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The Self-Employment Income Drop

Monday, December 12, 2022 - 2:15pm
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A new study from the Office of Revenue Analysis shows that most Washington, DC tax filers who relied on self-employment for their livelihood from 2010-2018 had low incomes and had more stagnant incomes than their neighbors with steady wage employment. Most strikingly, when a tax filer switched from a typical wage-earning job to self-employment, their reported income dropped by 20-50 percent. Switching away from self-employment had the opposite effect, raising incomes by 65-85 percent. The minimum wage appears to play a key role in driving this divergence for some. This self-employment income drop is a cautionary datapoint about the effect of the gig economy and independent contracting on Washingtonians’ economic prospects and mobility.

Our analysis tracks the IRS-reported taxable incomes of Washingtonians from 2010-2018, divided by income level and employment type. We divided all 2013 unmarried tax filers into five bins based on their 2013 income levels (Table 1).

Table 1: Table of adjusted gross income bins in 2013. Bin 1 covers $1–22 k, Bin 2 covers $22–45 k, Bin 3 covers $45–75 k, Bin 4 covers $75–100 k, and Bin 5 includes incomes above $100 k.

And, we divided these same tax filers into two broad types of employment. Generally, there are two ways to work for pay: earn a wage as an employee, or work for yourself through self-employment and keep the profits your business earns. We focused on tax filers who rely heavily on these two income types:

  • Primarily wage-earning: Almost all of the income they report on their taxes is wage or salary income from a job.
  • Majority self-employed: Less than half of their tax income is from wages, and they report being self-employed (by filing IRS Schedule C or SE).

Figure 1: Line chart showing median adjusted gross income from 2010 to 2018 for three groups: minimum‑wage‑eligible wage earners, minimum‑wage‑ineligible wage earners, and self‑employed workers. Both groups of wage earners see median AGI climb steadily from around $14 k to $27 k, with minimum‑wage‑ineligible earners earning slightly more. Self‑employed workers have much lower median AGI, staying near $10‑12 k with only slight growth.

When we look at the cohort of tax filers in Bin 1, self-employed tax filers (gray line) appear to have persistently stagnant incomes, while wage earners (solid and dotted blue lines) saw large increases in income post-2013.

What drove the apparent divergence between wage-earners and the self-employed? One possible explanation is that in December 2013, Washington DC passed a minimum wage increase, which gradually raised the minimum wage from $8.25 per hour in 2013 to $13.25 per hour in 2018. The minimum wage also appears to have raised the incomes of low earners who worked at jobs within DC (solid blue line, Figure 1) above those who worked at wage jobs in Virginia, Maryland or for the federal government (dotted line).

Switching Employment Type

The law treats employees and self-employed individuals very differently. Of particular importance for our study is that minimum wage and overtime protections do not apply to self-employed workers. Relatedly, this research shows that there is a substantial income drop associated with self-employment.

As the rising minimum wage increased the earnings from wage employment, low-income individuals seem to have moved away from self-employment and toward minimum wage-protected jobs. The number of low-income, majority self-employed tax filers was increasing from 2010-2013, but then started to shrink after 2013, falling by 1,500 people from 2013-2018, especially among low earners:

Figure 2: Stacked area chart showing the income distribution of self‑employed taxpayers from 2010 to 2019. The lowest income bin ($1–22 k) occupies the majority of the area, accounting for about 60% of self‑employed filers and gradually shrinking slightly over time. Middle income bins ($22–45 k and $45–75 k) occupy a smaller share that stays roughly constant, while the highest bins ($75‑100 k and $100 k+) represent the smallest proportions but increase modestly.

When we divide DC tax filers by income and employment, we find that most self-employed people earned low incomes. About 60 percent of self-employed tax filers were in the lowest income bin, earning $1-22,000 per year (See Figure 2). Common professions for low-income self-employed people or independent contractors include drivers, janitors, home/office cleaners or hair stylists.

One possible reason for the falling number of majority self-employed, low-income tax filers in DC is the large income drop associated with self-employment. Despite similar pre-2014 income trajectories, our study finds that tax filers who became self-employed earned less in 2018 than they had in 2010 (See Figure 3). Conversely, those who left self-employment for a wage-earning job doubled their income from 2013-2018.

Figure 3: Line chart showing median adjusted gross income from 2010-2018 for Bin 1 single taxpayers who switched sources of income. Those switching to wage-earning see median AGI dip slightly then rise sharply from around $11k to over $22k after 2013, while those switching to self-employment maintain low median AGI near $10-12k with only modest growth.

Moreover, this pattern still holds for middle-earning switchers unaffected by the minimum wage. Tax filers making from $22,000 to $45,000 in 2013 lost approximately half of their income when they became self-employed. Even higher-earning tax filers saw persistent income gains when they left self-employment for a wage-earning job. Those who became wage-earners made about $50,000 in 2018, up from $30,000 when they were self-employed in 2013 (Figure 4).

Figure 4: Line chart showing median adjusted gross income from 2010-2018 for Bin 2 single taxpayers ($22k–$45k in 2013) who switched sources of income. Individuals who switch to wage-earning see median AGI remain around $30k then climb to roughly $50k by 2017 before easing, whereas those who switch to self‑employment hover around $25k until 2013 and then drop to about $13k and stay low.

This study establishes that there is a tax income drop associated with self-employment at most income levels, and shows that since the minimum wage was raised in DC incomes have diverged at the bottom. The minimum wage appears to have increased the incomes of those who work at DC establishments by $3,100 above similar low-wage workers who worked in Maryland and Virginia, while the incomes of the self-employed have stagnated. This study also documents that switching to become self-employed is associated with a 20-50 percent income drop. Other research does show that the self-employed have more opportunities for tax avoidance or misreporting than wage-earners, which could mean that their reported tax income is lower than their actual income, though that dynamic seems unlikely to completely explain the self-employment income drop.

The reversal in the growth of the low-income self-employed population after 2013 suggests that government policy can affect the number of people who are wage workers and who are self-employed. To the extent that policymakers are making decisions along this margin, encouraging tax filers into wage-earning seems to increase their reported income, tax collections, and observed economic mobility.

What data is this?

The data in this study comes from annual individual income tax return records for all tax filers in the District of Columbia for years 2010 to 2018.