Illegal Worker Misclassification:
Payroll Fraud in the District’s
Construction Industry
Karl A. Racine
Attorney General
for the District of Columbia
oag.dc.gov
September 2019
Issue Brief and Economic Report
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 1
ISSUE BRIEF
Illegal Worker Misclassification:
Payroll Fraud in the District’s Construction Industry
Misclassifying Workers as Independent Contractors Harms Workers, the Industry,
and the District
INTRODUCTION
Illegal worker misclassification is a practice that seriously harms some of the District’s workers, law-
abiding businesses, and the public. Illegal worker misclassification is a form of payroll fraud where
employers classify workers who should be considered direct employees as independent contractors.
This practice allows the employer to avoid paying important taxes and following crucial employment
laws. It is rampant in the District’s construction industry, and it has serious consequences for the District
and its residents:
• Misclassified workers lose basic employee protections like minimum wage, overtime, and paid
sick leave. They are denied participation in important programs like unemployment insurance
and workers’ compensation. And they are left footing the bill for payroll taxes their employers
fraudulently avoid. These burdens often fall heaviest on immigrant and low-wage workers who
are least likely to be willing to risk complaining or enforcing their rights.
• Law-abiding construction contractors lose out on business opportunities when their competitors
illegally undercut them. Employers who misclassify their employees evade labor costs, helping
them squeeze legitimate contractors out.
• The public loses out on important payments that support social insurance programs like Social
Security, Medicaid, unemployment insurance, and workers’ compensation. These are programs
designed to protect all of us, and contractors committing payroll fraud undermine them.
The Office of the Attorney General (OAG) commissioned a study to determine how much labor costs
construction companies avoid—and how much everyone else loses out—when they commit payroll
fraud by misclassifying their employees. We found that:
• The cost evasion of illegally misclassifying workers in the District’s construction industry
begins at 16.7 percent, which companies can use to underbid and undercut high-road
employers.
• Moreover, payroll fraud is rarely committed alone; it is accompanied by wage theft and other
practices to cheat workers out of what they are due. Coupled with even a modest amount of
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 2
wage theft, the cost evasion of doing business illegally can reach 27 percent, a massive amount
in a competitive, bid-oriented industry.
• Further, employers committing payroll fraud rarely pass on the cost savings from
misclassification, like the cost of providing employee healthcare, to their workers. If employers
keep all the money they did not pay in fringe benefits for themselves, the cost evasion of
doing business illegally jumps from 16.7 to 48.1 percent.
Those illegally gotten gains are accrued on the backs of some of the District’s most vulnerable workers,
of contractors trying to operate the right way, and of District taxpayers. That is why OAG is using its
enforcement authority to sue companies committing this kind of payroll fraud and deter illegal behavior.
This Issue Brief describes what illegal worker misclassification is; what our study found about its
significant, detrimental effect on the District and its residents; and what OAG is doing to combat it.
WHAT IS ILLEGAL WORKER MISCLASSIFICATION AND WHERE DOES IT HAPPEN?
Illegal worker misclassification is a form of payroll fraud where employers classify workers who should
be considered direct employees as independent contractors instead. Through unlawfully misclassifying
employees, an employer avoids paying important taxes and following crucial employment laws.
By improperly classifying workers as independent contractors, businesses illegally reduce their labor
costs in multiple ways:
• First, for each misclassified worker, the company evades mandatory payroll taxes that fund
social welfare programs, such as Social Security, Medicare, and unemployment insurance.
• Second, because misclassification fraudulently keeps workers off a company’s official payroll,
employers can illegally reduce other payroll-related costs, such as workers’ compensation
insurance premiums.
• Third, because independent contractors are not subject to overtime laws, employers can
unlawfully avoid providing overtime pay to workers.
By evading these costs, employers can illegally increase profits and also gain an unlawful advantage in
the market.
Misclassification is disturbingly common. While there has not been a District-specific study of the
prevalence of misclassification, the last nationwide study by the Internal Revenue Service found that 15
percent of employers engaged in misclassification, affecting 3.4 million workers and robbing the federal
fisc of $1.6 billion annually (in 1984 dollars).
1
1
Treasury Inspector General for Tax Inspection 2013, Employers Do Not Always Follow Internal Revenue Service
Worker Determination Rulings, at 1, available at
https://www.treasury.gov/tigta/auditreports/2013reports/201330058fr.pdf.
