Statement of Kelly D. Pinkham, Assistant Director, Center for Full Employment and Price

Testimony Before the Subcommittee on Income Security and Family Support
of the House Committee on Ways and Means

May 08, 2007

Introductory Remarks

Good morning Chairman McDermott, Chairman Neal, Ranking Member Weller, Ranking Member English and members of the Committee: thank you for allowing me the opportunity to make a few remarks about the growing national problem of the improper classification of employees as independent contractors, a practice known as “misclassification.”  I have been asked to share with you the results of a research study completed by Dr. Michael Kelsay, Dr. James Sturgeon and myself in the department of economics at the University of Missouri – Kansas City.

Our study is titled “The Economic Costs of Employee Misclassification in the State of Illinois” and covers the period of 2001 through 2005.  Support for our research was provided by the National Alliance for Fair Contracting, a labor-management organization.  We would also like to thank the staff of the Illinois Department of Employment Security.  Without their thoughtful and professional assistance, our study could not have been completed.

Since our time together is short, my testimony will focus on the summary section of our study.  The complete study, along with related supporting materials, will be submitted with our written statement.  Given the amount of numerical data I am presenting, figures will be rounded when possible (for example, instead of 18.2 %, I will say 18%).

Notes Regarding Misclassification Research Studies

Other studies in addition to ours have shown that misclassification by employers is increasing across the United States.[1]  The prevalence of misclassification varies across different industries and is particularly acute in the construction sector.  Moreover, the “underground economy” (that is, workers paid in cash) is outside the scope of these studies.  Thus, the numerical estimates provided by these studies surely underestimate the full extent of the problems associated with the employer practice of misclassification.

The data for studies like ours comes from the unemployment insurance audits performed in the individual states.  Generally, three kinds of audits are conducted by the states: random, non-random (normally benefit-related) and targeted audits.  States that perform targeted audits discover a greater extent of misclassification.  Illinois is one of those states that do not perform targeted audits.  In fact, from 2001-2005, 77% of the audits in Illinois were random audits.

Employee Misclassification in Illinois

• In 2001, state unemployment insurance audits found that more than 14% of the Illinois employers audited had misclassified workers as independent contractors.  By 2005, this percentage was nearly 20%.  This translates into approximately 64,000 total employers statewide.[2]  Since 77% of these audits were the random kind of audit, the rate of misclassification found in Illinois suggests that the actual extent may be higher in Illinois than in other states that have been studied.  
• When an employer practices misclassification in Illinois, the results show that this behavior is pervasive.  The percentage of employees that are misclassified at a given company indicates that it is a common occurrence, not a random one, in those companies that do misclassify.  In 2001, 23% of the violating firms’ workers were misclassified; this had increased to almost 28% in 2005.  That means the rate of misclassification by violating employers increased 21% from 2001 to 2005. 
• We estimate that an average of almost 8% of employees in Illinois was misclassified annually for the period 2001-2005.  This grew from a level of 5.5% in 2001 to 8.5% in 2005.  This represents a 55% increase in the rate of misclassified employees. 
• The number of employees statewide that were affected by the improper practice of misclassification averaged nearly 370,000 annually from 2001-2005.  For 2005, this estimate increased to almost 420,000.

Estimates of Revenue Losses to the State of Illinois

1,         Unemployment insurance system: We estimate that the unemployment insurance system lost an average of over $39 million every year from 2001-2005 in unemployment insurance taxes that were not levied on the payroll of misclassified workers as they should have been.  During 2005, we estimate that the unemployment insurance system in Illinois lost almost $54 million. 

2.         State income tax revenue: According to published data, workers classified as independent contractors are known to underreport their personal income; as a result Illinois suffers a loss of income tax revenue when employees are misclassified.  According to the IRS reports, wage earners report 99% of their wages whereas non-wage earners (such as independent contractors) report approximately only 68% of their income.  This represents a gap of 31%.  Other reliable studies estimate this gap to be as high as 50%.

