New 'Medicare' Taxes To Hit Middle Class

By: Robert Graboyes and Douglas Holtz-Eakin

For those who savor perverse policy incentives, the Patient Protection and Affordable Care Act (PPACA) is a gift that keeps on giving.

Today's surprise is a counterintuitive tax that, under certain circumstances, is small for low- to middle-income families, bigger for high-income families, but biggest of all for those caught in the middle.

This tax is especially bad news for small businesses and for people in high cost-of-living parts of the country.

For many years, most of us have paid a Medicare payroll tax of 1.45% on wages and salaries.

But in 2013, the PPACA adds two new "Medicare" taxes. ("Medicare" is in quotes because the two new taxes really have nothing to do with Medicare and simply fund the PPACA's huge insurance expansion.)

Gift Of The MAGI

The first new tax is a payroll surtax — an extra 0.9% on wage and salary income over $200,000 for single filers or $250,000 for joint filers.

The second is a new 3.8% tax on some or all investment income of taxpayers with modified adjusted gross income (MAGI) over $200,000 for single filers or $250,000 for joint filers.

What are the implications of these taxes?

Let's run some numbers. Consider three couples, whom we'll call the Lows (lower-income), the Middles (middle-income), and the Highs (higher-income).

Each has $30,000 in investment income, but the Lows have $100,000 in wage income, the Middles have $230,000 in wage income, and the Highs have $260,000 in wage income.

Thus, their MAGIs (wages + investments) are $130,000, $260,000, and $290,000, respectively.

Suppose one spouse in each couple is offered a more exhausting job for a $10,000 wage increase.

The Lows' wages and MAGI will both remain below the $250,000 cutoff, so their taxes rise only by the existing payroll tax ($145).

The Highs are already well over the threshold for both wages and MAGI. With a $10,000 wage increase, their tax increase will include both the regular payroll tax ($145) and the new surtax ($90), for a total of $235.

With a progressive taxation system, one would imagine that the Middles' tax increase would lie somewhere between $145 and the $235.

In fact, their taxes rise by $525 — more than twice the Highs' increase and more than three times the Lows' increase.

This is because the new investment tax falls on either investment income ($30,000 for the Middles) or the difference between MAGI and the $250,000 threshold, whichever is less.

After the $10,000 wage increase, the Middles' MAGI-minus-$250,000 rises by $10,000 — from $10,000 to $20,000.

Thus, the new taxes produce both an additional payroll tax of $145 and an increase in the investment tax of $380 — a total of $525 — even though the Middles' investment income has not changed.

This regressive result hits households where wages are below the $200,000/ $250,000 threshold but where MAGI is above that threshold.

Under these circumstances, the investment tax formula effectively misinterprets a wage or salary increase as an investment income increase.

Cracking Nest Eggs

This effect is likely to hit a substantial number of small-business owners — particularly those who report their business earnings on their personal income tax.

The tax would also hit, for example, a couple that has saved a modest nest egg for retirement and in which each spouse's salary is around $100,000 (not a huge amount in high cost-of-living areas).

This problem matters for two reasons.

First, this adds another 5.25% tax disincentive against taking initiative and working harder — on top of federal and state income taxes and Social Security taxes.

Second, this tax is irrational and is buried invisibly in the PPACA. It reminds us that Congress had to pass the bill before Americans could find out what was in it.

This originally appeared in Investor's Business Daily on December 29, 2010.