Introduction to Section 1706: Background and Impacts
Section 1706 of the 1986 Tax Reform Act has been the source of much discussion. What it did was remove "safe harbor" presumption from workers, i.e., computer consultants, in the "technical services" industry, thereby creating uncertainty whether one was a contractor or employee, and opening the way to abusive collection actions against anyone who engaged computer consultants, either directly or through an agency.
Investigation of the way Section 1706 was adopted shows it was at the behest of lobbyists for an organization of several leading technical and accounting services firms (mainly the then "Big 8") who had ambitions to corner the market on providing computer consulting services, and sought to discourage their small competitors or drive them out of business.
For a number of years after Section 1706 was adopted, representatives of the large firms would actually work with IRS agents to "finger" their small perceived competitors for tax audits and penalties, often even if the contract worker had filed and paid his taxes, or even if he was duly incorporated.
The computer consulting business
Computer consulting is a professional practice similar to law, medicine, or accounting, in that most work consists of short-term projects, from six months down to six minutes (usually the smallest practical billing period). The high cost of administering a W-2 employee makes it unfeasible to do so for periods of less than six months, so such work only makes sense as contract work, done by professionals who typically have multiple clients, even at the same time.
Immediate impact on computer contractors
Most smaller computer consulting firms went out of business. Most solo practitioners found they had to give the contract to a "broker" or "agency", even if they found the work themselves, and work as a W-2 employee with the agency paying them as little as half of what it billed the client. Some tried incorporating, and that helped some, but not enough, because the IRS would often ignore the incorporated status of workers.
An informal survey of computer consultants during the 1990s found the cost in earnings averaged more than $100,000 per year each, or more than $2 million for a 20-year career. It is estimated that about 300,000 such workers were affected, for a total perhaps greater than $30 billion per year, or a loss of perhaps $10 billion in tax receipts.
Small contracts went underground
Increasingly, clients desperate to get work done would conceal their expenditures for such work, or pay in cash and not report it or take a deduction, and ask the contractors not to report the earnings, which could be traced back to the client. The result was to drive much computer consulting underground, and consultants, who had been more tax-compliant than almost any other profession, joined the ranks of occupations like home and landscaping, or sex, services. It can be estimated this caused a loss in tax receipts of more than $20 billion per year.
Or the work went undone
It is difficult to estimate the damage done to clients by not allowing them to do critical computer work, but many small businesses (and some large ones) operate on the edge, and their inability to get such work done at an affordable cost has likely contributed to countless business failures during the decades since 1986. Such potential clients were never prospects for the firms behind Section 1706.
Contribution to the dot-com collapse
What precipitated the bursting of the dot-com bubble was mainly the suspension of further funding by venture capitalists before completion of their original business plans could have made them profitable, and a leading cause of their inability to achieve profitability was their inability to engage contract computer workers due to Section 1706. Informal surveys of many of the firms supports this explanation.
Contribution to loss of competitiveness
Surveys have indicated that the increased costs, risks, and uncertainties of Section 1706 have greatly contributed to the inability of smaller U.S. firms to compete in world markets. Union contracts and health insurance may have done that for large enterprises, but it is easy to overlook that most international trade involves smaller firms, who are more affected by regulatory and tax factors. We can estimate the impact on our balance of payments deficit to be as high as $10 billion.
Contribution to off-shoring jobs
Informal surveys of executives of firms who have been off-shoring jobs confirms that a leading factor in their decisions has been the risks, costs, and uncertainties introduced by Section 1706. It is difficult to disaggregate all the factors, but the fact they mention it so often, without being prompted, suggests it is a major factor, perhaps of more than 10% of the jobs lost to other countries, which some estimate to run as much as 400,000 jobs a year. Twenty percent of that would be 40,000, multiplied by average earnings of $60,000 per year, or $2.4 billion lost to the economy, and at $240 million to tax receipts.
Section 1706 not unique
Section 1706 is not unique. Most regulations and taxes, whatever the reasons given for them for public consumption, are mainly designed to suppress small competitors of larger enterprises, and therefore to achieve an advantage for them they could not have obtained in a free market. However, it is one of the easier to identify and analyze. It has not just been computer consultants who have been harmed, but all of us.