Uber and Lyft are threating to shut down operations in California because the state considers their drivers employees rather than independent contractors. The distinction might seem esoteric but it’s part of an increasingly consequential debate about work and taxes in America.
Unlike employees, independent contractors do not benefit from state workplace protections such as minimum wage, workers compensation, or overtime nor from unemployment insurance (although the CARES Act temporarily made them eligible). And, crucially, companies withhold payroll and income taxes for employees but not independent contractors.
This makes sense if you’re a small-business owner like an accountant, lawyer, or plumber. Why do you need a minimum wage if your take-home pay is revenue minus business expenses? But is an Uber driver their own small business or an employee of a larger business?
California lawmakers made drivers employees by enacting Assembly Bill 5 (AB 5) in 2019. The law classifies all workers (gig or otherwise) as employees unless they meet a three-part test establishing them as an independent contractor.
All states have so-called worker classification rules; California just sets a higher bar for workers being deemed independent contractors. New Jersey recently enacted similarly stringent rules and states like New York, Oregon and Washington are considering them.
Gig workers fail California’s independent contractor test because gig companies such as Uber and Lyft control too much of their work. As a California Superior Court judge recently concluded in a case brought against them over AB 5, “It’s this simple: Defendants’ drivers do not perform work that is ‘outside the usual course’ of their business.”
The companies are appealing that ruling, but their best chance to reverse AB 5 is probably Proposition 22, a ballot initiative that would classify drivers for app-based services as independent contractors. And taxes may be the biggest reason why Uber, Lyft, DoorDash, Instacart, and Postmates are funding the initiative.
Who counts an employee is a taxing question
If you’re an employee, you split responsibility for paying your federal payroll tax with your employer. (At least legally; the economics of who pays are more complicated.) But if you’re an independent contractor, you must pay all the payroll taxes yourself. California employers must also pay the state’s unemployment insurance tax and withhold a state payroll tax for all employees that funds disability and paid leave programs.
Further, if you’re an employee, your employer withholds a part of each paycheck for federal and state income tax. And employers must report annual wages or salaries paid to their employees as well as taxes withheld to the IRS. If you’re an independent contractor, you’re responsible for making those payments on your own. Not surprisingly, independent contractors are far more likely than employees to underreport income or not file a tax return at all.
Overall, worker misclassification costs California an estimated $7 billion in revenue annually. Still, it’s difficult to say how AB 5 will ultimately affect state finances (AB 5’s fiscal score only estimated administrative costs). Workers will pay more taxes, but they’ll also be eligible for more benefits. Additionally, if more lower income workers file California income tax returns, they could start claiming the state’s refundable earned income tax credit.
But for businesses, the calculation is far simpler: Costs go up.
Workers typically pay the employer share of payroll taxes in the form of lower pay. But that’s not possible for employees earning at or below the state’s newly mandated minimum wage ($12 in California and rising to $15). If a business cannot shift the employer share of the payroll tax to the worker, the business either must raise prices or eat the additional cost itself.
Despite all the headlines after AB 5 passed, gig companies are not the only businesses misclassifying workers to avoid paying taxes. For instance, home care and construction workers often work for 40 hours or more each week for an employer but don’t qualify for employee benefits and protections because of misclassification.
New type of workers, same tax (avoidance)
Notably, Proposition 22 would not overturn AB 5 but instead specifically label drivers of app-based services as independent contractors. It would also make the drivers eligible for a wage floor and some anti-discrimination protections.
In a sense, these companies are trying to create a new type of worker classification. Already, many New York drivers are part of the Black Car Fund, which provides worker compensation (via a surcharge on fares) but not other worker protections. And Uber’s CEO recently asked Congress to give drivers additional benefits without classifying them as employees.
But none of these ostensible compromises over worker classification include taxes. Which is strong evidence that taxes are the real issue.
That’s not to say the related tax costs aren’t real. In addition to Uber and Lyft threatening to shut down, some other gig companies have already have pulled back operations in California, angering workers looking for jobs during the ongoing economic slowdown.
And that tradeoff creates a fight that some states do not want. The New York Times reported nearly half the states explicitly classified drivers for app-based services as independent contractors.
But the real contours of the debate should be clear: Gig companies want to keep their costs low, and their potential workforce large, by passing tax obligations onto their workers. We’ll soon see if that’s a trade California voters and other state policymakers want to make.
Richard Auxier also discussed this issue with Tax Notes reporter Paul Jones on the latest episode of the Tax Notes Talks podcast.
