Our Dumbest Tax

By Marc Tracy

Via his own post on The New Entrepreneur, Business Week's John Tozzi penned a great article exposing a truly outrageous discrepancy between the way the federal tax code treats the self-employed and the way it treats everyone else: "self-employed workers who buy their own health insurance essentially pay an extra tax on their premiums." The way it works is that while payroll employees pay for their premiums out of pretax income, and while the corporations (or, indeed, small business owners who give themselves health insurance through their companies), meanwhile, do the same, getting to deduct it as a business expense, the self-employed must purchase their insurance and pay for their premium the same they would buy a new suit, or a meal at a restaurant: with the decidedly post-tax money in their pockets.

Tozzi proceeds to go through the chances (or, really, lack thereof) of this fundamental injustice's becoming rectified in the course of the completion of new health-care reform. It is worth mentioning that one policy that may come out of the legislative sausage-grinder is a tax on insurance that payroll employees receive from employers premiums, a development that may, if constructed in a certain way, actually go a long way toward making the current system more equitable between the employed and the self-employed.

All that said, there is one sense in which Tozzi does bury the lead. He refer to the self-employment tax, under which those who receive income instead of or in addition to payroll wages are taxed double the standard 7.65% payroll tax--a 15.3% tax in addition to federal and other income taxes. The reasoning behind taxing the self-employed twice as heavily for payroll derives from the fact that while payroll employees pay their 7.65% and then their employers take care of the other 7.65%, the self-employed worker is, in a sense, both employer and employee, and therefore should take care of both halves. (As Tozzi points out, the self-employed has access to more deductions from his self-employment tax than the payroll-employed has to her payroll tax, but essentially always, as Tozzi also points out, the self-employed will still end up paying significantly more.)

However, the simple, ostensibly logical reasoning articulated above--self-employed pays both employer and employee shares of payroll tax--masks the fact that the self-employed are paying double for no actual good reason! Is the only way to get enough revenue for our payroll programs--chiefly Social Security and Medicare--to unfairly gouge the self-employed? (We get particularly agitated over the self-employment tax because we have been able to, er, enjoy it ourselves.)

Think of it this way. The tax code is constantly used as a way for the federal government to use fiscal incentives and disincentives in order to try to shape society in a way it believes is best. The lack of a tax on mortgage interest, for example, reflects the government's desire (whether or not it's correct) to encourage homeownership; the progressiveness of the tax code itself (whether or not it's nearly progressive enough actually to achieve its goal) reflects the government's desire to lessen class inequality by taking a bit more from the rich than it does from the poor.

But what societal good is possibly served by taxing the self-employed more heavily here? As far as we can see, the encouragement/discouragement that this policy offers is a carrot for staying in a payroll job and a stick for entrepreneurially striking out on your own. Needless to say, we don't think that's a very wise policy goal to have, and nor do most people.

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August 14, 2009 9:44 AM