After doing my taxes this year, I wondered if self-employed individuals are at a disadvantage when it comes to paying federal taxes.

I didn’t profit off of my self-employed venture (i.e., this blog) when I factored in the cost of web hosting and cable internet, but anyone who makes a profit of more than $400 owes a 15.3% tax on 92.35% of that profit in order to cover their contribution to Social Security and Medicare. But based on a survey of my past W2s, Social Security and Medicare account for only about 7.6% of my gross income. What gives?

So I set out to test my theory that the federal government imposes a financial disincentive on self-employment. In order to do so, let’s invent two people: Sally and Jim.

Sally works for company X. In 2006 she earned a salary of $50,000.

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 by 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, $3,533, from his gross income, giving him an Adjusted Gross Income of $46,467.

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 for the year to $6,951, or 13.9% of her gross income.

Jim also takes the standard deduction plus one exemption, leaving a taxable income of $38,017, and bringing his taxes 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 Social Security tax rate is 6.2%. Over the course of the year, she had $3,100 deducted from her paycheck for that. Her Medicare tax rate was 1.45%. A total of $725 was taken out for that.

So in total, Sally’s take home pay was:

Whereas Jim’s take home pay was:

That’s a staggering 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.” Does Jim really have to pay the government a fee of $2,353 every year 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 SE Tax rate is 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 in my example above, that only amounts to a tax relief of $887 for Jim (Sally’s tax of $6,951 – Jim’s tax 6,064 = $887).

I wonder if historically self-employed persons were seen as more of a burden on Social Security and Medicare after they stop working, whereas in the past many employers had pensions (now 401(k) plans), and medical plans, thus reducing somewhat the overall public burden of their employees.

This page describes the Social Security & Medicare Tax Rates from 1937 to the present, and contrasts the rates for employees vs. the self-employed. The difference between the two 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.

Turns out Sally’s 50,000 salary really includes a hidden payroll tax paid by the employer, making her true salary something like $53,825 ($50,000 + $3,100 + $725). So what if Jim had invoiced Sally’s company for $53,825. How would they compare then?

Turns out they’re pretty much the same. In the end, it appears there is no financial disincentive for being entrepreneurial, even though from the perspective of someone who’s self-employed, it may feel that way, especially when looking at a wage-earner’s advertised salary. This is exactly the opposite of what I had expected to find. I set out to prove a disincentive, and ended up disproving it.