time, and permitting the deduction from self-employment earnings in recognition of the fact that net earnings include the "employer share" of SECA taxes, whereas FICA tax rates apply to wages exclusive of the employer share of FICA tax. 167 The deduction is intended to make SECA taxes the economic equivalent of FICA taxes. The statute, however, permits a deduction equal to 7.65 percent of net earnings determined without regard to this deduction, whereas the "employer" tax of 7.65 percent applies to the amount determined after this deduction. Hence, the deduction, which represents the employer side of the SECA tax, is larger than the actual liability for the employer share of the SECA tax.' Thus, for the same economic wage, SECA tax collections are less than FICA tax collections. To make the SECA tax the economic equivalent of FICA tax, the deduction should instead have been determined as the deduction amount necessary to yield an amount that when grossed up by 7.65 percent equals the original amount of net earnings. Beginning in 1991, the permitted deduction deviated further from consistency with FICA taxes when the taxable wage base with respect to HI taxes was raised (and eventually eliminated in 1994) but the deduction was not altered to reflect that fact. Rather, the deduction of 7.65 percent of net earnings continued to apply, despite the fact that the deduction with respect to the OASDI portion (6.2 percent) of the 7.65 percent should conceptually only reflect OASDI taxes paid up to the taxable wage base and not the entire amount of net earnings. The deduction thus leads to a taxable wage base that is conceptually too low for HI tax purposes for self-employed taxpayers with earnings above the OASDI taxable wage base. 168 While prior to the raising of the HI cap the deduction worked in this same manner, it did not matter in practice since both OASDI and HI taxes were capped at the same level. Thus the deduction, though conceptually too high, had no effect on HI collections because if a taxpayer were above the OASDI taxable wage base, and thus permitted a deduction that was conceptually too large, he would also have been above the HI taxable wage base after the deduction and thus HI collections would not have been affected. 167 2. A deduction would be allowed for income tax purposes for half of SECA For example, a self-employed taxpayer with $100 in net earnings is, under present law, permitted a deduction of $7.65, resulting in a SECA tax base of $92.35. The SECA tax on that base is $14.13 (15.3 percent of $92.35). Half of that, or $7.065, represents the employer share of SECA. Note however that the deduction permitted ($7.65), which is intended to represent the employer share of the tax, exceeds the employer share actually paid. 168 Technically, the deviation from economic equivalence of FICA and SECA taxes due to the problem just described does not occur until net earnings from self-employment after the proper deduction for the employer share of tax exceeds the OASDI taxable wage base. The proposal as described accounts for this. This excess deduction has no impact on the OASDI-equivalent portion of the SECA tax for high-income taxpayers above the OASDI taxable wage base, but it does affect HI collections when the HI taxable wage base exceeds that of the OASDI taxable wage base. 170 The proposal described above corrects the inequities of present law. examples illustrate the difference between present law and the proposal. Example 1. The following Wage-earner.-Taxpayer is employed for $25 per hour at a small accounting firm, earning $50,000 a year for 2,000 hours of work. The taxpayer's employer pays FICA taxes on the entire amount of the employee's earnings, because the employee earns less than the taxable wage base of $90,000 for 2005. The employer FICA tax is 7.65 percent of the $50,000, or $3,825. The employee pays tax at the same rate on the same base, so his tax is also $3,825, for total FICA taxes paid of $7,650. The taxpayer's true pre-tax compensation is thus $53,825 ($50,000 plus $3,825, the employer share of FICA). His wages after all FICA taxes is $46,175 ($53,825 $7,650). Self-employed individual.-A self-employed accountant has net-earnings from selfemployment equal to the wage earner's true pre-tax earnings of $53,825. Under present law, the taxpayer is permitted a deduction from net earnings equal to 7.65 percent of net earnings, or $4,118 (7.65 percent of $53,825). The SECA tax of 15.3 percent is applied to the net earnings after this deduction of $49,707 ($53,825 - $4,118), resulting in a SECA tax of $7,605. The selfemployed taxpayer's income after SECA taxes is $46,220 ($53,825 - $7,605). Thus, for the same economic income, the self-employed taxpayer's SECA tax is $45 ($7,650 - $7,605) lower than that of the employee, resulting in self-employed income after SECA taxes exceeding the employee's comparable income after FICA taxes by the same amount. Under the proposal, the deduction from net earnings for the self-employed individual is adjusted to 7.1064 percent of net earnings, resulting in a deduction of $3,825, and a base for SECA taxes of $50,000 ($53,825 pre-tax earnings less $3,825 SECA deduction). The SECA tax base is thus made equivalent to the FICA tax base for taxpayers with the same economic income. The SECA tax of 15.3 percent multiplied by the $50,000 tax base results in SECA tax liability of $7,650, the same as the combined employer and employee share of FICA taxes in the case of the employee. 169 The proposal has the effect of increasing SECA taxes for some individuals, as well as increasing revenues for the Social Security and Medicare Trust Funds. The proposal may also result in additional earnings for Social Security and Medicare purposes, which is likely to increase benefits for some individuals, as well as long-term costs under such programs. Example 2. Wage-earner.