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 3
Unsurprisingly, illegal worker misclassification is most common in industries where committing payroll
fraud gives the most significant undue advantage. For example, industries where work is awarded by
bid, thereby creating significant pressure to keep labor costs down, are ripe for misclassification.
Likewise, misclassification is common in industries with high injury rates, which drive up workers’
compensation insurance premiums. The construction industry fits both descriptions well and is known
for rampant misclassification. One study found that as many as one third of construction workers in
southern states are misclassified.
2
Even in California, with its robust worker protections and
enforcement, one in six construction workers is misclassified.
3
HOW DOES MISCLASSIFICATION HARM WORKERS?
Crucially, misclassification strips workers of key protections to which they are entitled.
• Misclassified workers lose the guarantees of federal and state employment and labor laws.
These include basic protections such as minimum wage, overtime, and paid sick leave; they also
include labor law protections, such as those allowing for organizing and collective bargaining.
• Misclassified workers miss out on important safety net programs and benefits. Those who find
themselves unemployed or injured on the job lose the protection of unemployment insurance
and workers’ compensation—important safety net programs that are especially crucial in high
risk and unstable industries such as construction. When one carpenter was asked if he received
anything for an on-the-job injury, such as medical attention or compensation, he explained that
the only thing he ever got was “more work.” Misclassified workers are also ineligible for
important benefits like paid leave, health insurance, and retirement plans that companies
otherwise provide to employees.
• Misclassified workers are left footing their
employers’ tax bill. In a typical employer-
employee relationship, both employer and
employee pay an equal portion of the
employee’s wages in Social Security and
Medicare taxes. When a worker is misclassified
as an independent contractor, they are
responsible for paying both the employee and
employer share of Social Security and Medicare
taxes. This imposes additional unexpected tax
liability on misclassified workers, who are often
low-wage earners least able to shoulder an
2
Ordonez, Franco, and Many Locke. 2014a. “Immigrants are Most Susceptible to Worker Misclassification.”
McClatchy Washington Bureau, September 5, available at
https://www.charlotteobserver.com/news/business/article9160514.html.
3
Yvonne Yen Liu, Daniel Flaming, Patrick Burns, Economic Roundtable 2014, Sinking Underground: The Growing
Informal Economy in California Construction, at 1, available at https://economicrt.org/wp-
content/uploads/2014/09/Sinking_Underground_2014.pdf
“If the job doesn’t cover it, you have to
pay full taxes. Because they’re not
even doing the taxes. You gotta eat
and save money at the end of the day
to pay taxes.”
– Padison Alberto Vargas, carpenter
who experienced misclassification and
wage theft
“
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 4
extra cost. In addition, workers may not understand their tax responsibilities, especially where
employers refuse to provide them with the appropriate tax forms. In such circumstances,
workers may later become ineligible for Social Security and Medicare, both of which require
regular tax contributions over time.
HOW DOES MISCLASSIFICATION HARM THE INDUSTRY?
Misclassification also takes a toll on businesses who attempt to operate legally. This is especially so in
industries like construction, where work is procured through a bidding process. By unlawfully
misclassifying workers and avoiding labor costs, a business can underbid lawfully operating companies,
squeezing them out of potential business opportunities. Misclassification can also prompt other
companies to improperly cut corners and avoid costs themselves. For example, because costs for
materials and permits are more fixed, contractors may consider cutting safety measures or depressing
worker pay and benefits. On-the-fence contractors may start misclassifying their own workers. In this
way, misclassification can spread from a few bad apples, creating the risk of forming an industry
standard practice.
HOW DOES MISCLASSIFICATION HARM THE PUBLIC?
Finally, misclassification cheats the public out of resources for important social insurance programs.
• Social Security and Medicaid lose significant resources. By committing payroll fraud, a would-
be employer shirks their responsibility to pay into Social Security and Medicare, putting the
burden of paying their portion on workers who may be ill-equipped to do so. If workers don’t
take up this unfair burden, then taxpayers are cheated out of the benefits of these programs.
• State-run unemployment insurance programs go underfunded. Employers also avoid paying
contributions to unemployment insurance programs, which protect workers who become
unemployed through no fault of their own.
• Workers’ compensation premiums go
unpaid. Since employers avoid covering
misclassified workers under their workers’
compensation insurance, the public may
end up footing the bill for medical care
and disability for low-income, uninsured
workers.
contractors making profit from taxpayers’
money, but they don’t contribute to the
system.”