• Based upon IRS estimates that 30% of the income of misclassified workers is not reported, we estimate that an average of $125 million of income tax was lost annually in Illinois for 2001 through 2005.  In just 2005, we estimate that $149 million of income tax was not collected in Illinois.
• Based upon the higher estimate that up to 50% of the income of misclassified workers is not reported, an average of $208 million of state income tax was lost annually in Illinois from 2001 through 2005.  For just 2005, we estimate this loss to have been $248 million.

3.      Worker’s compensation insurance: Misclassification also impacts worker’s compensation insurance.  Among other effects, costs are higher for employers that follow the rules placing them at a distinct competitive disadvantage.  A national study reported that the cost of worker’s compensation premiums is the single most dominant reason why employers misclassify (Planmatics, 2000).  Employers who misclassify can underbid the legitimate employers who provide coverage for their employees.  The practice of misclassification shifts the burden of paying workers’ compensation insurance premiums onto those employers who properly classify their employees.  It has the further effect of destroying the fairness and legitimacy of the contract bidding process.  The same national study (Planmatics, 2000) reported that many previously misclassified workers were later added to their company’s worker’s compensation policy by their employer after they were injured, resulting in the payment of benefits even though premiums had not been collected.

• Based upon the statewide average worker’s compensation insurance premium rates published by the State of Illinois, we estimate that, on average, $96 million annually of worker’s compensation premiums were not properly paid for misclassified workers.  
• Worker’s compensation premiums are much higher in the construction industry.  In Illinois the statewide rate for all industries is less than $3.00 (per $100 of payroll).  However, within construction, rates can range from $8.01 for electrical wiring to $27.94 for concrete construction.  Using an average premium rate of $10 per $100 of payroll, we estimate an annual average of $23 million of worker’s compensation premiums were not properly paid by construction employers in Illinois.  Using a higher average premium rate of $15 per $100 of payroll, we estimate this average annual amount to be $35 million.

Concluding Remarks

• Misclassification of employees has a negative financial impact on individual workers, the Illinois state government, and the private sector in Illinois.  The workers are directly impacted by being denied the protection of various employment laws and by being forced to pay costs normally borne by employers. State income tax revenues and the unemployment insurance system in Illinois are adversely affected.  Misclassification also imposes additional costs on honest employers who play by the rules, on taxpayers, and the public at large.  Furthermore, the operation of fair, competitive markets is profoundly compromised when the bidding process is undermined by the practice of misclassification.  Illinois will stand to benefit from better documentation of misclassification, from adopting measures that help to improve compliance with state statutes and from targeting employers who intentionally and repeatedly misclassify their employees.

Reccommendations

As a beginning, we recommend the following steps for consideration by policy makers and public officials in Illinois: (1) the Legislature empower the IDES to perform “targeted” audits on problem employers like those done in other states,[3] (2) develop meaningful penalties to deter those employers who intentionally and/or repeatedly violate state laws on misclassification, (3) seek to align the three different definitions for what constitutes an “independent contractor” currently applied by the IDES, the Department of Revenue and the Worker’s Compensation Commission, and (4) review current authorities and procedures for the sharing of information among state agencies so that violations of state statutes will receive a comprehensive and coordinated response with the intent of recovering all payroll-related funds that are due and of deterring future willful violations.

[1] In a report by the National Employment Law Project, it was reported that US DOL quarterly audits found 30,135 employees misclassified in 2002.  This was a 42% increase from the prior year. 

[2] According to the Illinois Department of Employment Security, the average number of employers over 2001-2005 was 34,954 in construction and 319,054 in all industries.  In 2005, there were 36,154 construction employers and 326,945 in all industries.  These numbers exclude local, state, and federal government.

[3] Targeted audits are those audits identified where a higher degree of misclassification may be observed.  For example, targeted audits might be audits of employers with (1) delinquent filings or (2) multiple delinquent quarters of unemployment insurance due.  Planmatics (2000) encouraged states to maintain audit selection criteria that reflect potential noncompliance (e.g. high employee turnover, type of industry, and prior reporting history).