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2017 Tax Law’s Pass-Through Deduction Could Encourage “Workplace Fissuring”

As our new report explains, the 2017 tax law’s deduction for “pass-through” income may contribute to “workplace fissuring” — when firms obtain the services of workers such as truck drivers or janitors without hiring them directly, often paying them less and in turn contributing to growing compensation inequality. In their rush to enact the law, President Trump and Congress ignored that risk to workers, and it’s yet another strong reason why policymakers should repeal the deduction.

The law provides a 20 percent deduction for certain pass-through income — income that owners of businesses such as partnerships, S corporations, and sole proprietorships report on their individual tax returns, which previously was taxed at the same individual tax rates as their wage and salary income. The deduction results in a lower tax rate for certain business owners (including independent contractors) than for traditional employees, which encourages workplace fissuring in two basic ways.

First, it provides a tax break to workers hired as independent contractors, so employers can use it to entice new hires to accept positions as contractors instead of traditional employees. But the drawbacks for those contractors could outweigh their tax gains, as many disadvantages of independent contractor status for workers are advantages for employers. Independent contractors don’t enjoy legal protections regarding the minimum wage, overtime, sexual harassment, and workplace safety; they typically don’t get employee benefits such as health insurance that employers often provide to employees; and they must pay both the employer and employee shares of payroll taxes. Employers also have an incentive not to disclose these drawbacks to their employees or to understate them relative to the deduction so that independent contractors won’t try to negotiate higher pay to make up for them.

Second, the pass-through deduction could further encourage firms to rely more on contracting firms and franchises. Consider a lead firm deciding whether to retain its in-house IT department or hire an outside contractor firm to do the same work with the same management structure. The owner-managers of the contractor firm qualify for the pass-through deduction, but the in-house managers don’t. The contractor owner-managers can therefore charge the lead firm less while doing the same work for the same take-home pay as the in-house managers, enticing the lead firm to choose the contractor option.

Similarly, a firm may choose not to open a “branch” (where it employs a manager and workers) and instead expand with a “franchise” (in which the owner-manager owns the establishment and pays royalties to the original firm, and the remaining profits are eligible for the deduction). That way, the firm can effectively pay the franchise owner less than a manager without reducing the owner’s after-tax income.

As for rank-and-file workers, they would remain traditional employees whether they worked for the contractor firm or franchise or the lead firm. If they worked for the contractor or franchise, however, they might receive lower pay and fewer benefits. Outsourcing reduces wages by 4-7 percent for janitors and by 8-24 percent for security guards, while reducing health insurance benefits for both, economists Arindrajit Dube and Ethan Kaplan found. Other studies have found similar results. These workers also may have fewer chances for training or career advancement. In addition, labor-law violations are more common at franchise restaurants and hotels: franchise-owned fast-food restaurants were 24 percent likelier to violate labor laws than those owned directly by the lead firm, and the back wages they owed workers were 50 percent higher per violation, an analysis found.

The 2017 law’s supporters may say that the pass-through deduction’s incentives for workplace fissuring encourage entrepreneurship, with individuals creating more contractor firms and opening more franchises. And, on paper, the deduction could create a large number of new businesses. But that’s not the type of entrepreneurship that spurs innovation and job creation — instead, firms would merely be breaking themselves into pieces and creating new types of entities to generate tax savings.

In short, the new pass-through deduction moves tax policy in the wrong direction. It may push more workers into low-wage firms or put them outside the protections of labor laws, while depressing wages and weakening employer-provided benefits and workplace standards. That’s one more reason that policymakers should undo this serious policy mistake and repeal the pass-through deduction.