The Taxation of Capital and Labor Through the Self-Employment Tax
CBO analyzed three options that would modify the way that income for the self-employed would be taxed.
Since 1950, self-employed individuals have been covered by the Social Security system. In many regards, their obligation to pay Self-Employment Contributions Act (SECA) taxes into the Old-Age, Survivors, and Disability Insurance (OASDI) and Hospital Insurance (HI) trust funds and their entitlement to Social Security and Medicare benefits parallel those of workers who are not self-employed and who thus are covered under the Federal Insurance Contributions Act (FICA). In both cases, the OASDI tax base is limited to income below a certain threshold, and the HI tax base is not constrained by any income ceiling.
The two systems, however, diverge in an important way. The FICA tax is based solely on income from labor—that is, wages. The SECA tax, in contrast, is based on net business income, which includes compensation for the owner’s labor, but can also include income from capital—that is, the business’ profits. (For people who are not self-employed, capital income includes interest, dividends, rents, and capital gains.) Moreover, the SECA tax base ends up excluding more than half of the labor income of self-employed people. Such differences in tax treatment among businesses providing the same goods and services may prompt people to make choices that they would not otherwise make about self-employment or the organizational form of a business, thereby reducing the efficient allocation of resources.
In The Taxation of Capital and Labor Through the Self-Employment Tax, CBO decomposes the SECA tax base into its labor and capital components and analyzes three approaches that would modify the SECA tax base. (A printer-friendly version of the full report provides the information summarized here.)
The Composition of the SECA Tax Base Is Changing in Ways Not Anticipated by the Social Security Laws
CBO estimates that almost 70 percent of self-employment income subject to the SECA tax was received by sole proprietors. Another quarter was received by owners of partnerships (including limited liability companies). The remaining income could not be linked to a type of entity in CBO’s analysis.
Between 2001 and 2004, those shares did not change, but the breakdown by type of partnership changed significantly. In 2001, the share of partnership income accounted for by general and limited partnerships—the types mentioned in the Social Security laws—dropped from 49 percent to 30 percent. The rest came from limited liability companies and limited liability partnerships. Because those types of entities are not mentioned in the Social Security laws, there has been controversy over how much of their income is subject to the SECA tax.
The SECA Tax Base Captures Significant Capital Income and Excludes More Than Half of Labor Income
CBO decomposed the SECA tax bases for HI and OASDI into their labor and capital components. CBO estimated the labor income for self-employed workers using an assessment of their reasonable compensation—an amount that should bear some resemblance to the market wage for their services. All other positive net income was attributed to capital.
CBO estimates that 42 percent of the SECA-HI tax base derives from capital, and the remainder derives from labor (see the figure). The FICA tax base, in contrast, derives entirely from labor.
Not only does the SECA tax capture a significant amount of capital income, but more than half of the labor income of self-employed people (56 percent) is not included in the SECA-HI tax base. If the businesses were incorporated, virtually all of that labor income would be considered taxable under FICA.
With both the taxed capital income and the excluded labor income accounted for, the total SECA-HI tax base is roughly three-quarters of the amount of income that would be taxable under the FICA-HI rules.
Lawmakers Could Change the SECA Tax Base to Try to Align It More Closely with the Rules Governing the FICA Tax Base
CBO analyzed three approaches that would modify the SECA tax base by either reducing the share of capital income or increasing the share of labor income it includes. Those options are as follows:
- Apply a material participation standard to partners and members of limited liability companies. This option would ensure consistent SECA tax treatment among owners of different types of unincorporated entities. As intended, it would subject more labor income to the SECA tax, but it would also capture more capital income. Thus, it would expand the SECA tax base slightly.
- Limit the SECA tax base to reasonable compensation for services performed. This option would remove capital income from the SECA tax base entirely, but would present an opportunity for many self-employed people (especially sole proprietors) to reduce their SECA tax by underreporting their reasonable compensation. If limited to partnerships, however, the option would capture more labor income than under current law. In any case, it would significantly reduce the size of the SECA tax base.
- Permit a deduction of a percentage of capital assets as a proxy for capital income. By design, this option would reduce the share of capital income that is captured by the SECA tax. However, it would cover only a small percentage of capital income, in part because it would provide no relief for the returns on intangible capital. Furthermore, the option would shelter some labor income of firms with low profit margins. Thus, it would reduce the size of the SECA tax base.