Why a New IRS Change Will Push Some Entrepreneurs into Corporate Desk Jobs

As the end of the year approaches, the IRS has announced its new late repayment penalty rate. The rate has climbed from around 3% two years ago to 8% today.

Most workers in the US are W-2 employees and have taxes deducted from their paychecks each pay period. However, if those employees claim more exemptions, the taxes deducted from each check decrease.

At the end of the year, though, the IRS requires taxpayers to calculate what they owe and compare it to what they paid throughout the year. If someone paid more than they owe throughout the year, they receive a refund. On the flip side, if you pay less than what you owe throughout the year, the IRS makes you pay the difference.

It doesn’t stop there though. If you pay less than 90% of your tax bill, it’s possible that the IRS will charge you an underpayment penalty (conditional on some other factors).

This penalty is the rate that has more than doubled from 3% to 8% over the last two years.

Why the increase? Well, on the surface, the increase makes some sense. As I highlighted during tax season last year, money today is more valuable than money in the future. Therefore, taxpayers who underpay throughout the year do so to the disadvantage of the IRS.

Rising interest rates throughout the last two years represent the fact that present money is becoming relatively more valuable compared to future money. The IRS late repayment penalty takes this into consideration, and so rising penalties are a result.

As I mentioned earlier in the article, most US employees are W-2 employees of traditional business organizations. There is a straightforward process for setting up taxes for these employees, so underpaying is rare. However, entrepreneurial citizens who follow less traditional pathways are much more likely to underpay taxes and, as a result, are most negatively affected by the rate increase.

Entrepreneurs on the Margin
So who is most at risk for underpaying? Well, any self-employed person who earns income outside of a traditional W-2 contract is at risk. This ranges anywhere from entrepreneurs who are starting a new business to independent contractors and gig economy workers. If you receive what the IRS calls 1099 Nonemployee Compensation (NEC), you’re at risk.

The reason for this is clear: When you are a W-2 worker, your employer and the IRS work together to deduct estimated taxes from your paychecks. This process is very straightforward for all involved because it is so common.

Not so for the self-employed. The IRS expects workers who receive income on their own to calculate their estimated taxes themselves and pay them throughout the year. If you fail to do this with sufficient accuracy, chances are you’ll be hit with the freshly increased 8% penalty.

This represents an obvious disadvantage for the self-employed worker. Some may argue that calculating and paying taxes this way isn’t that hard, but this is the wrong way to look at things.

Self-employed workers spend a significant amount of their time hustling and doing logistics to manage their own businesses. Not many of them have extra hours to be accountants. The result of this is that many self-employed workers need to hire accountants they otherwise wouldn’t. A simple W-2 job might be able to get by with a free TurboTax package, but an accurate quarterly tax payment system is going to cost something.

The problem with this becomes clear when we consider an example. Imagine an entrepreneur named Joseph. Joseph is on the fence about whether he wants to become a freelance writer or a corporate journalist. He’s run all the numbers, and the two options are of almost exactly equal value to him. Being a freelance writer barely wins out, but if the media job offered even a slightly higher salary, he’d switch.

Economists would say that Joseph is “on the margin.” He’s right on the cusp of changing his mind. In a country with hundreds of millions of people, it’s a pretty safe bet that some people are on the margin about taking the leap and becoming self-employed entrepreneurs.

Now imagine as Joseph is about to start his freelance gig, he learns about the need to calculate his own taxes. He looks into it a bit and has some confusion. How does he factor in deductions? How does he account for the fact that in his first year, he is radically unsure about how much revenue he’ll really make?

The confusion and risk scare him, and, because he is already on the margin, he decides that the sure bet of being a corporate journalist is a better job.

If the late repayment penalty is low or non-existent, we should expect it to deter fewer freelancers. As it grows, the relative cost of self-employment increases.

Unfortunately, as our system exists now, my expectation is that the complications and penalties of our tax system put freelance workers at a disadvantage, and this disadvantage only grows as the late repayment penalty rises.

Thinking on the Margin
If we didn’t consider the case of entrepreneurs on the margin, we might not think this change is going to be a big deal. After all, a few more percent on a penalty doesn’t seem to have a big impact in the grand scheme of things.

But thinking like an economist involves recognizing that with any given decision there are people who are on a knife’s edge. Thus, when the government imposes additional costs on being self-employed, even relatively small ones, this is going to move some people away from self-employment altogether.

Resources then flow completely differently than they would have otherwise. For example, Joseph as an independent journalist may have created a new website or platform which changes the industry. If, instead, he works for a legacy media organization, those changes will not occur. The consequences of government penalties can be massive, but they are often hard to see.

The ability to think on the margin can be used to expose a lot of flawed reasoning in politics. For example, the idea that we can just tax our way out of debt is common, but thinking on the margin reveals an issue with this.

As taxes go up, the benefit of an additional hour of work or an additional investment goes down. If you were on the fence about working that last hour or making that last investment, an increase in taxes will push you away from doing so.

If that happens, tax revenue will actually be less than it otherwise would’ve been. This is the logic underlying the famous Laffer curve.

So when you’re thinking about policies, don’t just think about the straightforward effect. Practice thinking on the margin. A penalty doesn’t just mean violators pay more. Instead, a new penalty or tax often means people won’t bother engaging in productive behavior at all.

Editor’s note: This piece originally was published by the Foundation for Economic Education (FEE).