Tax Inclusive, Tax Exclusive, and Tax Bases

tax notes
Tax Inclusive, Tax Exclusive, and
Tax Bases in Between
By Yair Listokin
Yair Listokin is an associate professor of law at Yale
Law School.
Some taxes, most notably FICA, use a base that is
neither tax inclusive nor tax exclusive. This article
provides formulas for expressing tax rates on hybrid
tax bases in tax-inclusive and tax-exclusive terms, and
demonstrates that obligations under the SelfEmployment Contributions Act fail to track obligations under FICA because of confusion about the
appropriate tax base adjustment.
Tax rates are generally expressed on a ‘‘taxinclusive’’ or ‘‘tax-exclusive’’ basis. For a taxinclusive rate, such as the U.S. federal income tax,1
‘‘the amount of tax is included in the amount of
taxable income to which rates are applied.’’2 Taxexclusive rates, by contrast, exclude the amount of
tax paid from the taxable base.3 Sales taxes are
typically reported in tax-exclusive terms.4 Simple
formulas convert tax-inclusive rates to equivalent
tax-exclusive ones,5 and vice versa, enabling
straightforward comparisons of different tax rates.6
Not all taxes are expressed in tax-inclusive or
tax-exclusive terms, however. Instead, some tax
rates are applied to a hybrid tax base that allows a
partial deduction for taxes paid. Most prominently,
the FICA tax rate of 7.65 percent on employees7 and
7.65 percent on employers8 is neither a tax-inclusive
nor a tax-exclusive rate. The FICA taxable base
excludes the amount owed under FICA by em-
See section 275(a)(1) (denying an income tax deduction for
‘‘Federal income taxes’’).
Michael J. Graetz and Deborah Schenk, Federal Income
Taxation 101 (2009).
Graetz and Schenk, supra note 2.
See below.
See William G. Gale, ‘‘The National Retail Sales Tax: What
Would the Rate Have to Be?’’ Tax Notes, May 16, 2005, p. 889.
Section 3101.
Section 3111.
TAX NOTES, February 28, 2011
ployers but includes the amount owed under FICA
by employees. While others have noted that this
peculiarity in FICA makes the statutory burden of
FICA on employers versus employees relevant,9
they have not provided formulas for expressing
FICA rates in terms of more commonly used tax
bases. Also, the hybrid nature of the FICA taxable
base makes comparison of FICA rates with other tax
rates expressed in terms of tax-inclusive or taxexclusive bases extremely difficult. The resulting
confusion is demonstrated by the complexity of the
Self-Employment Contributions Act (SECA) tax levied under section 1401. SECA provides a partial
deductibility scheme for self-employment taxes that
is intended to replicate the hybrid inclusive/
exclusive nature of FICA. SECA fails in this goal,
however, and provides the self-employed with a tax
base that is too small relative to the FICA tax base.
In this article, I provide a general formula for
expressing tax rates applied to hybrid inclusive/
exclusive tax bases in tax-inclusive or exclusive
terms. The formula enables comparison of FICA
rates with other important rates, such as income tax
rates, and places recent changes to FICA rates in
appropriate context. I then apply the formula to
calculate the appropriate SECA tax and demonstrate that the current SECA formula fails to achieve
payroll tax parity between self-employed individuals and wage earners.
Converting Payroll Tax Rates
This section assumes the existence of only one
type of tax — a payroll tax. Tax-inclusive rates (ri)
are imposed on a base of gross salary (G), and
tax-exclusive rates (re) are imposed on a base of net
salary (N), where gross salary is the total amount
paid by the employer and net salary is the amount
pocketed by the employee. Thus, N=G(1-ri) (equation 1) and G=N(1+re) (equation 2). Some algebra
yields re=ri/(1-ri) and ri=re/(1+re).
The taxable base for payroll taxes10 is neither
gross salary — the total amount of salary and tax
payments paid out by the employer — nor net
See Bertil Holmlund, ‘‘A Note on Changes in Payroll Taxes
— Does Legal Incidence Matter?’’ Nat’l Tax J. 479-482 (1981);
James McClure and T. Norman Van Cott, ‘‘Teaching Note: Let’s
Stop Professing That the Legal Incidence of the Social Security
Tax Is Irrelevant,’’ 26 Eastern Econ. Rev., 483-485 (2000).
