Introduction
For the better part of a year, Members of Congress have been furiously trying to ram health care reform legislation past procedural hurdles in order to get a package to President Obama's desk for his signature. Republican Scott Brown's election to the Senate in January has convinced supporters of the Democrats' health plan that the only way to move forward is to pass the same bill that cleared the Senate in late December and then enact a set of "fixes" through a separate piece of legislation that would be brought up under the reconciliation process.
Yet, often absent from this debate are key flaws in the Senate legislation that will trap large numbers of taxpayers in coming years. One rarely-mentioned defect is a $2,500 cap on annual contributions to Flexible Spending Accounts in cafeteria plans.[1] These accounts have become ever more popular as a way to use pre-tax dollars to pay for doctor's office visits, prescriptions, and other out-of-pocket medical costs. Another change that will affect many middle-class Americans is a boost in the minimum amount of medical expenses a person would incur before they could be written off against an income tax liability. The Senate package requires these costs to exceed 10 percent of Adjusted Gross Income (AGI) before a portion would become deductible (compared to 7.5 percent under current law). IRS data shows that of the 10.5 million taxpayers who claim the medical expense deduction, all but 106,000 reported AGIs of less than $200,000.[2]
Although these are but a few of the Senate bill's potential surprises for many unwitting taxpayers, this Issue Brief will explore in-depth an underreported provision which, over the longer term, could cause serious trouble for millions of households.
Payroll Tax Hike: No Cure for What Ails Medicare
In an effort to raise money to finance new health care subsidies, Senate Democrats have proposed increasing the Hospital Insurance (HI) payroll tax, which was originally set at 0.35 percent in 1966 to fund what would become the Medicare "Part A" program. [3] It has increased more than eight times over since then, to the current rate of 2.9 percent. Furthermore, in 1966, the HI tax applied only to the first $6,600 of wages.[4] By 1991, however, the HI taxable maximum earnings base was raised to $125,000 and in 1994 the cap was eliminated entirely. [5]
The Manager's Amendment to the "Patient Protection and Affordable Health Care Act" that passed the Senate in late December 2009 proposes to raise the HI tax rate yet again –by nearly a full percentage point – to 3.8 percent on wages (or self-employment income) in excess of $200,000 for single filers. Joint-filing households are in for a much worse hit, because the new tax would apply to them when their combined taxable wages rise above $250,000. The legislation projects a total of $86.8 billion in new revenues from this change between the year it takes effect (2013) and 2019. This is nearly one-fourth of all the money the bill hopes to raise from its "Revenue Offset Provisions." [6]
The latter distinction is an important one. Taxpayers might be led to believe that the increase will provide a revenue infusion to the badly ailing Part A Trust Fund, which will exhaust itself in less than seven years.[7] Nonetheless, even though each dollar raised by the tax could be counted by Medicare's Actuaries as being deposited in the Medicare Trust Fund, Congress is reporting that same dollar as compensating for new health spending.
Medicare's financing problems notwithstanding, the Manager's Amendment sharply worsened the payroll tax increase. In the original version of the Patient Protection and Affordable Care Act, the rate hike was 0.5 percent, not the 0.9 percent that eventually won Senate approval. But perhaps lesser-known is the threat this tax will soon pose to single and married Americans earning less than $200,000 and $250,000, respectively. This danger is revealed in a Joint Committee on Taxation December 19, 2009 document:
[Provision] 15. Raise the hospital insurance tax on wages and self-employment income in excess of $200,000 ($250,000 joint) by 0.9 percentage points, unindexed [emphasis added].
To most taxpayers, that last word "unindexed" might seem innocuous. However, in tax parlance it hides a sinister meaning: the $200,000 and $250,000 thresholds would not be adjusted for the cost of living on an annual basis. Instead, they will remain frozen in perpetuity, even as Americans' wages continue to grow.
