Center on Budget and Policy Priorities

12/19/2018 | News release | Distributed by Public on 12/19/2018 10:20

Pass-Through Deduction in 2017 Tax Law Could Weaken Wages and Workplace Standards

[1] 'Firm' here refers to both C-corporations and pass-throughs.

[2] This term comes from former U.S. Department of Labor official and Brandeis University Dean David Weil. Much of this paper draws on his book The Fissured Workplace (Harvard University Press, 2014).

[3] Chuck Marr, Brendan Duke, and Chye-Ching Huang, 'New Tax Law Is Fundamentally Flawed and Will Require Basic Restructuring,' Center on Budget and Policy Priorities, updated August 14, 2018, https://www.cbpp.org/research/federal-tax/new-tax-law-is-fundamentally-flawed-and-will-require-basic-restructuring.

[4] Stan Veuger, '8 Ways to Improve the Tax Code,' National Interest, January 25, 2017, https://nationalinterest.org/feature/8-ways-improve-the-tax-code-23963. See also Amanda Becker, 'U.S. Republican tax law's pass-through deduction open to gaming - experts,' Reuters, April 25, 2018, https://www.reuters.com/article/usa-tax-congress/u-s-republican-tax-laws-pass-through-deduction-open-to-gaming-experts-idUSKBN1HV2XW; Michael R. Strain, 'To Help Families, Don't Cut Their Taxes,' Bloomberg, November 8, 2017, https://www.bloomberg.com/view/articles/2017-11-08/to-help-families-don-t-cut-their-taxes.

[5] Chye-Ching Huang, 'Senate Hearing Testimony Highlights 2017 Tax Law's Fundamental Flaws,' Center on Budget and Policy Priorities, April 25, 2018, https://www.cbpp.org/blog/senate-hearing-testimony-highlights-2017-tax-laws-fundamental-flaws; Marr, Duke, and Huang.

[6] Shu Yi-Oei and Diane Ring of Boston College Law School examined the legal and other issues that could determine how much employment shifts toward independent contracting (but not contractor firms or franchises) as a result of the deduction. They concluded that much will depend on how the IRS and courts interpret the 2017 tax law and other statues as well as businesses' assessments of the risks, their industry's structures, and their willingness to change their relationship with workers. See Shu-Yi Oei and Diane M. Ring, 'Is New Code Section 199A Really Going to Turn Us All into Independent Contractors?,' Boston College Law School Legal Studies research paper, January 12, 2018, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3101180.

[7] Linda J. Blumberg, Sabrina Corlette, and Kevin Lucia, 'The Affordable Care Act: Improving Incentives for Entrepreneurship and Self-Employment,' Urban Institute, 2013, https://www.urban.org/research/publication/affordable-care-act-improving-incentives-entrepreneurship-and-self-employment.

[8] U.S. House of Representatives Committee on Ways and Means, 'Historic New Tax Relief to Help Main Street Job Creators,' December 28, 2017, https://waysandmeans.house.gov/historic-new-tax-relief-help-main-street-job-creators/.

[9] Recent U.S. Bureau of Labor Statistics (BLS) data indicate that 6.9 percent of workers were independent contractors in 2017. That's a slight decline from the 7.4 percent figure for 2005, despite the recent attention to 'gig economy' jobs (such as Uber drivers) in which workers are classified as independent contractors. The BLS data, however, measure what workers do for their main jobs; much of this work is likely done as a side job and so is not captured by the survey. See Annette Bernhardt, 'Making Sense of the New Government Data on Contingent Work,' Medium, June 10, 2018, https://blog.usejournal.com/making-sense-of-the-new-government-data-on-contingent-work-97209bb0c615.

[10] To be sure, as discussed below, independent contractors have to pay both the employer and employee portions of payroll taxes while employees only have to pay the employee portion. The payroll tax rate for employees and independent contractors is the same, however, if one considers the employer's portion of the tax a coming out of an employee's pre-tax compensation, as the employee typically 'pays' the tax in the form of lower wages. See Jonathan Gruber, 'The Incidence of Payroll Taxation: Evidence from Chile,' Journal of Labor Economics, Vol., 15, No. 3, 1997, pp. 72-101.

[11] Calculations assume that these workers take the standard deduction.

