Is the self-employment tax an entrepreneurial disincentive?
After doing taxes this year, it seemed to me that self-employed individuals might be at a disadvantage when it comes to paying federal taxes.
I conveniently didn’t profit off of my self-employed venture (this blog) when you consider the cost of web hosting and cable internet, but anyone who makes a profit of more than $400 owes an additional 15.3% tax on 92.35% of that profit in order to cover their contribution to Social Security and Medicare. Based on my own historical W2s, Social Security and Medicare account for only 7.6% of my gross income.
So I set out to test the theory that the federal government imposes a financial disincentive on self-employment. In order to do so, let’s invent two people:
Sally works for company X. In 2006 she earned a gross salary of $50,000 a year.
Jim is a consultant. He often works many different jobs as an independent contractor, but in 2006 he worked solely for company X and invoiced the company for a total of $50,000 over the course of the year. Jim’s work expenses are minimal. Other than getting to and from work (usually walking), company X provides him with office supplies, workspace, and a computer.
When Sally fills out her 1040 form, she enters $50,000 from her W2 in the line marked “Wages, salaries, tips, etc.”
When Jim fills out his 1040 form, he enters 0 in that line, because all of his income was reported on a 1099-MISC form. He instead fills out Schedule C-EZ (Net Profit from Business), and considering his negligible business expenses, he enters all 50,000 in the line marked “Business income or (loss).”
Sally has no deductions, so her Adjusted Gross Income remains 50,000.
Jim, however, has to fill out schedule SE (Self-Employment Tax). His total earnings were $50,000, which he multiples times 0.9235 to figure what the government considers his net earnings: $46,175. His self-employment tax is 15.3% of that, or $7,065. He then deducts one half of that from his gross income ($3,532), giving him an Adjusted Gross Income of $46,468.
Sally takes the standard deduction plus one exemption (subtracting $8,450 from her AGI), leaving a taxable income of $41,550, and bringing her total taxes owed for the year to $6,951, 13.9% of her gross income.
Jim also takes the standard deduction plus one exemption, leaving a taxable income of $38,018, and bringing his taxes owed to $6,064 plus his self-employment tax from Schedule SE of $7,065, for a total tax burden of $13,129, or 26.3% of his gross income—almost twice that of Sally.
However, there are two things that Jim did not have deducted from his earnings that Sally did. Social Security and Medicare. Sally’s SS tax rate is 6.2%. In total she had $3,100 deducted from her paycheck for that. Her Medicare tax rate was around 1.45%. $725 was taken out for that. So in total, Sally’s take home pay was:
50,000 gross -6,951 federal -3,100 social security -725 medicare ------ $39,224 net income (78.4% of gross)
Whereas Jim’s take home pay was:
50,000 gross -13,129 federal ------- $36,871 net income (73.7% of gross)
That’s an annual difference of $2,353, nearly 5% of Jim’s gross income. That, it would seem, is the aforementioned financial disincentive, or the cost of Jim’s freedom (depending on how you look at it). I’m not joking (about the latter) either. The IRS says you are considered an employee if “the employer has the legal right to control the details of how the services are performed.” Thus Jim has to pay the government a fee of $2,353 every year in order for the simple freedom to determine “what will be done and how it will be done.”
That seemed strange to me, so I did a little research on the self-employment tax. According to the IRS website, the SE tax is indeed a means to levy the Social Security and Medicare taxes.
Self-employment tax (SE tax) is a social security and Medicare tax primarily for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most wage earners.
The 15.3% SE tax consists of two parts, 12.4% for social security (old-age, survivors, and disability insurance) and 2.9% for Medicare (hospital insurance).
But still, based on my past experience (where I got the 6.2% and 1.45% figures above), the self-employment tax rate is nearly double what actually gets deducted from my wages.
They go on to say that:
you can deduct half of your SE tax in figuring your adjusted gross income. Wage earners cannot deduct social security and Medicare taxes.
Though that only amounts to a tax relief of $887.
I wonder if historically self-employed persons were seen as more of a burden on Social Security after they stop working and Medicare while they are, whereas in the past many employers had pensions (now 401(k) plans), and medical plans, thus reducing somewhat the overall public burden.
This page describes the Social Security & Medicare Tax Rates from 1937 to the present, and contrasts the rates for employees vs. the self-employed:
| Social Security | Medicare | Total | |
| Employee | 6.2% | 1.45% | 7.65% |
| Self-employed | 12.4% | 2.9% | 15.3% |
The difference hasn’t always been so severe. That changed in 1984. Stephanie suggested that maybe the employer pays the difference, confirmed by this site:
Employees have half that amount deducted from their pay, and they may feel they are paying less because their employer picks up the rest. However, when an employer looks at the cost of hiring you, he considers total cost, including payroll tax.
So in the end, it appears there is no real financial disincentive for being self-employed. Sally’s 50,000 salary really includes a hidden payroll tax paid by the employer. Her super-gross salary is something like $53,825, which consists of her stated salary plus the other half of the payroll tax paid by her employer on her behalf. Comparing a $50,000 salary to a $50,000 contractor is like comparing grapefruits to oranges.
Hilariously because Jim gets to deduct half of his self employment tax from his overall income (simply for paying it himself), he actually pays less overall tax, $887 dollars to be exact.
I should add that this exactly the opposite of what I expected. I set out to prove a disincentive, and ended up disproving it.
ryan was technicallly self employed last year, and of his 47,000 gross, after all deductions for “work expenses” (get a tax accountant) he ended up owing about $6000 total. i’d say self employment is a beautiful thing.