Inflation: Congress's Secret Tax Weapon
The Economic Recovery Tax Act of 1981 is best remembered for its across-the-board reductions in federal income tax rates, but the law also introduced the concept of "indexing" for inflation for many parts of the Tax Code. Although Congress had legislated occasional changes to the personal exemption amount, standard deduction level, and income brackets for various tax rates after World War II, no automatic mechanism existed to keep these features current with annual inflation.
During the 1970s, especially, this lack of adjustment created a phenomenon called "bracket creep," in which families whose incomes were simply keeping up with the cost of living were being pushed into paying progressively higher tax rates with the passage of time. As the Heritage Foundation's Thomas Humbert noted at the time, "while only some 3 percent of taxpayers faced marginal tax rates of 30 percent or above in 1960, by 1981 bracket creep had shoved 34 percent of them up to the 30 percent level or higher." [8]
After a phase-in period as well as a two-year hiatus for implementation of the Tax Reform Act of 1986, indexing for the personal exemption, standard deduction, and tax brackets became a permanent fixture of the Tax Code in 1989, and subsequently survived attempts by lawmakers to undo it. Taxpayers were fortunate that organizations such as NTU were able to fight for indexing's rightful place in the tax laws. NTU's research affiliate calculated that in 1990 alone, a family with a taxable income of $50,805 saved $493 thanks to this inflation protection.[9]
Today, however, lawmakers are poised to unleash a new form of "bracket creep," this time in a portion of the payroll tax. Some would argue that because the new tax rate is set at such a high income level, this policy couldn't possibly harm significant numbers of Americans. Several scenarios, however, cast doubt on such an assertion.
How Will the Pain Spread?
Under current law, the personal exemption, standard deduction, and brackets for the individual income tax are adjusted according to a formula that includes the monthly averages of the Consumer Price Index for all Urban Consumers (CPI-U) over a 12-month period (September through August) preceding the tax year.
What if the $200,000 and $250,000 HI tax thresholds in the Manager's Amendment were indexed to the CPI-U measurement? Although long-term forecasts tend not to account for monthly changes, President Obama's Fiscal Year 2011 Budget projects an annual average change in CPI-U of 2.1 percent between the years 2013 and 2019.[10] If indexed to this rate over their first 10 years of existence, the HI tax thresholds on single and married Americans would have to grow to approximately $246,000 and $308,000, respectively.
However, other indexing options would make the thresholds grow faster. The Social Security Administration uses a measurement known as the Average Wage Index (AWI) to annually set the amount of earnings subject to the Old Age, Survivors, and Disability Insurance (OASDI) tax. This measurement might be a fairer way to index the new HI tax increase, since both the HI and the OASDI tax are levied upon payrolls and self-employed income. According to the Actuaries of the Social Security Trust Fund, the AWI is expected to increase by an average of roughly 3.9 percent in the years ahead under its "Intermediate Growth Scenario."[11] This is the scenario representing the middle consensus over how federal entitlement program finances will take shape in the future.
If indexed to this rate over their first 10 years of existence, the proposed HI tax thresholds would have to grow to approximately $293,000 and $367,000, respectively.
These figures don't answer a question on the minds of Americans whose wages currently don't exceed the $200,000 or $250,000 thresholds: When will the pain start for us? The answer is, sooner than many would think.
At a 3.9 percent growth rate, $175,000 of taxable HI income would reach approximately $257,000 at the end of 10 years. Thus, a relatively well-off single person or an upper-middle class couple could begin feeling the pinch in the space of a decade.
Suppose, however, that a family moves up the ladder at a slightly faster pace. For example, Bureau of the Census data indicates that between 1988 and 2008, the top 5 percent of households increased their incomes by an average of about 5.5 percent each year. [12] Although these households had "total money incomes" beginning at about $180,000 in 2008, a significant share of their earnings would be from non-wage sources such as mutual funds or rental properties. Nonetheless, at a 5.5 percent growth rate, $175,000 of HI taxable income would reach $255,000 after seven years. Thus, a single individual or couple in this category who happened to be heavily reliant on paychecks and self-employment earnings instead of investments, would start paying the higher tax within seven years.