[12] U.S. Bureau of Labor Statistics, Occupational Employment Statistics, May 2018, https://www.bls.gov/oes/.

[13] The potential tax savings are small for workers with low incomes since the pass-through deduction is limited to 20 percent of taxable income. A single earner making $16,000 in pass-through income (and no other income) who takes the $12,000 standard deduction only gets $80 of tax savings from the pass-through deduction.

[14] Brian Faler, 'Pass-through regulations take aim at contracting gamesmanship,' Politico, August 9, 2018, https://subscriber.politicopro.com/tax/whiteboard/2018/08/pass-through-regulations-take-aim-at-contracting-gamesmanship-1752512. Moreover, Congress has not increased the IRS's enforcement budget to deal with this and other enforcement challenges presented by the 2017 tax law: in 2018, it left enforcement at roughly the same level as in 2017 and $1.5 billion (23 percent) below its 2010 level in inflation-adjusted terms. Emily Horton, '2018 Funding Bill Falls Short for the IRS,' CBPP, March 23, 2018, https://www.cbpp.org/blog/2018-funding-bill-falls-short-for-the-irs.

[15] David Kamin, 'Pass-Through Regulations: Doubling Down on Arbitrariness and Breaks for the Top,' Medium, August 8, 2016, https://medium.com/whatever-source-derived/pass-through-regulations-7298efcfcb7a.

[16] Weil, p. 21; Sarah Leberstein and Catherine Ruckelshaus, 'Independent Contractor vs. Employee: Why independent contractor misclassification matters and what we can do to stop it,' National Employment Law Project, 2016, https://www.nelp.org/wp-content/uploads/Policy-Brief-Independent-Contractor-vs-Employee.pdf; Bryce Covert, 'Actresses - and Millions of Other Workers - Have No Federal Sexual-Harassment Protections,' The Nation, October 2017, https://www.thenation.com/article/actresses-and-millions-of-other-workers-have-no-federal-sexual-harassment-protections/. Employees who have been misclassified as independent contractors by their employers are still entitled to these protections. U.S. Government Accountability Office, 'Improved Coordination, Outreach, and Targeting Could Better Ensure Detection and Prevention,' August 10, 2009, https://www.gao.gov/products/GAO-09-717.

[17] Weil, p. 21.

[18] Kelly Daley et al., 'Worker Classification Knowledge Survey Volume I-Technical Report,' Abt Associates, November 16, 2016, https://www.dol.gov/asp/evaluation/completed-studies/Worker_Classification_Knowledge_Survey_Vol_I_Technical_Report.pdf; Abt Associates, 'Understanding of Employee Protections,' November 2016, https://www.dol.gov/asp/evaluation/completed-studies/Understanding_Of_Employee_Protections.pdf.

[19] U.S. Bureau of Labor Statistics, 'Table 1. Employer costs per hour worked for employee compensation and costs as a percent of total compensation: civilian workers, by major occupational and industry group,' March 2018, https://www.bls.gov/news.release/ecec.t01.htm.

[20] Lily Batchelder and David Kamin, 'The GOP tax plan creates one of the largest new loopholes in decades,' Los Angeles Times, December 31, 2017, www.latimes.com/opinion/op-ed/la-oe-batchelder-kamin-tax-deduction-pass-through-income-20171231-story.html.

[21] Shu-Yi Oei and Diane M. Ring, 'The Tax Lives of Uber Drivers: Evidence from Internet Discussion Forums,' Columbia Journal of Tax Law, Vol. 8, 2017.

[22] The 2017 tax law also eliminates the ability to deduct tax preparation fees, making them more expensive for some filers.

[23] For more, see Kathleen DeLaney Thomas, 'Tax Reform for the Gig Economy?,' Harvard Law Review blog, October 17, 2018, https://blog.harvardlawreview.org/tax-reform-for-the-gig-economy/.

[24] For an exploration of some of the literature on the difficulty most people have making rational financial decisions, see The Committee for the Prize in Economic Sciences in Memory of Alfred Nobel, 'Scientific Background on the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2017 Richard H. Thaler: Integrating Economics with Psychology,' October 2017, https://assets.nobelprize.org/uploads/2018/06/advanced-economicsciences2017-1.pdf?_ga=2.81780823.1940396267.1536071873-1125184579.1536071873.

