The Relation between Payroll and Income Tax Avoidance

Abstract

ABSTRACT Payroll taxes, such as contributions mandated through the Federal Insurance Contributions Act (FICA), are a considerable expense for businesses and a large source of government revenue. Despite the significant cost, little is known about the determinants of payroll tax avoidance. By misclassifying employees as independent contractors, firms can avoid their portion of FICA contributions and other employee-related costs. This paper uses publicly available Wage and Hour Division (WHD) compliance action data from the U.S. Department of Labor (DOL) to identify employee misclassification and examine whether firms that avoid income taxes also avoid payroll taxes. This study documents two main results. First, firms with higher CashETR, indicating lower income tax avoidance, are more likely to have Fair Labor Standards Act (FLSA) violations detected during a WHD audit. Second, firms increase their CashETR following the discovery of FLSA violations, indicating a reduction in income tax avoidance. Data Availability: The data that support the findings of this study are available from the U.S. Department of Labor's Wage and Hour Division. JEL Classifications: H25; H26; K31; K34.