“
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 5
WHAT WE FOUND: THE EFFECT OF ILLEGAL MISCLASSIFICATION ON DISTRICT WORKERS,
BUSINESSES, AND THE PUBLIC
OAG commissioned a research report to determine the costs a construction contractor in the District
can evade by illegally misclassifying its workers. Importantly, this report primarily considers only the
costs of misclassification, not the full range of illegal practices that typically accompany misclassification
(and that are discussed in more detail below).
Our main finding is that a construction contractor in the District can reduce their labor costs by 16.7
percent through the act of unlawfully misclassifying workers as an independent contractors alone.
This comes from foregone payments to workers and avoiding tax and social insurance payments. For
every $100 a misclassifying employer pays in labor costs, it saves $11.50 in payments to the worker by
not paying overtime and shifting the burden of payroll taxes to the worker. The misclassifying employer
avoids an additional $5.20 by not paying unemployment insurance taxes and reducing its workers’
compensation premium.
In an industry where every dollar counts, a 16.7 percent premium on doing business legally is significant.
Holding all else equal, this gives law-breaking contractors a marked advantage over high-road employers
who play by the rules. And it generally puts substantial pressure on industry players to cut corners in
safety or labor costs or, worse, to likewise misclassify their workers.
Stunningly, the 16.7 percent advantage contractors gain from illegally misclassifying their workers is just
the beginning of the costs they can evade—and the harm they can do—by skirting workplace laws. The
report makes conservative assumptions to measure the impact of misclassification in isolation. But
rarely is misclassification committed by itself: It is often accompanied by other practices like wage theft
(failing to pay owed wages, overtime, or minimum wage) and failing to offer fringe benefits that would
otherwise be provided to employees. These practices quickly change the economics of the construction
business even further. For example, our report makes the following findings:
• If illegally misclassified workers experience even a modest amount of wage theft, receiving
only 90 percent of the average hourly wage of legally classified workers, then the cost reduction
for doing business illegally jumps from 16.7 to 27 percent. To put this in context, misclassified
workers in the carpentry business have found themselves working for less than one third of the
advertised hourly wage.
• Legally classified workers often receive several employer-provided benefits, such as paid leave,
health insurance, and retirement benefits. The report assumes that the misclassified worker
receives the full value of these benefits in the form of additional wages. Making a more realistic
(but still very conservative) assumption, if misclassified workers receive only half the value of
the fringe benefits to which they ought to be entitled, the cost reduction of doing business
illegally jumps from 16.7 to 48.1 percent.
These quickly mounting numbers demonstrate the strong incentive for contractors to combine the
practice of illegally misclassifying their workers with other practices that further diminish worker pay
and protections. The more low-road businesses engage in these practices, the more they undermine the
market, making it difficult for high-road businesses to operate legally in the District. And the more
construction companies make misclassification a regular business practice, the more District and federal
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 6
social safety net programs get drained, and the more workers lose out on pay, benefits, and protections
owed to them.
HOW IS OAG FIGHTING ILLEGAL WORKER MISCLASSIFICATION?
Given the substantial incentives to misclassify workers, enforcement agencies must create a significant
deterrent effect to ensure compliance with the law. Unfortunately, although the federal repercussions
of misclassification are felt in the tax system, the Internal Revenue Service has very little power to
address it. Under the “Safe Harbor Rule,” Section 530 of the Revenue Act of 1978, to avoid any tax
consequences from misclassification, a company must only show a reasonable basis for classifying
workers as independent contractors, including that it has always structured its work this way or that it is
a practice that is widespread in the industry. If it does so effectively, it can freely avoid any penalties.
Meanwhile, private lawsuits to enforce
misclassification laws are important but can
have limited effectiveness. It can be hard for
workers, particularly immigrant workers
concerned about their immigration status, to
come forward and fight a company. Those who
do often need the pay that they have been
denied for so long, creating pressure to settle
with the company and compromise the value
of their claim. These infrequent and low-dollar settlements can be written off by companies as the cost
of doing business illegally.
In the face of these challenges, the District government has filled the void. In 2013, the Council of the
District of Columbia passed the Workplace Fraud Amendment Act to combat this very problem in the
construction industry. This law provides that in most circumstances, construction workers are
considered employees. And should an employer seek to classify a worker as an independent contractor,
the employer must show that the worker is free from the employer’s control, is economically
independent, and performs work outside the scope of the employer’s core business. OAG has the
authority to take construction companies to court for illegally misclassifying their workers, and recover
penalties and restitution to enforce the law.