[25] U.S. Government Accountability Office, 2009.

[26] National Employment Law Project, 'Independent Contractor Misclassification Imposes Huge Costs on Workers and Federal and State Treasuries,' 2015, https://www.nelp.org/publication/independent-contractor-misclassification-imposes-huge-costs-on-workers-and-federal-and-state-treasuries/.

[27] The Bureau of Labor Statistics Survey on Contingent Workers and Alternative Employment Arrangements found a very small share of workers employed by contractor firms, but experts on the topic do not believe that the BLS estimate captures the full scope of such arrangements since the survey asks about work for only one type of contractor firm: firms that work on-site at the client firm and for one client. Workers for contractor firms may work for multiple clients (as may be the case for a janitor) or offsite (as may be the case at a call center). Moreover, some workers may not be able to accurately identify their employer. See Bernhardt 2018. For a look at the issues in measuring contract employment and other forms of fissured work, see Annette Bernhardt et al., 'Domestic Outsourcing in the United States: A Research Agenda to Assess Trends and Effects on Job Quality,' Upjohn Institute, Upjohn Institute Working Paper 16-253, 2016, http://research.upjohn.org/up_workingpapers/253/.

[28] David Dorn, Johannes F. Schmieder and James R. Spletzer, 'Domestic Outsourcing in the United States,' unpublished, January 31, 2018, https://www.dol.gov/asp/evaluation/completed-studies/2016-2017-Scholars-Program/Domestic-Outsourcing-in-the-United-States.pdf.

[29] Matthew Dey, Susan N. Houseman, and Anne E. Polivka, 'What Do We Know about Contracting Out in the United States? Evidence from Household and Establishment Surveys,' Labor in the New Economy, eds. Katharine G. Abraham, James R. Spletzer, and Michael J. Harper (University of Chicago Press, 2010), pp. 267-304.

[30] Elizabeth Weber Handwerker, 'Increased Concentration of Occupations, Outsourcing, and Growing Wage Inequality in the United States,' unpublished, April 2017, http://www.sole-jole.org/17733.pdf.

[31] Mark Bergen and Josh Eidelson, 'Inside Google's Shadow Workforce,' Bloomberg, July 25, 2018, https://www.bloomberg.com/news/articles/2018-07-25/inside-google-s-shadow-workforce.

[32] For the purposes of this section, we assume that the managers have negotiated sufficient additional compensation to make up for the loss of their own benefits mentioned above. Their failure to do so would add to the potential employer savings from outsourcing.

[33] IHS Markit, 'Franchise Business Economic Outlook for 2018,' January 2018, https://franchiseeconomy.com/files/Franchise_Business_Outlook_Jan_2018.pdf. The federal government stopped tracking data on franchising in the 1980s. See Francine LaFontaine and Roger D. Blair, 'The Evolution of Franchising and Franchise Contracts: Evidence from the United States,' Entrepreneurial Business Law Journal, Vol. 3, 2009, pp. 381-434.

[34] Arindrajit Dube and Ethan Kaplan, 'Does Outsourcing Reduce Wages in the Low-Wage Service Occupations? Evidence from Janitors and Guards,' Industrial Labor Relations Review, Vol. 63, No. 2, 2010.

[35] Katharine G. Abraham and Susan K. Taylor, 'Firms' Use of Outside Contractors: Theory and Evidence,' Journal of Labor Economics, Vol. 14, No. 3, 1996, pp. 394-424; Samuel Berlinski, 'Wages and Contracting Out: Does the Law of One Price Hold?,' British Journal of Industrial Relations, Vol. 46, No. 1, 2008, pp. 59-75; Dorn, Schmieder, and Spletzer.

[36] The recent decline in employer-sponsored training may partly reflect workplace fissuring. C. Jeffrey Waddoups, 'Did Employers in the United States Back Away from Skills Training During the Early 2000s?,' Industrial and Labor Relations Review, Vol. 69, No. 2, 2016, pp. 405-434.

[37] Weil, pp. 122-158; David Weil and Min Woong Ji, 'Does Ownership Structure Influence Regulatory Behavior? The Impact of Franchising on Labor Standards Compliance,' Industrial and Labor Relations Review, Vol. 68, No. 5, 2015, pp. 977-1006.

