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 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2017-2021 2017-2026
Change in Revenues 47.1 73.7 76.6 79.5 82.5 85.6 89.0 92.6 96.3 100.5 359.4 823.2

Source: Staff of the Joint Committee on Taxation.

This option would take effect in January 2017.

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 self-employment income in HI taxes. Unlike the payroll tax for Social Security, which applies to earnings up to an annual maximum ($118,500 in 2016), the 2.9 percent HI tax is levied on total earnings.

Workers with higher earnings are also subject to a surtax on all earnings above a certain threshold: $200,000 for unmarried taxpayers and $250,000 for married couples who file jointly. At those thresholds, the portion of the HI tax that employees pay increases by 0.9 percentage points, to a total of 2.35 percent. 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, spending for the HI program has 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 generally continue to fall until the HI trust fund is exhausted in 2026.

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 who file jointly), the HI tax on earnings that exceed 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 $823 billion over the 2017–2026 period, the staff of the Joint Committee on Taxation estimates. (The estimate includes the reduction in individual income tax revenues that would result as some labor compensation shifted from a taxable to a nontaxable form.)

The main argument in favor of 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. Another argument in support of the option is that an increase in the tax rate would be simpler to administer than most other types of tax increases because it would require 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 they would be in the absence of the higher tax rate.

Another disadvantage of the option is that it 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-income taxpayers 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.