“It's about the passion”

US Federal Misclassification Bills 2010: The wrong approach

Update 2012. Note both the Bills referred to below have not passed Congress and are not enacted. The principles discussed below remain relevant and important.

September 2010

The federal Employee Misclassification Prevention Bill (April 2010)

In April this year (2010), an amendment to the US Fair Labour Standards Act was moved in Congress. Called the Employee Misclassification Prevention Act, it is progressing through the US Senate committee hearings process.

The stated justification for the Bill is that workers are being denied social security and other benefits because they are being misclassified as independent contractors. Further, it is claimed that the US federal and state governments are losing billions of dollars in tax revenue because businesses misclassify workers as independent contractors, thus avoiding paying employee taxes to the governments.

The Bill seeks to prevent 'misclassification' by imposing new, additional reporting requirements on US businesses. If a business uses individual people who are self-employed, the business must report the details of these people to government departments. If the business does not make the report, then the individual is presumed to be an employee.

Taxpayer Responsibility, Accountability, and Consistency Act of 2009
The Employee Misclassification Prevention Act is being dovetailed with a new federal tax act called the Taxpayer Responsibility, Accountability, and Consistency Act of 2009. This Bill retains common law for defining the difference between employee and independent contractors. However, for the purposes of tax law, it requires the Internal Revenue Service (IRS) to use the provisions of the Employee Misclassification Prevention Act to decide if a person is an employee or an independent contractor. Furthermore, if someone is found not to be an employee for tax purposes, the IRS must report this to the Department of Labor.

The combination of the two pieces of legislation in this way is a neat bureaucratic trick. The Department of Labor is normally short of enforcement resources. The combined Bills effectively make the IRS an enforcement instrument of the Department of Labor. It considerably strengthens the hand of the bureaucracy against self-employed people.

The outcome will be to impose on self-employed people a presumption that they are employees simply because a person who may use their services fails to file federal red tape forms. The self-employed person has no control over this, because they are not responsible for the submission of the paperwork.


Why have these Bills been proposed?

On 17 June 2010, the Senate Committee overseeing the Bills held a hearing at which about four panellists spoke in favour of the Bills and one against.

Perhaps the best summary of the reasons for the Bills came from the National Law Employment Project (NELP), a labour law lobby group. Its submission asserts that the laws are needed because:
  • Businesses rort the system ripping off workers: "Firms argue they are off-the-hook for any rule protecting an 'employee', including the most basic rights to minimum wage and overtime premium pay, health and safety protections, job-protected family and medical leave, anti-discrimination laws, and the right to bargain collectively and join a union. Workers also lose out on safety-net benefits like unemployment insurance, workers compensation, and Social Security and Medicare."
  • Businesses avoid paying taxes: "Misclassifying employers stand to save upwards of 30% of their payroll costs, including employer-side FICA and FUTA tax obligations, workers compensation and state taxes paid for employees."
  • Businesses obtain unfair advantage: "Businesses that 1099 and pay off-the-books can underbid competitors in labor-intensive sectors like construction and building services, and this creates an unfair marketplace."
NELP says that
    "... genuine independent contractors constitute a small proportion of the American workforce, because by definition, an "independent contractor" is in business for him- or herself. ...Examples are a plumber called in by an office manager to fix a leaky sink in the corporate bathroom, or a computer technician on a retainer with a manufacturing company to trouble-shoot software glitches."
And
    "A 2000 study commissioned by the US Department of Labor found that up to 30% of firms misclassify their employees as independent contractors."
Further
    "Most government-commissioned studies do not capture the so-called "underground economy," where workers are paid off-the-books, sometimes in cash. These workers are de facto misclassified independent contractors, because the employers do not withhold and report taxes or comply with other basic workplace rules."
And
    "A 1994 study by Coopers and Lybrand estimated the federal government would lose $3.3 billion in revenues in 1996 due to independent contractor misclassification, and $34.7 billion in the period from 1996 to 2004."
A good deal of justification for the Bills has be drawn from a Department of Labour 2000 report Independent Contractors: Prevalence and Implications for Unemployment Insurance Programs. The report is in fact a good summary of the various arguments around the self-employed issue as at 2000, but probably doesn't do much to enable conclusions to be drawn about specific legislative outcomes.


