How the Tax System Favors Government Workers and Punishes Independent Contractors

The 2016 tax filing deadline is now just one month away. Which makes it timely to point out how unfair our tax system is to middle class workers who want to prepare for their retirements. It is also timely to explain how there is a completely different set of retirement rules, far more favorable, that apply to unionized government workers.

If you are a member of the emerging “gig economy,” or a sole proprietor running a small business, or an independent contractor, and if you are reasonably successful, then you paying nearly 50% of every extra dollar you earn in taxes. The following table shows the marginal tax burden for independent contractors who earned more than $81.5K and less than $118.5K in 2015:

Marginal Tax Rate for Independent Contractors

(for 2015 earnings > $81.5K and < $118.5K)

The challenges posed by this reality bear closer examination. Let’s say, for example, that someone in this category needs to earn more money, and they have an opportunity to earn a few extra bucks by taking on a side project. For these earnings, they will pay 25% federal, 8% state, 12.4% Social Security (as employee and employer), and 2.9% Medicare. And by the way, the employee’s portion of their Social Security contribution is NOT tax deductible. What if they decide to put that money into a 401K?

According to current tax law, private sector taxpayers can only defer up to $18,000 of their income into a 401K, up to $24,000 if they are over the age of 50. Contrast this to the unionized public employee’s pension fund.

If the payments into a public employee’s retirement account exceed $24,000 per year – which they usually do – they remain tax deferred. A California Policy Center study (ref. table 4) examining 2011 compensation for City of San Jose employees showed that the average employer contribution for a police officer’s pension (not even including whatever they may have also contributed via withholding) was $53,222 in 2011, more than twice the amount they would have been able to avoid paying taxes on if they were private citizens. For San Jose firefighters it was even more, their average employer pension contribution was $62,330 in 2011. And even for the miscellaneous employees, the city’s contribution exceeded the tax deferred amount allowed private citizens, averaging $26,164 – again, not including whatever pension contributions these employees may have paid themselves through withholding. San Jose’s case is typical.

So why aren’t public employees paying taxes on whatever annual pension contribution they make in excess of $18,000, or $24,000, depending on their age? Because there is NO practical limit on how much can be contributed into a defined benefit plan while still avoiding taxes. The IRS created the limit on how much you can put into a 401K in order to discourage people creating “abusive tax shelters.” But they did not apply this moral standard to defined benefit pensions.

Meanwhile, there’s not only a ceiling on how much the taxpayer can put into their 401K, but, of course, there’s NO guarantee that those 401K investments will perform. When a middle class self-employed person confronts a 48.3% marginal tax rate, if they can afford it, they are pretty much compelled to put money into their 401K. Then they can watch the S&P 500 and knock on wood. Since the S&P 500 is currently at the same level it was at back in June 2014, with governments and consumers across the world engulfed in maxed-out debt which renders them unable to continue to consume at the rates they used to, and global overcapacity idling shipping from Rotterdam to the Strait of Malacca, they’d better knock very hard indeed.

As for the pension funds for unionized government workers? If they become underfunded, though faltering investment returns, or retroactive benefit enhancements, or “spiking,” private citizens make up the difference through higher taxes and reduced services.

One final injustice must be noted: Once the private sector independent contractor retires, if they’re lucky they’ll collect around $25,000 per year in exchange for a lifetime of giving 12.4% of their gross income to the Social Security fund. And if that, plus their S&P 500 savings account’s 2.5% per year dividend income isn’t enough to live on, they’ll have to keep working. But wait! If that work earns them more than $15,710 per year, their Social Security benefit is cut by $1.00 for every $2.00 they make.

Let’s recap. A middle class private sector independent contractor pays a 48.3% tax on any income they earn between $81,500 and $118,500, which includes a 12.4% payment into Social Security on 100% of that income. Half of that 12.4% isn’t even deductible. If they invest money in a retirement account, there is at most a $24,000 ceiling on how much they can invest per year. If their retirement account tanks, there’s no bail-out. And if they still have to hold a job after they’ve finally qualified for full Social Security benefits after 45 years of work, there is a 50% tax on that benefit for every dollar they earn in excess of $15,710 per year.

By contrast, a unionized government worker in California collects a pension that averages – for a 30 year career – well over $60,000 per year (ref. here, here, here, and here). At most they contribute 12% into their pension fund via payroll withholding, in most cases much less. Their pension fund earns 7.5% and if it does not, the taxpayers bail it out. And when they retire, if they want to go back to work, there is NO penalty whatsoever assessed on their pension income.

Ensuring reasonable retirement security for Americans against the headwinds of unsustainable debt and an aging population is one of the great challenges of our time. And the biggest obstacle to finding solutions is that American workers do not adhere to the same set of rules. There is rather a continuum of rules, with unionized government workers at one privileged extreme, and independent contractors – those glibly lauded members of the “gig economy,” at the opposite end, paying for it all.

This is the context in which we have recently witnessed the irresistible alliance of Wall Street pension bankers and government union leadership annihilate the latest attempt at pension reform in California. Tax season brings it home in all its bitter glory.

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Ed Ring is the president of the California Policy Center.