OAG currently has two attorneys in its Housing and Community Justice Section focused on workplace
justice and who are actively pursuing enforcement actions against companies who appear to be illegally
classifying their workers. In August 2018, OAG sued Power Design, Inc.—a national electrical
subcontractor that does extensive business in the District—and related companies for misclassifying
over 500 electrical workers, as well as for related violations of the minimum wage, overtime, sick leave,
and unemployment insurance laws. Power Design used a labor structure found throughout the District’s
construction industry. Instead of hiring employees to do electrical work, it contracted with third-party
subcontractors, who in turn hired hundreds of workers—all classified as “independent contractors” —to
complete projects at Power Design worksites. These workers functioned in every way like employees of
Power Design and should have been treated accordingly, with all the protections employee status
provides. OAG’s suit seeks statutory penalties under the Workplace Fraud Act as well as damages,
“We’re all immigrants, they know that we need
the work and that we won’t say anything.”
– Anonymous electrician who experienced
misclassification, wage theft, and unsafe working
conditions
“
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 7
liquidated damages, and penalties for violations of an array of other employment law violations. In
addition to this lawsuit, OAG is actively investigating similar misclassification schemes in the
construction industry that illegally keep workers off the books and unprotected.
OAG seeks to continue affirmatively protecting the rights of workers in the District of Columbia. Workers
who believe that they have been illegally misclassified or experienced other forms of wage theft can
contact OAG’s Housing and Community Justice Section by phone at (202) 442-9854. Workers can also
learn about their rights under District of Columbia law and how they can get help if their rights are being
violated at https://oag.dc.gov/workers-rights.
ECONOMIC ANALYSIS
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 9
ECONOMIC ANALYSIS
Economic Analysis of Incentives to Fraudulently Misclassify Employees in
District of Columbia Construction
Dale Belman and Aaron Sojourner*
May 22, 2019
EXECUTIVE SUMMARY
This Report analyzes the cost savings to construction companies generated by worker misclassification
prohibited by the District of Columbia’s Workplace Fraud Act (WFA), D.C. Code § 32-1331.01, et seq.
We develop estimates of how much higher a typical D.C. construction company’s labor costs would be if
they pay their employees legally compared to their costs if they fraudulently misclassify employees as
independent contractors. We assume that the cost of basic hourly labor compensation paid in either
case is equal. Cost differences are generated by evading or shifting overtime pay, taxes, and legally-
required social-insurance contributions under fraudulent misclassification. Under these conservative
assumptions, a company employing workers legally would incur 16.7% higher costs than if the company
fraudulently misclassified its employees. The total impact is split as 11.5% in reduced worker take-home
compensation and the other 5.2% from evaded publically-mandated payments toward Social Security,
Medicare, unemployment insurance, and workers’ compensation systems. These estimates likely
understate the economic differences between operating legally and fraudulently. Less-conservative but
realistic assumptions result in larger savings to companies and greater losses to misclassified employees
and the public. For instance, if the company does not pass through any of the value of typical employee
benefits to misclassified employees, then operating legally costs 48% more per worker-hour than
operating fraudulently. If fraudulently-misclassified workers experience some wage theft and receive
only 90 percent of the average hourly wage of legally-classified workers, then this single change from
the baseline scenario increases the estimated legal-cost premium to 27%. General contractors and
developers can share in the gains from the company’s fraudulent misclassification. This kind of fraud
undermines the ability of law-abiding companies to survive.
* Belman is a professor at the School of Human Resources and Labor Relations at Michigan State
University. Sojourner is an associate professor at the Carlson School of Management at the University of
Minnesota.
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 10
INTRODUCTION
This Report provides a generalized analysis and valuation of (i) the cost savings to construction
companies generated by worker misclassification prohibited by the District of Columbia’s
Workplace Fraud Act (WFA), D.C. Code § 32-1331.01, et seq.; (ii) economic loss to the District of
Columbia resulting from WFA violations; and (iii) economic loss to misclassified workers
resulting from WFA violations. To accomplish this, we evaluated general payroll costs
associated with operating in the construction industry in the District of Columbia and analyzed
general cost savings generated by failing to comply with the WFA. Our findings and conclusions
are summarized in this Report.
