Increase the Payroll Tax Rate for Medicare Hospital Insurance by 1 Percentage Point

The primary source of financing for Hospital Insurance (HI) benefits provided under Medicare Part A is the HI payroll tax. The HI tax is currently 2.9 percent of earnings, half of which is deducted from employees' paychecks and half of which is paid by employers. Self- employed individuals pay 2.9 percent of their net income in HI taxes. Unlike the payroll tax for Social Security, which applies to earnings up to an annual maximum ($106,800 in 2011), the HI tax is levied on total earnings.

Under the Patient Protection and Affordable Care Act of 2010 (Public Law 111-148), the portion of the HI tax that employees pay will increase by 0.9 percent of earnings in excess of $200,000, beginning in 2013. For a married couple filing an income tax return jointly, the surtax will apply to the couple's combined earnings above $250,000.

In recent years, expenditures for the HI program have grown at a much faster pace than revenues derived from the payroll tax. The Congressional Budget Office estimates that, in fiscal year 2011 and in most years thereafter, expenditures for HI will exceed the program's total income (including interest credited to the trust fund), which will necessitate that balances in the HI trust fund be drawn down. CBO projects that the balances will fall sharply during the 10-year budget period and will be exhausted in 2021.

This option would replace the 0.9 percent surtax on high-income taxpayers with a 1.0 percentage point increase in the total HI tax on all earnings. The HI tax rate for both employers and employees would increase by 0.5 percentage points to 1.95 percent, resulting in a combined rate of 3.9 percent. The rate paid by self-employed people would also rise to 3.9 percent. For taxpayers with income above $200,000 ($250,000 for married couples filing jointly), the portion of the HI tax that employees pay on income in excess of the surtax threshold would effectively be reduced from 2.35 percent to 1.95 percent; the portion that employers pay would increase from

1.45 percent to 1.95 percent. If implemented, the option would increase revenues by $286 billion over the 2012-2016 period and by $651 billion over the 2012-2021 period. (The estimates include the reduction in individual income tax revenues that would result from a shift of some labor compensation from a taxable to a nontaxable form.)

The main argument for the option is that the HI payroll tax is currently not sufficient to cover the costs of the program, as indicated by the prospective insolvency of the HI trust fund. Increasing that tax would boost the revenues that flowed to the HI trust fund to a substantial degree and keep the fund solvent for a longer period. A commonly used measure of the long-term financial status of Medicare Part A is the actuarial balance--that is, the present value of revenues (primarily from payroll taxes) plus the current trust fund balance minus the present value of outlays for the program and the desired trust fund outlays (one year's worth) at the end of a specified period.1 CBO projects that the actuarial imbalance for the HI trust fund over the next 75 years is 2.4 percent of taxable payroll, which is the difference between projected income-- 4.2 percent of taxable payroll--and projected costs--6.5 percent of taxable payroll. Eliminating a gap of that size would require, as an example, either an immediate increase in the HI payroll tax rate, from its current 2.9 percent to 5.3 percent, or an immediate cut of about one-third in spending on Part A. By raising the HI tax by 1 percentage point for most people (and by 0.1 percentage point for higher-income individuals), the option would delay the exhaustion of the HI trust fund by several decades but would not entirely eliminate the long- term gap between projected income and projected costs.

Another argument in favor of the option concerns tax administration. An increase in the overall payroll tax would be simpler to administer than the surtax that will go into effect in 2013. Another advantage of the option is that it would eliminate the marriage penalties that will result after the new surtax goes into effect. Under the surtax, two single people can each earn up to $200,000-- for a combined total of $400,000--without becoming subject to the higher tax rate in 2013. However, if they were to marry, the two workers would be subject to the surtax on their combined earnings in excess of $250,000. Because the HI payroll tax is based on individual earnings, increasing the HI tax rate--instead of imposing the surtax--would eliminate that penalty.

The option would have several drawbacks. When the surtax goes into effect in 2013, it will encourage taxpayers with income above the thresholds to reduce the hours they work or to shift their compensation away from tax- able earnings to nontaxable forms of compensation. Increasing the HI tax rate, as called for under the option, would extend those disincentives to all workers. When employees reduce the hours they work or change the composition of their earnings, economic resources are allocated less efficiently than would be the case in the absence of the higher tax rate.

Another drawback of the option is that an increase in the HI payroll tax rate, combined with the elimination of the surtax, would be relatively more burdensome for low- and middle-income workers than for higher-income earners. First, low- and middle-income workers and their employers would face larger rate increases relative to current law than would higher-income earners (whose rates have just increased as a result of the health care legislation) and their employers. Second, taxable wages make up a smaller proportion of income for higher-income earners than for low-and middle-income workers. Although all workers would pay the same percentage of earnings in HI taxes, higher-income households would pay a smaller percentage of their total income because those households derive a greater share of income from sources other than wages (such as capital income and rental income), which are not subject to the HI payroll tax.