Self-Employed Workers vs. Government Workers – A Financial Comparison

February 24, 2012

When discussing what level of compensation is appropriate and affordable for government workers, it is helpful to make apples-to-apples comparisons between public and private sector workers. In this analysis, the ultimate private sector taxpayer, the self-employed worker, is compared to the typical state or local government employee in California. In both cases, the annual compensation used for comparison is $70,000, which is the average base salary paid to state and local government employees in California (ref. U.S. Census data for California: State, and Local). But the impact of benefits paid by the government employer, combined with the impact of mandatory employee contributions (taxes, retirement set-asides, and healthcare costs), yield dramatically different end results in terms of total net compensation. Both the self-employed worker and the government worker make $70,000 per year. But to say they make the same amount of money is grossly misleading.

The table below, “Total Compensation – Gov’t vs. Self-Employed Worker,” begins to illustrate this disparity. The difference between total compensation and gross earnings in the case of the self-employed worker is zero. There is nobody paying for benefits beyond what the self-employed person earns. Whatever amenities they need to purchase, they have to pay for out of their gross earnings.

In the case of the government worker, there are a host of employer funded benefits; only the basic ones are covered here, using conservative assumptions. If it is assumed the average household health insurance coverage is $500 per month, and the employer pays 50% of that, this adds $3,000 per year to the total compensation of a government worker. In reality, factoring in employer coverages of medical, dental and vision plans, it is very unlikely the average government worker doesn’t get well in excess of $3,000 per year in employer health care benefits.

Current expenses for health care, however, are not the only health expenses that governments pay for their workers. Typically there are provisions for retirement health care coverage that are taken on as obligations by the government for their workers. For example, there are “medigap” plans, with all or part of the premiums paid for by the government. In some cases, such as with most safety employees and management employees, the government pays 100% of the premiums for lifetime premium health insurance plans. These future obligations must be funded during current employment. To estimate another $2,000 per year for this cost, or, more generally, to estimate $5,000 per year per employee for the average government contribution to current and retirement health care, is definitely conservative.

In addition to healthcare costs, state and local government employers cover pension benefits for which much of the costs – and in many cases 100% of the costs – are paid by the government, not the employee. If one assumes a contribution by the government employer of only 12% of gross salary per year – clearly lower than reality – this adds another $8,400 to the total compensation of a government worker.

A simmering question regarding pensions for government workers – how much can these pension funds really earn each year in interest – generates the next estimate. In our analysis “How Much Could California’s Government Pensions Cost Taxpayers,” along with “What Payroll Contribution Will Keep Pensions Solvent,” we have explored the underlying calculations in depth. The reader is invited to review those calculations and assumptions. But the bottom line is this: If pension funds have to lower their long-term expected rate of return by 2.0%, and they will, this will add at least $11,200 per year to the cost of funding the average pension. These obligations may be scaled back, but until they are, this amount must be included when adding up the total compensation of the average government employee in California.

Taking all of this into account, a self-employed person making $70,000 per year makes $70,000 per year. A government worker making $70,000 per year in base pay is actually making $94,600 per year in total compensation, 35% more. But it doesn’t end there.

The next table, below, examines the impact of what might best be described as “mandatory employee contributions,” taking the form of the employee share of health insurance coverage, retirement pensions and social security, along with state and local taxes. Once these mandatory contributions are deducted from the income (before tax in the case of health care and retirement contributions) of both the self-employed and the government worker, and the employer provided benefits – which are tax-free – are added back to the income of the government worker, the disparity between their actual net total compensation becomes even more dramatic.

If one assumes that the self-employed person is going to purchase health insurance for their household, they will pay 100% of the premium. Using the same assumptions, this means they will spend $6,000 per year for these benefits, whereas the government worker, paying 50% of the premium, will only spend $3,000 per year.

By participating in social security and medicare as a self-employed person, they are obligated to pay both the employee and the employer share of those assessments, which at a gross annual income of $70,000 will cost them $10,500 per year. By contrast, even if the government worker pays 10% of their salary into their pension – a level that is still fairly unusual to see among government workers – this will only cost them $7,000 per year.

In the above table, “Net Total Compensation – Gov’t vs. Self-Employed Worker,” these before tax deductions are subtracted from their base annual salary to arrive at their taxable annual salary. This taxable amount then has deducted from it what a California household in 2011 would have to pay in state and federal taxes. Finally, the non-taxable employer contributions are added back to the actual take-home pay to yield the net total compensation after mandatory contributions.

This is the apples-to-apples result: A self-employed person making $70,000 per year, once they’ve paid their taxes. social security and insurance premiums, will enjoy compensation of $45,021 per year. A government worker making $70,000 per year, once they’ve paid their taxes, pension contribution and insurance premiums, with the value of their current and deferred benefits added back, will enjoy compensation of $74,781 per year, 66% more.

It doesn’t end there. As shown on the next table, “Retirement Security – Gov’t vs. Self-Employed Worker,” the self-employed worker, who must pay $10,500 per year for social security and medicare, can expect to retire at the age of 66 with a social security benefit of $20,144 per year. The government worker, who must pay $7,000 per year for their pension, can expect to retire at the age of 60 with a pension of $46,666 per year. The total value of these respective retirement benefits, based on a life-span of 80, is $282,016 for the self-employed worker, and $933,324 for the government worker.

It is important to emphasize how conservative these numbers are. While the average pay of a government worker in California is only about $70,000 per year, the average pension for state and local government workers in California is not $46K per year, but nearly $70K per year. For state and local government workers who retire at age 66 and spend their careers in government service, the average pension is nearly $100K per year (ref. CalPERS Annual Report FYE 6-30-11, page 153, and CalSTRS Annual Report FYE 6-30-11, page 149). This means the assumptions used to calculate pension contributions at various rates of return, which assumed pensions equivalent to 66% of average salary, are obviously inadequate. This is because pensions aren’t calculated on average salary, they’re calculated on final salary. The assumptions underlying our pension contribution estimates also don’t take into account the current state of underfunding for pensions.

For a self-employed person to enjoy a net total compensation equivalent to the average government employee who makes “only” $70,000 per year, they would have to earn well in excess of $100,000 per year, particularly since as they climb in gross income, they encounter higher and higher tax brackets. A self employed person who makes less than $108,000 per year and more than $74,000 per year, because their income is still under the social security withholding ceiling, actually pays taxes at the margin of over 50%. But that is a topic for another post.