[38] Weil 2014; George A. Akerlof and Janet L. Yellen, 'The Fair Wage-Effort Hypothesis and Unemployment,' Quarterly Journal of Economics, Vol. 105, No. 2, 1990, pp. 255-283; Truman Bewley, Why Wages Don't Fall During a Recession? (Harvard University Press, 1999); Arindrajit Dube, Laura Giuliano, and Jonathan Leonard, 'Fairness and Frictions: The Impact of Unequal Raises on Quit Behavior,' IZA Discussion Paper 9149, June 2015, https://www.iza.org/publications/dp/9149/fairness-and-frictions-the-impact-of-unequal-raises-on-quit-behavior.

[39] Weil, p. 78.

[40] Weil, pp. 105, 112, 139-142.

[41] Weil, pp. 101-107.

[42] It's hard to know what the authors of the 2017 tax law intended because of 'the lack of any underlying logic in deciding who benefits from the pass-through deductions, and who does not.' David Kamin et al., 'The Games They Will Play: An Update on the Conference Committee Tax Bill,' SSRN, December 28, 2017, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3089423.

[43] In fact, 90 percent of workers make less than $96,000. U.S. Bureau of Labor Statistics, 'Occupational Employment Statistics,' 2018. For the other professions, see the median salary numbers cited above.

[44] A firm's high-income owner can receive the full deduction equal to 20 percent of profits if that amount is equal to 50 percent of the wages it pays and it is not in one of the industries denied the deduction. The owner of a firm with $1 million in profits can, therefore, receive the full $200,000 deduction if the firm pays at least $400,000 in wages.

[45] IRS Statistics of Income, Table 1, 'S Corporations: Total Receipts and Deductions, Portfolio Income, Rental Income, and Total Net Income, by Major Industry Tax Year 2013,' https://www.irs.gov/statistics/soi-tax-stats-table-1-returns-of-active-corporations-form-1120s. These figures compare 'wages and salaries' to 'total net income (less deficit).' They do not include 'compensation of officers' - if they did, profits would be even smaller compared to wages.

[46] Martin Sullivan, 'Economic Analysis: A Dozen Ways to Increase the TCJA Passthrough Benefits,' Tax Notes, April 9, 2018, https://www.taxnotes.com/tax-notes/partnerships-and-other-passthrough-entities/economic-analysis-dozen-ways-increase-tcja-passthrough-benefits/2018/04/09/27y53.

[47] Kamin et al.

[48] Kamin.

[49] Weil, p. 60. See also Oliver Williamson, 'The Theory of the Firm as Governance Structure: From Choice to Contract,' Journal of Economic Perspectives, Vol. 16, No. 3, 2002, pp. 171-195; Ronald Coase, 'The Nature of the Firm,' Economica, Vol. 4, No. 16, 1937, pp. 386-405.

[50] Blumberg, Corlette, and Lucia, 2013.

[51] Congressional Budget Office, 'Repealing the Individual Health Insurance Mandate: An Updated Estimate,' November 8, 2017, https://www.cbo.gov/publication/53300.

[52] U.S. Department of Labor, 'Joint employment under the Fair Labor Standards Act and Migrant and Seasonal Agricultural Worker Protection Act,' 2016, http://www.fissuredworkplace.net/assets/Administrator_Interpretation_on_Joint%20Employment_2016.pdf.

[53] U.S. Department of Labor, 'The Application of the Fair Labor Standards Act's 'Suffer or Permit' Standard in the Identification of Employees Who Are Misclassified as Independent Contractors,' 2015, http://www.fissuredworkplace.net/assets/Administrator_Interpretation_on_Misclassification_2015.pdf.

[54] Alana Semuels, 'The Future of the Department of Labor Under Trump,' The Atlantic, March 6, 2017, https://www.theatlantic.com/business/archive/2017/03/the-department-of-labor-under-trump/518307/.

[55] Ben Penn, 'Outlook 2018: Trump Labor Dept. Looks to Move Agenda Forward in Year Two,' Bloomberg BNA, January 2, 2018, https://www.bna.com/outlook-2018-trump-n73014473725/.