Promoting, Not Discouraging, Tax Compliance

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Imagine you are Jane or Michael, a 14 year old who just entered the work force for the first time. In 2014 you earn $1,000 babysitting for your neighbor or cutting the grass.  You are proud of your earnings and newfound financial independence.  Like most of your friends you open a bank account and you decide to start saving your earnings for college, or maybe law school, or even retirement.

While thinking about your earnings and plans to save, you research the tax aspects of your employment as well as aspects of retirement planning, including Social Security benefits. At first after going to the library and checking out books on the tax law, you are surprised to learn that your self-employment earnings are subject to self-employment tax, but you are somewhat consoled when you read on the IRS website that “[y]our payment of these taxes contributes to your coverage under the Social Security system.”  However, while researching Social Security, you subsequently learn that you need 40 quarters of Social Security credits to qualify and that you must earn $1,200 in 2014 to qualify for one quarter of credit.  You are disappointed when you realize that you did not reach this level of earnings in 2014 but you vow to earn a little more in 2015 so you can start building credit for Social Security.

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The next night at the dinner table your family is talking tax policy and the self-employment tax comes up. Your pesky older brother rails against his landscaping job because they want to treat him as an independent contractor rather than an employee.  He complains that even though independent contractors seem to have a great advantage because they do not pay Social Security tax if they earn less than $400, he still wants to be an employee taxed on the first dollar.

This makes you wonder why independent contractors get to pass on self-employment taxes up to $400 of earnings and how this will impact your $1,000 earnings. After some research you learn that Congress initially did not make self-employed individuals pay self-employment tax if their earnings from self-employment would not allow them to get credit for a quarter of self-employment earnings; however, in 1978 Congress indexed the earnings necessary to receive one quarter of credit to inflation but it did not index the starting point for self-employment taxes.  So, you must pay self-employment tax on your earnings of $1,000 (about $150) but you get no, zero, nada credit from Social Security for this payment.

Thousands of teenagers similar to Jane and Michael (perhaps tens of thousands), as well as other very low-income earners, face this each year in the Untied States. These individuals, after carefully doing their research, realize that they must pay tax for something billed as insurance and for which they will receive no benefit.  Many of the people faced with this situation are just entering the workforce and many may not have even reached the age of majority, making this a tax on the unrepresented.  The dilemma facing the Janes and Michaels is whether they should pay this tax and be good citizens as they enter the work force because Congress mandated that they pay it.  Should they stand up and rail against the system Congress created or should they quietly let the matter slip because in many instances the IRS has not received a Form 1099 or other indication of the income and enforcement action is unlikely.

To research the behaviors of teenagers faced with this dilemma, I have quizzed my law school students for the past several years. I assume that law students would comprise a very law abiding segment of this group because they face the bar review committee and must demonstrate compliance with the laws and possess high moral character and fitness to practice.  They do not want to put on their bar applications that they have unfiled returns and unpaid taxes.  Because my students have a heightened interest in tax leading them to take a tax clinic course, I assume that on tax matters they demonstrate even a higher standard of tax compliance than ordinary law students.

My first discovery in quizzing this group was that students who end up in my law school class seem, by and large, to never have earned money by babysitting or cutting grass – or at least they decline to admit it in an open classroom. As a group, only a small percentage of them ever worked in self-employed positions.  This lack of self-employment as an entry into the work force may stem from generational changes from when I grew up or may result from the demographics of those who can afford to attend my law school.  I realize that my job as a paperboy from ages 12-17 no longer exists for that age group.

Never having been self-employed, these students have no worries in regard to the self-employment tax and generally demonstrate a complete lack of knowledge about the self-employment tax.

Second, among the minority of students who have held self-employed positions, the percentage of these students reporting self-employed earnings as teenagers hovered right around the percentage I expected – absolute zero. I had one student several years ago who worked for a law firm the previous summer and earned about $6,000–$7,000.  He seemed dazed as he left the class to learn that he had a $1,000 bill for self-employment tax for his summer’s work.  Being the messenger made me slightly uncomfortable in that situation.  Unlike my fictional Jane and Michael, most teenagers in America do not seem to know about their self-employment tax filing obligations.  I do not attribute the failure to pay the tax to a desire on the part of my students to cheat on their taxes but primarily due to ignorance.  I also did not note a clamor to rush to file the missing back tax returns for those coming to the realization of their little known failure to file problem.