International background to the issue

The view that there is a tax and labour law enforcement problem relating to self-employed people has a history dating back to the early 1990s. It is a global issue, particularly for developed economies with a wide range of tax and welfare regulatory regimes. The 'problem' emerged because of the rise in numbers of self-employed people across developed economies during the 1980s-1990s.

The issue largely came to a head internationally in 2006 with a Recommendation at the International Labour Organisation. The ILO debate, which had been raging for a decade, mirrored all the arguments put by NELP (above).

In Australia the early attempts to 'fix' the 'problem' were similar to what is proposed in the US at the moment---namely, to declare self-employed people to be employees. (See my articles, here and here.) The UK also went down this same path with their IR35 regulations. After a decade the UK has found that this doesn't work and are now heading in a different direction. Australia, however, dumped the 'destroy self-employment' approach in 2000 and has instead largely embraced self-employed people within the tax and regulation systems. It has been successful---although there's plenty more work to be done. We explained these issues in a forward-looking agenda assessment following the successful 2006 ILO outcome.


Why the current Congressional attempts will fail if implemented

On the surface, the proposals before Congress look like an expansion of reporting requirements. This would seem harmless if it did no more than create another huge bureaucratic, red-tape burden for US businesses.

However, there is more to the proposals than just the red tape burden. The proposals:
  • Subvert the role of the US courts in being the impartial arbitrators of who is/is not self-employed. This substantially diminishes the right of people to be self-employed if they wish. This happens because the combined Bills transfer considerable decision-making power into the hands of publicly unaccountable, non-judicial IRS bureaucrats. These same IRS bureaucrats have a vested interest in the outcome of their investigations. As officers of the IRS, their task is to maximise the revenue to the IRS. This bureaucratic self-interest creates a pre-determined inclination on their part to find employment---regardless of what the facts of common law are.
  • Subvert the principles of justice by creating a presumption of employment. A key justice principle in protecting the rights of self-employed people is a presumption under common law of nothing. When investigating whether an individual is an employee or self-employed, the courts come to the question with an 'open mind' and seek to determine the truth based on facts. The Bills, however, create an artificial employee status when an engaging party fails to lodge records with the bureaucracy. This bureaucratic employee status defies the truth of what a self-employed person actually is.
  • Create a pretence of a solution to multiple and divergent issues. We have discussed this at length in our post-2006 paper. The issues that tax, wage laws, workers' compensation, work safety, anti-discrimination and so on address are all quite distinct and 'stand alone'. The attempt to fix all these regulatory issues by pushing people into being 'employees' through legislative decree does not fix the problems, but instead creates new ones. Rather, each area of law has to be considered on its merits and specific solutions to embrace self-employed people within the law need to be devised. And it's not difficult to do this.
  • Fail to address real problems. NELP (above) says that a large problem to overcome is the cash economy. That is, people who simply do not report for tax and other purposes. This is not a problem produced by self-employed people as such but is in fact a criminal avoidance of the law. The proposals do nothing to address intentional non-reporting.
NELP claims that the incidence of self-employment in the US economy is small. This is not our understanding. In fact, reports show that 26 per cent of the US workforce is self-employed. When the government sector is excluded, the incidence is much higher. This analysis is consistent with global figures we have sourced.

In putting these two Bills before Congress, the proposals impinge on a much larger segment of the US workforce, its economy and its entrepreneurial undertakings than has been claimed. The attack against 'misclassification' readily becomes an attack against the right to be self-employed and the entrepreneurship that goes with self-employed people.


Conclusion

Our observation is that for the sake of self-employed people, these two Bills before Congress need to be considered with much greater care than appears to be the case at the moment. They look like a simple administrative anti-avoidance mechanism, but involve much more than that. They will create an entire new regime of red tape that is unlikely to fix anti-avoidance but will most likely harm self-employed people.