-Taxpayer is employed for $100 per hour at a small accounting firm, earning $200,000 a year for 2,000 hours of work. The taxpayer's employer pays the OASDI portion (6.2 percent) of the FICA tax on the employee's earnings only up to the taxable wage base of $90,000 for 2005. The OASDI portion of the employer FICA tax is thus 6.2 percent of $90,000, or $5,580. The employee pays tax at the same rate on the same base, so his tax is also $5,580, for total OASDI portion of FICA taxes paid of $11,160. The employer HI portion (1.45 percent) of FICA tax is not capped and thus equals $2,900 (1.45 percent of $200,000). The employee pays HI tax at the same rate on the same base, so his HI tax is also $2,900, for total HI portion of FICA taxes of $5,800. FICA taxes for the employer and the employee are thus each $8,480, for total FICA tax of $16,960. The taxpayer's true pre-tax compensation is thus $208,480 ($200,000 plus $8,480, the employer share of FICA). His wages after all FICA taxes is $191,520 ($208,480 - $16,960). Self-employed individual.-A self-employed accountant has net-earnings from selfemployment equal to the wage earner's true pre-tax earnings of $208,480. Under present law, the taxpayer is permitted a deduction from net earnings equal to 7.65 percent of net earnings, or $15,949 (7.65 percent of $208,480). The OASDI portion of the SECA tax (12.4 percent) is applied to the net earnings after this deduction of $192,531 ($208,480- $15,949), but only up to the FICA wage base of $90,000, resulting in the OASDI portion of the SECA tax of $11,160. The HI portion of the SECA tax (2.9 percent) is not capped, and thus equals 2.9 percent of $192,531, or $5,583. The total SECA tax is thus $16,743, resulting in net income after SECA tax of 191,737 ($208,480- $16,743). Thus, for the same economic income, the self-employed taxpayer's SECA tax is $217 ($16,960 - $16,743) lower than that of the employee, resulting in self-employed income after SECA taxes exceeding the employee's comparable income after FICA taxes by the same amount. Note that the self-employed taxpayer pays the same OASDI tax as the wage earner, because both taxpayers are above the taxable wage base of $90,000. The entire shortfall occurs in the HI portion of SECA, as a result of the deduction from net earnings that implicitly assumes that the self-employed taxpayer pays the OASDI tax on amounts above the taxable wage base. Under the proposal, the deduction from net earnings for self-employed individuals occurs in two stages for taxpayers above the taxable wage base. For amounts up to the FICA taxable wage base increased by 7.65 percent ($90,000 times 1.0765 = $96,885 for 2005), a deduction of 7.1064 percent of earnings is allowed, equaling $6,885 ($96,885 times .071064). For this portion of the self-employed taxpayer's earnings, the SECA tax base is $90,000 ($96,885 pre-tax earnings less $6,885 SECA deduction) and the SECA tax is $13,770 ($90,000 x 15.3%). Note that the deduction equals one half of the SECA tax that will be owed, and equals the FICA tax that the employer and employee each owe in the case of the wage earner. The amount of net earnings above $96,885 is $111,595 ($208,480 - $96,885), and is permitted a deduction of 1.4293 percent of such earnings, or $1,595, prior to collection of HI tax on amounts above the cap. The HI portion of SECA tax on net earnings amounts above the cap is thus 2.9 percent of $110,000 ($111,595 - $1,595), or $3,190. Total SECA collections are thus $13,770, an amount equivalent to the FICA (OASDI and HI) collections up to the taxable wage base, plus $3,190, representing HI collections on amounts above the taxable wage base, for a total of $16,960. This amount is equivalent to the amount of FICA taxes collected on the wage earner with the same economic income. C. Extend Medicare Payroll Tax to All State and Local Government Employees Hospital insurance taxes (sec. 3121(u)(2)) Present Law and Background As part of the financing for Medicare benefits, a hospital insurance ("HI") tax is imposed on the wages of an individual received with respect to his or her employment. One-half the HI tax is imposed on the employer and one-half on the employee; the tax rate is 1.45 percent for the employee and 1.45 percent for the employer. The amount of wages subject to HI taxes is not capped. 171 Application of HI taxes to State and local government workers The application of HI taxes to State and local government workers has expanded over time. Before the enactment of the Consolidated Omnibus Budget Reconciliation Act of 1985 ("COBRA 1985"),172 State and local government employees were covered for Social Security and Medicare benefits only if the State and the Secretary of Health and Human Services entered into a voluntary agreement providing such coverage. In COBRA 1985, Medicare coverage (and the corresponding HI tax) was extended on a mandatory basis to State and local government employees hired after March 31, 1986, for services performed after that date. The Omnibus Budget Reconciliation Act of 1990174 extended Medicare coverage and the HI tax to State and local government employees who are not covered under a retirement system, effective with respect to services performed after July 1, 1991. 173 Under present law, State and local government employees are covered by Medicare and subject to the HI tax with respect to such employment if: (1) the employee was hired after March 31, 1986; or (2) the employee was hired before March 31, 1986, and either (a) there is a 171 HI taxes are imposed under the Federal Insurance Contributions Act ("FICA"). As part of the financing for Social Security benefits, FICA taxes also include an old-age, survivors, and disability insurance ("OASDI") component. The OASDI rate of tax is 6.2 percent for the employee, and 6.2 percent for the employer. The amount of wages subject to the OASDI portion of FICA taxes is capped at $90,000 (for 2005). 172 Pub. L. No. 99-272. 173 For purposes of this rule, an individual is considered to be hired after March 31, 1986, if the individual was performing substantial and regular services for the employer before April 1, 1986, the individual is a bona fide employee of the employer on March 31, 1986, and the individual's employment relationship with the employer was not terminated after March 31, 1986. These rules are generally referred to as the "continuous employment" requirement. Sec. 3121(u)(2)(C). |