid to the government. The amount that’s withheld includes federal, state, and local tax estimates, social security and Medicare deductions, unemployment insurance, and workers compensation insurance.
If all of that sounds like a lot – that’s because it is. It’s expensive to be a full-time employee, or, said differently, the IRS collects lots of money from the United States full-time workforce.
Conversely, independent contractors who file an IRS Tax Form 1099 don’t have taxes directly withheld from their payments. Instead, that worker pays taxes as an independent business. Self-employed workers don’t pay into unemployment or workers compensation insurance programs, so the IRS collects less money in support of these services. (Practically speaking, 1099 workers are not entitled to these services, yet some do still try — at times, successfully– to obtain unemployment and workers comp payments).
Some 1099 workers may try (illegally!) to take advantage of self-reporting. They may not report all of their income, or they may over-report expense deductions — neither of which full-time employees can get away with.
The government makes less money from 1099 workers, which is why it’s going through employment arrangements with a fine-tooth comb these days, looking for ways to impose penalties on misclassified workers and collect unpaid tax revenues.
It’s easy to understand why the IRS has taken this route: the government needs money, plain and simple, and according to our antiquated tax laws, this seems to be a reasonable way to try and find it. But this kind of enforcement is actually causing more harm than good, especially when it comes to job creation.
We live in a freelance economy — a fact that is good for both employers and workers. From a business perspective, labor has historically been one of the greatest fixed costs of doing business. Using contractors gives businesses the opportunity to convert that fixed cost into a variable one. Moreover, companies want to engage labor on a freelance basis, and many people want the freedom to work this way.
During every cyclical economic downturn, an increase in temporary labor serves as a leading indicator of a hiring rebound. This time, however, the increases in temporary labor point more to structural changes in the labor economy than to a proper recovery in full-time hiring.
Whether these changes are being driven by technology, the emergence of online job search exchanges, regulatory and fiscal uncertainty, or specific regulatory frameworks such as Obamacare, we won’t know for some time. What is clear, though, is the labor pool is rapidly shifting to freelance. The Freelancers Union, for example, estimates that there are now 42 million American independent workers, up from 10.3 million workers in 2005.
The freelance economy is here to stay, and the government needs to catch up. Calling this kind of mutually beneficial work arrangement a misclassification doesn’t serve anyone well.
The solution is not to enforce against what was, but to adjust the system to the changing labor landscape. For example, by creating a system that taxes individual workers equally, regardless of how that person earns a living, the government collects the revenue it needs to deliver the services its citizens require.
I recognize “misclassification” is only one piece of the tax gap. Nonetheless, it’s important to recognize the role the freelance economy plays in U.S. economic development and job creation.
Businesses for sure will breathe a sigh of relief if they don’t have to worry about classifying someone incorrectly. As a result, we can expect to see businesses hiring even more workers and creating a larger supply of opportunities for jobseekers.