Math error costs US Treasury $5 billion in lost tax revenue

Nothing gets lawmakers and pundits more outraged than government’s proverbial waste, fraud, and abuse. Nearly always, these stories involve spending. But taxes are hardly immune. One case of pure waste involves a simple math mistake that will cost the Treasury $5 billion in lost revenue over the next decade.

Much of this windfall goes to the highest income workers. A new report by my Tax Policy Center colleague Jim Nunns finds that a few of the very highest-paid business owners are enjoying a tax bonanza that exceeds $20,000-a-year. And worst of all, Congress has known about the problem for decades and never bothered to fix it.

Congress created this mess when it applied the wrong formula to the Social Security and Medicare payroll tax paid by sole proprietors and partners in law firms, private equity firms, and the like. The SECA (Self-Employment Contributions Act) tax is supposed to exactly parallel the better-known FICA tax, which is applied to employees. But, as it turns out, it doesn’t. And the result is that self-employed business owners pay less in payroll tax than employees earning exactly the same amount of money.

In an article first published in Tax Notes, Jim calculated this boondoggle reduces payroll taxes by about $100-a-year for a self-employed person making $100,000, about $500 for one making $300,000, and about $900 for a business owner making $500,000. If you pay yourself $1 million, you can save nearly $2,100 and if you’re getting $10 million, you pay $23,000 less in payroll tax than you should. That payroll tax savings is roughly half the median household income.

All because Congress made a simple math error. Here’s what went wrong:

The FICA payroll tax is divided into an employer share and a worker share. Employers pay 7.65 percent (6.2 percent for Social Security and 1.45 percent for Medicare), which is excluded from the worker’s wages subject to income tax. Workers pay an equal amount, plus an extra 0.9 percent Medicare tax, on wages over $200,000. The Social Security portion is capped at $117,000 in wages. The 1.45 percent Medicare tax applies to all wages.

The self-employed are supposed to pay an exactly parallel tax—half as an “employer” and half as “employee” (plus the extra 0.9 percent Medicare tax). But, thanks to a long-standing formula snafu (three mistakes, actually), they have not paid the right tax for years.

The basic error: Self-employment earnings need to be decreased to account for the exclusion of the employer share of FICA from wages. The SECA formula-writers messed up by making the deduction too large.

Take somebody making $100,000. If she is an employee, she and her firm each pay $7,650 in payroll tax for a total of $15,300. But if she is self-employed, her comparable earnings are $107,650 (wages plus the “employer” share of the payroll tax). Applying the 7.65 SECA deduction reduces her taxable earnings to $99,415, thus her tax is just $15,210.

To correct for this, the formula needs to reduce the SECA deduction to 7.1064 percent, so taxable earnings are the same $100,000 for a sole proprietor or partner as they are for an employee.

But the current law for the self-employed allows the full deduction of 7.65 percent—not only for earnings below the Social Security cap but, remarkably, even for earnings subject only to the 1.45 percent Medicare tax.

On top of all that, the current formula also incorrectly converts the Social Security wage cap for the self-employed.

There are some trade-offs. Because a sole proprietor is paying a smaller Social Security payroll tax, she’ll also get a slightly lower benefit when she retires. So by paying the correct tax, she’d get a bit more in old age. Plus, since she can deduct her “employer” share of payroll tax from earnings subject to income tax, she’d also enjoy a larger deduction for paying the correct amount. But those don’t come close to offsetting the windfall.

Congress should have fixed this error years ago but never bothered. House Ways & Means Committee chair Dave Camp’s tax reform would correct the mistake, but that measure is going nowhere.

Lawmakers love to express outrage when confronted with wasteful government spending. Let’s see if they do anything about a costly error when it comes to taxes.