Self-employed pay the highest income tax rate of any group in the US economy. In 2013 self-employed workers will owe a total tax rate of 25.3 to 43.3 percent on earned income between $400 and $110,000. What is the reason for this?
Employees pay only 7.515 percent for Social Security and Medicare taxes, while self-employed workers pay double that amount, 15.4 percent.
Why is that? The IRS considers self-employed workers to be "two persons in one," an employee and an employer. Thus, the self-employed individual must pay the IRS both the employee and the employer halves of Social Security/Medicare tax. Self-employed workers pay twice as much as either an employee or an employer pays for FICA taxes.
The pressure a 15.4 percent flat tax puts on self-employed pushes many self-employed into the IRS deductions trap.
Recently a friend who is a nationally known artist and sculptor went in to sign up for Social Security. She was told, "Sorry, you aren't eligible."
She hadn't earned her 40 quarters of credits. But she'd worked for decades! True, but she took too many deductions. She didn't earn the minimum amount to qualify for Social Security.
Even if you qualify to collect Social Security, every deduction for business expenses you take on Schedule C lowers your earnings for purposes of collecting Social Security.
The race to the bottom
In a race to the bottom, self-employed people try to take as many deductions for business expenses on Schedule C as they can to offset the 15.4 percent they must pay for SE (self-employment) tax.
In order to make a living wage, self-employed people take every deduction on Schedule C they possibly can. Some, like Martha, manage to reduce their earnings so much that they pay minimal or even zero SE tax. However, no one warns self-employed workers that taking deductions can diminish the amount received or even eliminate their right to collect Social Security when the time comes.
Because of the high SE tax rate, most self-employed people focus on earning the least amount of money possible by taking deductions on Schedule C instead of making the most money they can. This is insane!
Why double-taxing self-employed is wrong
What's unfair about the SE tax rate is that self-employed persons are not "two people in one". The self-employed person works 40 hours or more a week just like the employed person does. Why should self-employed workers pay twice as much Social Security/Medicare tax?
To look at this issue another way, let's ask, "How can an employer afford to pay for the employee half of FICA taxes?"
An employer with employees can afford to pay half for their employees' FICA taxes because of two economic principles (1) division of labor and (2) economies of scale.
Adam Smith in The Wealth of Nations gave a memorable example of these principles.
One night, a town caught fire. Residents dashed back and forth to the river with pails to get water and put the fire out. They were getting nowhere. Someone organized the villagers into two lines. They began passing empty pails down to the river to be filled. There, stronger villagers passed filled pails back up to the fire. Those nearest the fire specialized in throwing the water on the fire. And the town was saved.
Division of labor enables employers to pay some employees less than others. Call them "less skilled" or "unwilling to take risks," some employees are paid less than others. Division of labor lowers employers' labor costs.
Economies of scale means the bigger the company or organization, the more opportunities it has to lower costs overall and boost production. Lower costs enable employers to pay for their employees' business expenses. With lower costs, large employers can also afford to pay employee benefits, including half of their employees' FICA taxes.
Self-employed sole proprietors of businesses don't have big employers' advantages. Self-employed can't hire lots of employees at different salary levels. Nor do they get access to special deals, deep discounts, bank loans, and other means to lower their expenses. Put simply: self-employed can't earn enough profit to pay the employer half of SE tax.
Charging self-employed the highest income tax rate in the US while giving them deductions that diminish their Social Security earnings doesn't encourage entrepreneurship, innovation, job creation or even their survival!