Our analysis is designed to inform assessment of savings derived from fraudulent
misclassification in cases of WFA violations with limited financial information available. The
Report answers the question: for each dollar paid to a construction company that is
fraudulently misclassifying employees, how would the division of economic value between the
company, its workers, the general contractor and developer, and the public treasury differ if
the company were legally classifying its workers as employees? We use public information
sources to estimate the company savings realized through misclassification of employees.
MODEL
The core of our economic analysis takes the perspective of a typical construction company
operating in D.C. and deciding whether to legally classify an hourly worker as an employee or to
fraudulently misclassify the employee as an independent contractor. First, we model the key
economic parameters and how they affect the flow of resources to different parties. We build
an example. This yields conclusions about the economic impacts of fraudulent misclassification
per hour of work. Second, we reframe the example so the impacts are posed per dollar of a
fraudulent labor contract. Third, we consider how to incorporate additional factors into the
analysis.
Typical impacts per hour of work
Consider the typical flow of resources if the company classifies its employee legally (see Table 1:
“Legally” column). Based on the best-available data, we make the following assumptions, which
are reflected in Table 1.
• Hourly Pay (Post-SS&M). Construction employees earn $24.92 per hour in wage and
salary income on average in the Washington, D.C. area.
1
The employee will have $1.96
1
U.S. Bureau of Labor Statistics. Occupational Employment Statistics for workers in construction and extraction
occupations in the Washington-Alexandria-Arlington metropolitan area in May 2018.
https://www.bls.gov/oes/current/oes_47894.htm#47-0000
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 11
(7.65 percent of regular and overtime pay) deducted towards Social Security and
Medicare taxes (SS&M), making the employee’s post-deduction hourly wage $23.01.
The company will pay another $1.96 (7.65 percent) to Social Security and Medicare as
the employer contribution without it showing up on the employee’s pay stub.
• Hourly Overtime Pay (Post-SS&M). A typical construction worker earns an average of
$0.76 per hour in overtime pay. Of this amount, $0.70 goes to the worker and $0.06
goes to the employee share toward Social Security & Medicare taxes.
2
• Hourly Tax-Exempt Benefit Costs. A typical construction worker earns an additional
$7.48 in benefits that include overtime pay, paid leave, supplemental pay, health
insurance, and employment-based retirement benefits.
3
After separating out overtime
pay as set out above, the balance, excluding overtime pay, equals $6.72. We will refer to
this balance as “benefits.” Benefits are exempt from taxes and social insurance
contributions.
• Social Insurance Costs. As discussed above, the employer and employee each pay taxes
of 7.65 percent of the employee’s hourly pay (including overtime) toward SS&M. In
addition, the employer will pay for two legally-required forms of social insurance:
workers’ compensation and unemployment insurance. We estimate each contribution
at 5 percent of gross hourly wage costs, including overtime ($1.28 per hour each).
4
,
5
If a company bids on a contract assuming that workers will be paid as legally classified
employees, this implies a typical hourly labor cost totaling $36.91. The worker takes home
2
Construction workers employed full time typically work 42.6 hours per week, implying a 50-percent overtime pay
increase required on 6.1 percent of hours (2.6/42.6), according to the U.S. Bureau of Labor Statistics Current
Population Survey (https://www.bls.gov/cps/cpsaat21.htm).
3
The total of these four types of benefits equal 30 percent of wage and salary compensation for construction
workers nationally according to the U.S. Bureau of Labor Statistics Employer Costs of Employee Compensation data
(https://www.bls.gov/news.release/archives/ecec_12142018.htm). This share is similar between the U.S. and the
Washington metro area among all workers (https://www.bls.gov/opub/mlr/cwc/bls-introduces-new-employer-
costs-for-employee-compensation-data-for-private-industry-workers-in-15-metropolitan-areas.pdf).
4
Although workers compensation insurance is frequently purchased from private insurers, it is usually considered
social insurance because, similar to unemployment insurance or Social Security, it is required by state or federal
statute, addresses a failing of the private market, and is intended to improve social welfare broadly defined. In
some states, state agencies are the workers’ compensation provider of last resort. Workers’ compensation
premiums in construction are higher than for the average employer due to the higher risk of occupational injury
and experience rating of employers. A premium quote site, workerscompensationshop.com, provides hourly
premium ranges for D.C. employers of construction labor. The midpoint of the range for employees doing electrical
wiring is 3.74%, tile installation is 4.40%, flooring is 4.49%, HVAC installation is 4.51%, painting is 5.55%, carpentry
is 5.58%, plumbing is 5.64%, and concrete construction is 7.07%. We assume a 5 percent workers’ compensation
premium, which is in the middle of these estimates.
