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

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

(Billions of dollars) 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2014-2018 2014-2023
Change in Revenues 44 73 77 82 87 91 95 99 103 108 363 859

Source: Staff of the Joint Committee on Taxation.

Note: This option would take effect in January 2014.

The primary source of financing for Hospital Insurance (HI) benefits provided under Medicare Part A is the HI payroll tax. The basic HI tax is 2.9 percent of earnings: 1.45 percent is deducted from employees’ paychecks, and 1.45 percent is paid by employers. Self-employed individuals generally 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 ($113,700 in 2013), the 2.9 percent HI tax is levied on total earnings.

Under the Affordable Care Act of 2010, a surtax on earnings above $200,000 went into effect beginning in 2013. At that earnings threshold, the portion of the HI tax that employees pay increases by 0.9 percentage points—to a total of 2.35 percent. (For a married couple filing an income tax return jointly, the surtax applies to the couple’s combined earnings above $250,000.) The surtax does not apply to the portion of the HI tax paid by employers, which remains 1.45 percent of earnings, regardless of how much the worker earns.

In recent years, expenditures for the HI program have grown at a much faster pace than revenues derived from the payroll tax. Since 2008, expenditures for HI have exceeded the program’s total income—including interest credited to the Hospital Insurance Trust Fund—so balances in the trust fund have declined. The Congressional Budget Office projects that the balances will continue to fall and that the HI trust fund will be exhausted in the mid-2020s.

This option would increase the basic HI tax on total earnings by 1.0 percentage point. The basic 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 earnings above $200,000 ($250,000 for married couples filing jointly), the HI tax on earnings in excess of the surtax threshold would increase from 3.8 percent to 4.8 percent; employees would pay 2.85 percent, and employers would pay the remaining 1.95 percent.

If implemented, the option would increase revenues by $859 billion over the 2014–2023 period, the staff of the Joint Committee on Taxation projects. (The estimate includes 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 receipts from the HI payroll tax are currently not sufficient to cover the cost of the program, and increasing that tax would shrink the gap between the program’s costs and the revenues that finance it. 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. CBO projects that, under current law, the actuarial imbalance for the HI trust fund over the next 75 years would be 3.3 percent of taxable payroll, which is the difference between projected income (3.6 percent of taxable payroll) and projected costs (6.9 percent of taxable payroll). Eliminating a gap of that size would require, for example, immediately increasing the basic HI payroll tax rate from its current 2.9 percent to 6.2 percent or immediately cutting spending on Part A by almost one-half. Raising the HI tax by 1 percentage point would delay the exhaustion of the HI trust fund by more than a decade and would reduce the long-term gap between projected income and projected costs by almost a third. Another argument in support of the option is that an increase in the payroll tax rate would be simpler to administer than most other types of tax increases because it would require only relatively minor changes to the current tax system.

A drawback of the option is that it would encourage people to reduce the hours they work or to shift their compensation away from taxable earnings to nontaxable forms of compensation. 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.

In addition, this option would increase the tax burden of lower-income workers relative to that of workers with higher income. That is because a larger share of the income of lower-income families is, on average, from earnings that are subject to the HI tax. As a result, a percentage point increase in the HI tax would represent a greater proportion of the income of lower-incometaxpayers than would be the case for higher-income taxpayers. Moreover, because the option would not make any changes to the Medicare program, the increase in the tax burden would not be offset by greater Medicare benefits when people reached the age of 65.