Over longer time periods, the effects of these measurements would be much more pronounced. For example, at the 3.9 percent annual rate mentioned above, a taxpaying family making a combined $100,000 of wage or self-employment earnings today would just start to hit the new tax floor in 24 years, likely before that family's breadwinners could hope to retire. A heavy spate of inflation or a few years of good fortune would, of course, accelerate the day of reckoning.
But are these projections realistic? Would such a tax policy actually be allowed to drag on for years, affecting more and more Americans? Here the evidence is not speculative.
For one, as this Issue Brief noted in a previous section, indexing for certain parts of the federal tax system has only operated continuously since 1989—not even one-fourth of the modern income tax's existence. Furthermore, many components of income tax law remain unindexed. The single most egregious example is the taxable gain from the sale of a capital asset.
At the non-federal level, just 14 of the 34 states that have "progressive" income taxes adjust their brackets for inflation.[13] As a result, some residents with surprisingly modest earnings have found themselves paying rates originally intended for the so-called "well-off." For example, according to a Buckeye Institute study, the tax rate for a married couple earning just $6 per hour apiece was 10 times higher in 1997 than it would have been if Ohio's tax code had made allowances for inflation when it was adopted in 1972. That couple was subject to at least some tax in the fifth-highest of the state's nine brackets.[14]
But perhaps the most egregious example of "autopilot tax policy" is the federal Alternative Minimum Tax (AMT). Originally created in 1969 as a response to news that 155 wealthy filers had legally escaped paying income taxes, the AMT currently affects several million Americans each year – even with the "patch" that keeps inflation-eroded tax thresholds from threatening tens of millions more middle-class citizens.[15] Renewal of this patch on an annual or biennial basis has been so tenuous that the IRS was forced to provide interim tax advice to filers not knowing what Congress would eventually decide.[16]
Who Will Feel the Pain?
Given sufficient time, the new HI levy could eventually impact every worker and self-employed individual with earnings subject to tax. But how far into the population could the tax reach in the space of a decade or two? The answer is not clear-cut, but some hypothetical calculations can put the issue into perspective.
IRS statistics provide clues, but not concrete estimates, of who might be impacted by the new tax. According to Tax Year 2007 data, 1.0 million tax returns (out of 143 million filed) reported Adjusted Gross Incomes of $500,000 or more. Although only about one-third of all the AGI in this stratum consisted of wages, salaries, and self-employment income, a large portion of those filers would still face the higher rate. A total of some 3.5 million returns fell into the next highest category, less-than-helpfully sorted into a band of $200,000-under $500,000. This category indicated that nearly two-thirds of all AGI was made up of wages, salaries, and self-employment income,[17] so many filers here could initially be touched by the new tax.
The Congressional Budget Office (CBO) has conducted several studies of tax burdens using a different, more expansive definition of income compared to AGI. In 2005, the beginning threshold for the top 1 percent of households was slightly more than $413,000, while the average reported within that band was just over $588,000.[18] Overall, less than half the share of income in this percentile was attributable to wages, "proprietor's income," and "other business income" (parts of which might be subject to payroll taxes). About 1.1 million units were in this layer of the taxpaying system.
These metrics suggest that in excess of a million households (and perhaps close to 2 million) could start paying the higher HI tax when it is instituted in 2013 – a vague number. But estimates would become somewhat more solid in "out-years."
This multiplying effect would be especially acute because of the huge "marriage penalty" built into the proposal. While two single individuals could each earn $200,000 before having to worry about the tax, a joint-filing couple would have the headache after hitting $250,000 (rather than $400,000) in salaries or self-employment income combined.
Using the IRS figures, the next AGI category, $100,000-under $200,000, contained nearly 13.5 million filers with close to three-fourths of their incomes derived from paychecks or self-employment activities. The average income within this band was just over $130,000. Assuming that three-fourths of this average might be HI-taxable,[19] the typical filer in this category could reach the new HI tax threshold in 19-24 years under the 3.9 percent AWI growth described previously (depending upon filing status). Some near the upper end of this income range could cross the threshold in about half that time.