5
Unemployment insurance taxes for construction are higher than average. The average is 2.7 percent (District of
Columbia Department of Employment Services Unemployment Insurance Handbook for Employers, April 11, 2016,
page 15). We assume a 5 percent rate, just below twice the average rate.
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 12
$30.43 per hour in pay and benefits after accounting for the employee’s Social Security and
Medicare contribution. The balance, $6.48, goes toward costs of legally-mandated social
insurance.
Table 1: Typical flow of resources per hour of work by legal status of employment
Company classifying employee:
Legally
Fraudulently
Total: Value to Worker
$30.43
$26.80
Hourly Pay (post-SS&M)
$23.01
$26.80
Hourly Overtime pay (post-SS&M)
$0.70
$0
Hourly Tax-Exempt Benefit Costs
$6.72
$0
Total: Value to Social Insurance Contributions
$6.48
$4.84
SS&M Tax – Employee Share
$1.96
$4.84
SS&M Tax – Employer Share
$1.96
$0
Unemployment insurance tax
$1.28
$0
Workers’ compensation cost
$1.28
$0
Total: Employer hourly labor cost
$36.91
$31.64
Note: SS&M is Social Security and Medicare tax.
How would these flows differ if the company were to hire the hour of labor through fraudulent
misclassification of the employee as an independent contractor? Our analysis rests on two
primary, conservative assumptions.
1. Worker hourly pay under fraudulent misclassification equals the value of a legally-
employed worker’s hourly wage and salary income plus full benefit costs. This
conservative assumption isolates the difference caused by fraudulent misclassification
per se. Later in the Report, we consider the case where the worker does not receive the
full costs of benefits as wages, which magnifies the company’s advantage from
fraudulent misclassification.
2. The company’s savings from misclassification would come from:
a. avoiding paying overtime,
b. shifting employer’s Social Security and Medicare contribution to the worker, and
c. evading workers’ compensation and unemployment insurance costs.
In this case, the worker is paid a pre-tax wage of $31.64, equal to the employee’s pre-tax hourly
wage ($24.92) plus the full value of benefits ($6.72). However, under fraudulent
misclassification, the employer evades its SS&M tax payment. The employee must cover both
the employee and employer payment to Social Security and Medicare on this whole amount,
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 13
totaling $4.84.
6
This leaves a post-SS&M wage of $26.80 per hour for the employee fraudulently
misclassified as an independent contractor (see Table 1: “Fraudulently” column).
Typical impacts per dollar of fraudulent labor cost
Comparing the total hourly labor costs between legal and fraudulent classification of the
employee implies the employer’s hourly costs are 16.7 percent higher ($5.27 per hour) when
operating legally.
7
The $5.27 per hour in fraudulent cost saving comes from a combination of
$3.63 lower worker earnings and $1.64 in lower tax and social insurance payments (see Table 2:
Impacts per dollar of fraudulent labor costs).
Table 2: Impacts per dollar of fraudulent labor cost
Company classifying
employee
Legally
Fraudulently
Legally - Fraudulently
Difference
Dollars
Percent of Total
Fraudulent Cost
Total: Worker
$30.43
$26.80
$3.63
11.5%
Total: Public
$6.48
$4.84
$1.64
5.2%
Total labor cost
$36.91
$31.64
$5.27
16.7%
Put another way, for every $100 in labor cost for a fraudulently-misclassifying company, the
company saves $16.70 in costs relative to what it would have to pay if it operated legally or
relative to what a similarly-productive, law-abiding competitor would pay. This implies an
estimated 16.7 percent legal-cost premium, the percentage increase in costs for operating
legally over fraudulently. Of this 16.7 percent, 11.5 percent comes from lost worker take-home
earnings and 5.2 percent comes from lost tax and social-insurance payments.
This difference creates a strong incentive for companies to operate fraudulently. Companies
operating fraudulently can easily underbid those operating legally. It also creates a strong
incentive for general contractors and developers to turn a blind eye to fraud.
Distribution of the gains from fraudulent misclassification
Where do these fraudulently-saved dollars go? We assume a workflow involving three parties:
the fraudulently-misclassifying company, the general contractor who hired the company, and
6
Note that the SS&M contributions for a misclassified worker are higher than the SS&M contributions for a worker
legally classified as an employee. This is because we assume that a properly classified employee’s tax-exempt
benefits are fully passed through in the form of taxable wages should that worker be misclassified as an
independent contractor—thus increasing the compensation subject to SS&M taxes. We make this assumption to
isolate the per se effect of misclassification. As discussed below, incomplete pass-through of such benefits would
increase the savings associated with misclassifying workers.