See Graetz and Schenk, supra note 2.
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With FICA rates as they were in 2010
(t=s=0.0765), the tax-inclusive FICA rate is thus
14.213 percent (from equation 5). This rate, expressed in terms that make it more comparable to
income tax rates, which are stated in tax-inclusive
terms,13 is substantially different from the commonly expressed FICA rate of 15.3 percent.14 The
tax-exclusive FICA rate is 16.57 percent. The Tax
Relief, Unemployment Insurance Reauthorization,
and Job Creation Act of 201015 lowered Old Age,
Survivors, and Disability Insurance rates owed by
employees from 6.2 to 4.2 percent.16 This means that
s=0.0565, reducing the tax-inclusive FICA rate to
12.35 percent.17 The size of the tax reduction in
tax-inclusive terms is therefore somewhat less than
the official 2 percent reduction in rates.18 Had the 2
percent reduction been applied to the employer
Although this article focuses on payroll tax, any hybrid tax
base between gross and net receipts can be converted into
tax-inclusive and tax-exclusive equivalents using the formula
More generally (for any tax that is partially but not
completely deductible), if the total rate of tax is r and a
percentage q of the tax is deductible, then t=q*r and s=(1-q)*r.
The intermediate tax base P can then be expressed as it is in the
The income tax, like the employee portion of the FICA tax,
is ‘‘own tax-inclusive.’’ The income tax allows deductions for
other taxes. See section 164.
See, e.g., Social Security Administration, ‘‘Social Security
and Medicare Tax Rates,’’ available at
oact/progdata/taxRates.html (stating that the total FICA rate is
15.3 percent for years after 1990).
P.L. 111-312.
Modifying section 3101.
Equation 5, with s=0.0565, t=0.0765.
The reduction is less than 2 percent because the taxinclusive base is larger than the FICA tax base. In tax-exclusive
terms, the reduction from the 2010 tax act is from 16.57 to 14.1
percent. The reduction is greater than 2 percent because the tax
exclusive base is smaller than the FICA tax base.
portion of FICA19 (t=0.0565) instead of the employee portion, the tax-inclusive FICA rate would
have gone down to 12.59 percent.
A Lack of Parity Between FICA and SECA
The formulas of equation 5 and equation 6 facilitate calculation of payroll tax equivalents for the
self-employed. Gross earnings (what is taken in)
and net earnings (what is left after paying payroll
tax) are well-defined bases for the self-employed. A
tax-inclusive FICA rate of 14.21 percent, applied to
gross earnings of the self-employed, treats selfemployed individuals exactly like wage earners for
FICA purposes.
However, the self-employment taxes owed under
section 1401 are not expressed in tax-inclusive or
tax-exclusive terms. Instead, section 1401 reports the
same SECA rates as the FICA rates of sections 3101
and 3111. The total SECA rate is 15.3 percent, which
is a rate dependent on a tax base that has little meaning for the self-employed. If this rate were applied to
gross self-employed earnings, it would overtax selfemployed individuals relative to wage earners because wage earners and their employers can exclude
the employers’ payroll tax payment from the payroll
tax income base. As a result, section 1402(a)(12) reduces the taxable earnings base subject to SECA by
allowing a deduction ‘‘equal to the product of — (A)
the taxpayer’s net earnings from self-employment
for the taxable year (determined without regard to
this paragraph), and (B) one-half of the sum of the
rates imposed by subsections (a) and (b) of section
1401 for such year.’’ SECA tax owed is therefore
equal to G*(1-0.5(t+s))*(t+s) (equation 7). With
t=s=0.0765, the tax-inclusive SECA rate is 0.1413=
(1-0.5(0.153))*(0.153), or 14.13 percent. The taxinclusive SECA rate is 8½ basis points below the
tax-inclusive FICA rate, despite the apparent intent
of section 1402(a)(12) to make the bases for FICA and
SECA identical. The size of the disparity between
tax-inclusive SECA rates and tax-inclusive FICA
rates grows as payroll tax rates increase. If t=s=0.25
for a total payroll tax rate of 50 percent, the taxinclusive FICA rate under equation 5 becomes 40
percent, while the SECA rate under equation 7 becomes 37.5 percent. And while the size of the disparity between FICA and SECA under current rates
is small, the high value of SECA payments (almost
$54 billion in 2009)20 implies that the total value of
the advantage to the self-employed may be approximately $45 million annually.
