A hotshot computer consultant in Pennsylvania hung out her “shingle” on LinkedIn in 2011 in hopes of attracting business. A technology referral firm, impressed with her profile, asked her to join their roster of talent available for assignments. Soon the firm connected her with a client. She delivered what was needed. She billed the middleman for her time. The firm in turn billed the client.

Everyone was happy: The client got great advice; the hotshot was paid well; the referral company earned a commission. What’s not to like? A lot, according to the Pennsylvania Labor Department, which two years later was chasing the referral firm for what it says were unpaid unemployment insurance taxes, plus penalties and interest. The referral firm’s alleged crime? Not treating the hotshot as an employee in order to avoid paying employment taxes.

Welcome to the arcane but consequential fight over who is an “independent contractor” and who is an “employee”—a collision between Depression-era labor laws and Internet age professionals that’s throwing a wrench into the way millions of talented Americans want to work. There’s nearly nothing companies fear more than regulatory uncertainty that could result in unexpected tax bills down the road, so the crusade to reclassify consultants as “employees” means that now independent professionals often don’t get hired in the first place. And with 50 states applying their own subjective standards and definitions for these categories, this uncertainty is only compounded, to the point where its hard for even diligent companies to be confident their arrangements won’t be questioned after the fact. On the talent side, moreover, independent contractors who end up being recast against their will as employees risk having their own tax planning and business expenses (for things like home offices, for example) disrupted. (Disclosure: One of us co-founded and is CEO of a firm which works with independent talent interested in project-based work; the other is a lawyer focusing on helping businesses properly engage talent.)

To be sure, there’s some abuse of the rules governing what qualifies as freelance work, particularly at the low-paid end of the labor market; powerless workers (landscapers are one example) are sometimes taken advantage of by companies or staffing firms who hide behind “independent contractor” status to avoid extending basic protections for injury or pay, or against discrimination. But by interfering in the relationship between professionals who want to work independently and companies who want to tap their talents, governments are unwittingly hurting growth, incomes, and innovation. Fixing this will require policymakers to update the mental model of work that informs our antiquated labor laws.

Seeing why requires a little history. Prior to the 1900s, the question of who was an employee and who an independent contractor wasn’t really important. There were no taxes to be withheld from “wages,” no Social Security, Medicare, or unemployment benefits to be paid by the government, and no protections for “employees” such as the minimum wage or worker’s compensation. All this changed when landmark laws such as the Social Security Act and Fair Labor Standards Act were first enacted in the 1930s. But the definition of “employee” was murky. In one famous early case, for example, the Supreme Court explained, “The word [employee] is not treated by Congress as a word of art having a definite meaning. Rather it takes color from its surroundings in the statute where it appears … which must be read in the light of the mischief to be corrected and the end to be attained.”

If that sounds like a formula for uncertainty, it was. Looking for a more predictable way to distinguish between employees and independent contractors, government agencies and courts eventually borrowed heavily from nineteenth-century concepts of master and servant. Every law student knows the case from first-year torts: If a master sends his servant to pick up coal at the rail station and the servant injures a third party while engaged in that endeavor, the master can be held liable for the injuries. This waffly test worked OK from the Depression through the post-war industrial era, but it starts to fail in today’s economy, in which complex modern firms routinely assemble teams comprised of both full time employees and independent consultants.

This trend of mixing employees and contractors will only continue. More and more people today are choosing to be independent contractors because they want greater flexibility and control over their lives. For example, in a 2013 survey conducted by oDesk, more than half of the professionals that had both a “regular” job and also freelanced as an independent contractor on the side responded that they planned to shed their regular job and only work as an independent contractor within the next two years. Increasingly, these workers are typically highly educated and independent-minded, dubbed “SuperTemps” by one of us in the Harvard Business Review. These workers are not an aberration, but a growing component of the modern labor force. Needless to say, the idea that this vocal group’s livelihood is being put at risk by archaic legal categories is a source of resentment and anger that politicians will be hearing more about.

Truth is, the prime motive for reclassifying independent professionals today is not about legal theory or fears of worker abuse. It’s about money. The Obama Administration claims that cracking down on worker misclassification could generate an additional $7 billion in federal taxes over the next decade. Many state governments similarly view reclassification of independent contractors as a cheap way to raise millions in “unpaid” taxes. The last time the IRS figured out how much money they were “losing” was in 1984, when it estimated the tax loss at $1.6 billion (which would be about $3.7 billion in 2014 dollars). The IRS has been working on updating those numbers, which should be out next year.

But if their income is their income, no matter what a worker is called, how can there be such a “tax gap”? The answer is that governments believe independent contractors systemically underreport their income; employees whose taxes are withheld from their paychecks obviously can’t.

Even if we were to jump to the far-fetched conclusion that all independent professionals are tax cheats, there’s a better way forward. The suspected revenue problem can be solved without upending business models that many industries—from taxis, tutoring, and translation to website and graphic design—have used for decades.

Rather than second-guessing the relationships between businesses and independent contractors and meddling in their financial arrangements, we should simply require independent contractors to register their “business” with the IRS and state agencies. This would assure greater transparency for both businesses and governments. We could also develop income withholding and tax reporting norms that better reflect how independent contractor relationships function.

Technology can help. Say you take a cab ride that costs $60 and you pay by swiping your credit card through Square. The technology exists, but not the current systems, to allow that $60 payment to be automatically reported to the IRS, and for a proper amount of withholding to be deducted. In this case, if $1 is Square’s merchant fee, and $59 goes to the cab driver, that $59 could be further segregated so that, for example, $57.23 goes to the driver’s account and $1.77 goes to the IRS to cover taxes. Voila! In fact, this idea—a 3 percent withholding on some independent contractors—was enacted in 2006 but then repealed before it went into effect because of complaints, raised during the Great Recession, that it would harm economic growth and would be too administratively burdensome. Innovations like this would meet the government’s needs without harming the business relationship between the principal and contractor because the reporting and remittance issues would disappear.

The bottom line is that with a growing swath of the American workforce looking to work more independently (and firms naturally wanting to tap this talent pool), government shouldn’t be a barrier based on outdated assumptions about how work is organized. Innovators like those at The Freelancer’s Union, a group organizing the self-employed, are championing reforms to extend traditional employee-style benefits and protections to independent professionals while still honoring modern choices as to how they want to work. For now, the independent contractor conundrum is a classic case of old ways of thinking stopping a sensible evolution of work that both workers and firms desire—and a reminder (as with employer-based health care generally) that America is still in the grip of a tax and benefit system designed around the norms of the last century.

Image via shutterstock.

Freelance Workers Are Our Future. So Why Are We Penalizing Them?

By Jody Miller and William Hays Weissman

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