7
Legal/Fraudulent hourly cost = $36.91/$31.64 = 1.167 = 16.7 percent higher.
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 14
the developer who hired the general contractor. Through the bidding and negotiation process,
these parties implicitly divide the gains from these evaded costs between themselves. For every
$100 in fraudulent labor cost, the legal cost is estimated at $116.70. This $16.70 difference (L-F)
can be shared in any combination between the company, general contractor, and developer.
Legal cost - Fraudulent cost = Company Gain + General Contractor Gain + Developer Gain
L - F = C + G + D
1 = C/(L-F) + G/(L-F) + D/(L-F) = Company share + General Contractor share + Developer share
For instance, suppose the company bid $105.00, then its gain is $5.00 and its share of the gain
is 29.9 percent.
8
The general contractor gets $11.70 in savings relative to the cost of hiring a
legally-operating company and can share this value with the developer by underbidding any
competing general contractors who would hire competing, law-abiding companies at cost
$116.70. The general contractor can win and cover its costs with any bid between $116.70 and
$105.00, so it has $11.70 to divide between itself and the developer. If they divided it equally,
the general contractor would bid $110.85, claiming $5.85 in general-contractor gain and
yielding $5.85 in gain from cost saving to the developer. The general contractor and developer
shares of gain from the fraudulent operations of the misclassifying company would each be 35
percent.
If a fraudulently-operating company is observed to have a labor subcontract worth $B, this is
the sum of F + C. Auditing the company’s books may reveal evidence about the difference
between the amount paid to the company from the general contractor (B=F+C) and the amount
spent on misclassified labor (F). This difference would be the company’s gain (C).
With an estimate of a company’s fraudulent labor cost (F) in hand, applying the estimated 16.7
percent legality premium gives a basis for estimating economic impacts of fraudulent
misclassification.
If fraud goes undetected and unpunished, standards in the industry can unravel and force law-
abiding companies out of business. Just as the company has an incentive to use fraudulent
misclassification to lower its labor costs so as to win bids, the general contractor has an
incentive to accept the lower bid and pass some of that value to the developer through its bid.
This will disadvantage general contractors who only use law-abiding subcontractors. The
developer, in turn, has an incentive to accept the lower bid from the general contractor who
hires the fraudulently-misclassifying company.
8
$5.00/$16.70 = 0.299.
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 15
Incorporating additional factors
Our approach has been developed with specific, simplified assumptions about how the
construction labor market functions and estimates depend on these assumptions. This section
discusses how to incorporate additional factors into the analysis.
• Incomplete pass through of benefit value: We assumed that misclassified workers would
receive the full value of benefits that would have been earned had that worker been
properly classified. If less than full pass-through occurs, the fraudulent labor cost will be
reduced by lowering both payments to workers and to the public. The difference in
labor cost between legal and fraudulent operations will be larger. For instance, in the
typical case considered above, if only half the value of benefits (half of $6.72) passes
through, then the legal-cost premium almost doubles, from 16.7 percent to 30.5
percent. If none of the benefit value passes through, then the legal-cost premium rises
to 48.1 percent.
• Wage theft: If workers are not paid what they are owed or promised so that the
effective hourly wage when operating fraudulently is below the hourly wage when
operating legally, the fraudulent labor cost decreases by that amount, raising the labor-
cost difference between legal and fraudulent operations. For instance, if a worker
classified fraudulently would receive only 90 percent of the hourly wage that the worker
would if classified legally (90 percent of $24.92), then this one change from the baseline
scenario increases the legal-cost premium to 26.7 percent.
• Materials: If the contract includes nonlabor inputs, then their cost should be deducted
from the value of the bid (B) before estimating labor costs because these material costs
should be similar whether operating legally or fraudulently. In general, the legal-cost
premium will be maximized when the labor share of costs is maximized. Contracts
including material costs will shrink the total-cost difference. Our information suggests
that this rarely occurs, because higher-level contractors usually provide materials to the
companies they hire to avoid paying markups.