Why does the section 1402(a)(12) adjustment fail
to achieve parity between FICA and SECA? Because
Modifying section 3111.
See IRS, IRS 2009 Databook, at 3 (Table 1 (2010)), available at
TAX NOTES, February 28, 2011
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salary — the amount that the employee retains.
Instead, the taxable base for a payroll tax is an
intermediate base that I will call P for payroll tax
base.11 The payroll tax base P is defined in relation
to the gross salary, G, and net salary, N. Let the
payroll tax rate on the employer be denoted by t
and let the payroll tax rate on the employee be
denoted by s. With the payroll tax base P and the tax
rates t and s, the gross salary is G=P(1+t) (equation
3) and the net salary is N=P(1-s) (equation 4).12
Replacing N in equation 1 with N’s value from
equation 4 and replacing G in equation 1 with G’s
value from equation 3 yields P(1+t)(1+ri)=P(1-s).
Solving for ri yields ri=(t+s)/(1+t) (equation 5). On a
tax-inclusive basis, total FICA taxes owed are
G*(t+s)/(1+t). A similar rearrangement using equation 2 yields re=(t+s)/(1-s) (equation 6).
When s=t, then PSECA=G*(1-t). For positive t, PSECA < PFICA.
To see this, substitute PSECA=G*(1-t) and PFICA=G/(1+t). Multiplying both sides of the inequality by (1+t) yields G(1-t)(1+t) >
G, which is true for all positive t.
This article provides formulas to convert tax rates
calculated on hybrid tax bases, such as the payroll
tax base into tax-inclusive and tax-exclusive equivalents. These formulas hopefully simplify the currently complex task of comparing tax rates on
hybrid inclusive/exclusive bases with tax rates on
simpler bases, a complexity demonstrated by the
failure of the code to properly adjust the SECA tax
base to make it identical to the FICA tax base.
Future work should take into account that there are
many different interacting taxes applied to income,
including payroll tax, federal income tax, and state
income tax. While these taxes may be expressed in
tax-inclusive or tax-exclusive terms in relation to
themselves, they may compare differently with
other taxes. For example, the federal income tax
denies a deduction for federal income taxes paid22
(it is tax-inclusive regarding itself) but allows deductions for other taxes, such as state income taxes,
the employer portion of FICA, and half of SECA
taxes.23 The federal income tax is therefore taxexclusive regarding these other taxes. The formulas
derived in this article are a first step in the more
daunting task of accurately comparing tax rates
across myriad different tax bases.
Section 275.
Section 164.
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and practitioners. To be considered for publication,
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the adjusted tax base for SECA purposes, obtained
by subtracting half of the SECA rate from gross
earnings, PSECA=G*(1-0.5(t+s)), is different from the
FICA tax base PFICA=G/(1+t).21 The official rates are
the same for both FICA and SECA (15.3 percent),
but the different bases yield different tax amounts
and different effective rates.
An example may be helpful. Suppose a company
is willing to pay $86,120 total to an independent
contractor or an employee and payroll taxes (FICA
or SECA) are the only relevant taxes. If the
company hires an employee, the employee’s wage
will be $80,000, the company will pay
0.0765*$80,000=$6,120 in FICA taxes, for a total of
$86,120. The employee will also pay $6,120 in FICA
taxes, leaving the employee with $73,880 in net
earnings. Total FICA taxes are $12,240. If the
company hires the same individual as an independent contractor, the individual will receive gross
earnings of $86,120 and SECA taxes under sections
1401 and 1402 will be $86,120*(1-0.0765)*0.153=
$12,168, less than the $12,240 in FICA taxes that
would have been paid had the individual been
hired as an employee.