® 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. Introduction 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- 1 See section 275(a)(1) (denying an income tax deduction for ‘‘Federal income taxes’’). 2 Michael J. Graetz and Deborah Schenk, Federal Income Taxation 101 (2009). 3 See http://www.taxpolicycenter.org/briefing-book/impro ve/retail/exclusive-inclusive.cfm. 4 Graetz and Schenk, supra note 2. 5 See below. 6 See William G. Gale, ‘‘The National Retail Sales Tax: What Would the Rate Have to Be?’’ Tax Notes, May 16, 2005, p. 889. 7 Section 3101. 8 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 9 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). 10 See Graetz and Schenk, supra note 2. 1065 (C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. TAX PRACTICE COMMENTARY / TAX PRACTICE 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 11 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 provided. 12 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 text. 13 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. 14 See, e.g., Social Security Administration, ‘‘Social Security and Medicare Tax Rates,’’ available at http://www.ssa.gov/ oact/progdata/taxRates.html (stating that the total FICA rate is 15.3 percent for years after 1990). 15 P.L. 111-312. 16 Modifying section 3101. 17 Equation 5, with s=0.0565, t=0.0765. 18 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. 1066 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 19 Modifying section 3111. See IRS, IRS 2009 Databook, at 3 (Table 1 (2010)), available at http://www.irs.gov/pub/irs-soi/09databk.pdf. 20 TAX NOTES, February 28, 2011 (C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. 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). COMMENTARY / TAX PRACTICE 21 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. Conclusion 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. 22 Section 275. Section 164. 23 SUBMISSIONS TO TAX NOTES Tax Notes welcomes submissions of commentary and analysis pieces on federal tax matters that may be of interest to the nation’s tax policymakers, academics, and practitioners. To be considered for publication, TAX NOTES, February 28, 2011 articles should be sent to the editor’s attention at taxnotes@tax.org. A complete list of submission guidelines is available on Tax Analysts’ Web site, http:// www.taxanalysts.com/. 1067 (C) Tax Analysts 2011. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content. 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.