• Value of missing insurance: The lack of coverage by workers’ compensation and
unemployment insurance is a significant but difficult to quantify loss to the employee
and to society. The cost of workers’ compensation and unemployment insurance
capture the expected value of the benefit stream triggered by the loss. The absence of
these benefits can impose heavy collateral costs on specific individuals, on their families,
and public institutions. The possible absence of health insurance given incomplete pass-
through of benefits exacerbates this. For example, consider a misclassified worker
lacking workers’ compensation insurance and medical insurance coverage and unable to
pay the cost of medical care after a workplace injury. They will not have income during
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 16
their convalescence. The individual and family will bear these costs along with health
care institutions, social welfare organizations, and public benefit systems (like food
stamps or public housing) that absorb the costs of unreimbursed care and family
support in the face of loss of income. Misclassified employees may also have more
difficulty exercising and enforcing other employee rights, such as those involving
minimum wage, occupational safety and health, concerted activity and organizing, and
protection from discrimination.
• Unfair competition for law-abiding companies: The increase in the proportion of
construction workers who are misclassified as independent contractors impacts how
business is done in the construction industry. Companies that fraudulently misclassify
gain the advantage of reduced labor costs. They are in a position to submit lower bids
than competitors who follow the law. As the number of companies that misclassify
increases, law-abiding companies win fewer bids, and have less work. Over time,
misclassification progresses from a method used by unscrupulous companies to earn
additional profits to the price of survival in the industry. Reducing the use of
misclassified workers provides a level playing field for law-abiding companies.
• Tax payments and off-the-books payments: our model assumes that Social Security and
Medicare taxes are paid in both scenarios. We also implicitly assume that the worker
will pay income taxes out of their earnings in either case. A factor that may contribute
to the violation of these assumptions is if workers are paid completely off the books,
rather than as fraudulently-misclassified independent contractors issued a 1099. With a
1099, the tax authorities have a paper trail and so the audit risk is higher. Without any
documentation, audit risks are lower and incentives to evade taxes are stronger. If
misclassified workers do not pay these taxes, then that value stays with the worker
rather than going to the public. This does not affect the legal-cost premium but does
affect the distribution of value between worker and public. Off-the-books payment may
also indicate legal vulnerability of workers and be associated with increased risk of wage
theft and incomplete benefit cost pass-through.
Illegal Worker Misclassification: Payroll Fraud in the District’s Construction Industry | 17
ABOUT THE AUTHORS
Dale Belman
Belman is a labor economist and professor at Michigan State University in the School of Human
Resources and Labor Relations. He has published in Industrial and Labor Relations Review,
Industrial Relations (Berkeley), Review of Economics and Statistics, Labour, Journal of Business
and Economic Statistics, and Oxford Economic Papers. Along with Paul Wolfson, he was
recognized by Princeton University with the Bowen Prize for the book, What Does the Minimum
Wage Do? (Upjohn, 2014).
Belman completed his Ph.D. in Economics at the University of Wisconsin, Madison in 1986. His
undergraduate work was completed at Bowdoin College. Prior to working at MSU, he was a
professor at the University of Wisconsin, Milwaukee. He has served as president of the
Institute for Construction Economics Research, a non-profit foundation which provides non-
partisan research on topics of concern to construction industry stakeholders.
Aaron Sojourner
Sojourner is a labor economist and associate professor at the University of Minnesota’s Carlson
School of Management in the Department of Work and Organizations. The Economic Journal,
Journal of Human Resources, Journal of Public Economics, Industrial and Labor Relations Review
(ILRR), Management Science, Early Childhood Research Quarterly, and Industrial Relations have
published his work and he serves on the ILRR international editorial board. He received the
John T. Dunlop Scholar Award from the U.S. Labor and Employment Relations Association in
2016, which recognizes emerging scholars for outstanding research contributions to issues of
national significance.
Sojourner has a wide range of policy experience and community service. He spent the 2016-‘17
academic year in Washington, D.C. serving as senior economist for labor for the U.S. President’s
Council of Economic Advisers, established in 1946 to offer the president objective economic
advice on the formulation of economic policy. Previously, he has served on Minneapolis Mayor
Betsy Hodges's Cradle-to-K Cabinet, advising the city on how to reduce racial disparities
through policies affecting children's first 3 years, as a director of Spring Bank, a community
bank in the Bronx and Harlem, N.Y, and as a fellow in the U.S. Senate’s Labor Policy Office.
Sojourner completed his Ph.D. in economics at Northwestern University in 2009. He has a
masters in public policy analysis from the University of Chicago and a bachelors in history from
Yale University.