All of this background leads to the point of this article allegedly about tax procedure – why do we have a tax imposed for the purpose of providing benefits but which does not? Do we have the expectation that the IRS would/could/should administer this law?  Why do we want to teach people as they enter the work force that they can ignore tax laws?  Does this lead to later non-compliance?  Would tax procedure be better served by laws that the tax administrator could administer and the taxpayer could see some benefit even if it is 50 years in the future?

We will argue in this column for procedures that work, laws that support them and laws that promote compliance. The requirement to pay self-employment taxes even when earnings do not contrubute to Social Scurity credits is a poorly designed law that at best benefits from a lack of understanding and likely promotes non-compliance. Most of the non-compliance in this post’s example likely results from ignorance rather than willfulness but do we want to promote non-compliance in any manner? Don’t we want to introduce our young citizens into a tax system that is rational and just? The current model does precisely the opposite.

 

 

 

Comments

  1. Thank you for the history on the reason for the disconnect.

    I am always amazed that with all the talk about the fictional “tax gap”, simple commonsense fixes like this are not addressed. (A similar situation exists with state use taxes. When I taught college level accounting courses, students were always amazed to learn they were supposed to be remitting use tax when they purchased items on line.)

    I think part of the problem is the people writing tax law at the federal level (i.e., congress) who have no real understanding of the code, much less how it operates in the “real” world. (See as examples, Geithner and Rangel.) And yes, I vote so I get to complain. 🙂 Not that I expect things to change much, particularly in regard to the level of tax law comprehension.

  2. Bob Kamman says:

    Those of us here at the Zoe Baird Fan Club would like to point out that according to IRS (Publication 926; yes, I know, can’t be cited as authority in court but probably should be mentioned to law students) this is not self-employment. It is household help that should be reported on Schedule H by the employer, if the filing requirements are met: $1,900 to any one employee in 2014, or $1,000 to all employees in any quarter. From Publication 926:

    Household work. Household work is work done in or around your home. Some examples of workers who do household work are:
    Babysitters, . . .
    . . .Yard workers.

    Furthermore IRS advises (Tax Topic 756):

    Do not withhold or pay social security and Medicare taxes from wages you pay to: . . .
    . . .An employee who is under age 18 at any time during the year, unless performing household work is the employee’s principal occupation. If the employee is a student, providing household work is not considered to be his or her principal occupation.

  3. The premise of Keith’s post is woefully incorrect: we do NOT “have a tax imposed for the purpose of providing benefits.”

    Since their inception, Social Security taxes and Social Security benefits were never intended to be, and are not now, interrelated. Indeed, if they were interrelated, that scheme would be unconstitutional. The U.S. government conceded as much when the constitutionality of the Social Security Act was before the Supreme Court. See Helvering v. Davis, 301 US 619, 645 (1937) (stating government’s argument that taxes imposed by Social Security Act “are not earmarked, and that Congress is at liberty to spend them as it will”).

    Those facts oblige Keith to teach his students that Congress could eliminate Social Security benefits, yet retain what are erroneously called Social Security taxes. They also require him to teach his students that, even today, those taxes are paid into the Treasury as general revenues and are not earmarked for any Social Security benefits.

    From those facts, the students would learn that they should structure their lives so they never need rely on Social Security. The students would also learn that, under our Constitution, one’s paying of a tax does not “entitle” him to a corresponding individual benefit.

    Even setting all that aside, Bob Kammen is right. Neither the baby-sitter nor the yard worker is “self-employed.” For one reason, I doubt that any sane individual would allow a minor the discretion to choose the means by which to accomplish his or her baby-sitting or yard-work job. Yet that discretion is the sine qua non of self-employment. For that reason too, Keith’s former student who “worked for” a law firm could not have been self-employed.

    Finally, we teach our young citizens best when we educate them that the most “rational and just” tax system must be a constitutional one.

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