Revisiting the CBO data, in the 96th through the 99th percentiles of households, the beginning income amount was nearly $201,000 while the average was just under $270,000. About two-thirds of the income in this category was related to wage, proprietor's, and other business income. These percentiles contained some 4.7 million households.[20] Thus, many, but not all, of these Americans would begin to shoulder the heavier HI tax burden in a decade or so under a 3.9 percent compounding rate.
Returning to the Census Bureau's measurements, the top five percent of households by total money income consisted of approximately 5.9 million units in 2008.[21] With a beginning threshold of $180,000 total (perhaps $120,000 of which would be HI-taxable), a 5.5 percent income growth rate could likewise put large numbers of people fitting this financial demographic in the crosshairs of the new HI tax after the passage of more than 10 years (depending upon the number of earners in the household).
Once again, none of these measurements is precise, but they do show it is quite feasible that the new, unindexed HI tax could grow to snag between 4 and 5 million taxpayers after ten years of its operation. That number could double after 20 years, especially if economic growth improves the wealth of upper-middle-income Americans.
In addition, the House's reconciliation bill would effectively extend the equivalent of the new 3.8 percent HI tax to "unearned income" (investments, annuities, interest, net rent, and certain small business income) for taxpayers in the $200,000 single/$250,000 joint filing bracket. If this tax becomes law in combination with the Senate bill's HI provision, the probability of fiscal injury becomes much higher for taxpayers in the groups described above.
Conclusion: A Tax Pandemic in the Making
Charitable political observers might attribute this new inflationary tax proposal to unintended consequences; more skeptical types might instead chalk it up to malicious design or deliberate indifference. Whatever the motive, the result of passing the Senate's health care plan intact will be to trap millions, and over time tens of millions, of Americans in a costly spiral that resembles other tax-policy debacles such as the AMT.
Will Congress act to correct this flaw, or better yet eliminate the tax hike altogether during the reconciliation process now underway? This seems unlikely, given the large amount of revenue the tax would raise to mask the massive costs of government-run health care. Assuming the tax goes into effect, will leaders simply enact "patches" similar to those slapped on the AMT, once they perceive a threat to the livelihoods of a sufficient number of constituents? Perhaps, but no one can guess when such a political tipping point would be reached. If past history is any guide, however, taxpayers could be waiting a long time for relief. This is made all the gloomier by the prospect in reconciliation of the 3.8 percent tax on "unearned income."
It is far easier to destroy a virus in the Petri dish than it is to treat an ever-expanding infection after it is let loose. Congress would do well to end this ghastly "experiment" with inflationary taxation in its legislative laboratory, rather than inflict it on unsuspecting Americans.
About the Authors
Pete Sepp is Vice President for Policy and Communications for the National Taxpayers Union. Kristine Tuinstra is State Policy Analyst with the National Taxpayers Union Foundation, the research and educational arm of the National Taxpayers Union.
Notes
[1] Joint Economic Committee of the U.S. Congress, "Estimated Revenue Effects of the Manager's Amendment to the Revenue Provisions Contained in the 'Patient Protection and Affordable Care Act,'" JCX-61-09, December 19, 2009, https://www.jct.gov/publications.html?func=startdown&id=3641.
[2] Internal Revenue Service, Statistics of Income Division, "Table 2.1: Returns with Itemized Deductions: Sources of Income, Adjustments, Itemized Deductions by Type, Exemptions, and Tax Items, by Size of Adjusted Gross Income, Tax Year 2007," https://www.irs.gov/pub/irs-soi/07in21id.xls.
[3] Social Security Administration, Office of the Chief Actuary, "Social Security and Medicare Tax Rates," https://www.ssa.gov/OACT/ProgData/taxRates.html.
[4] Social Security Administration, Office of the Chief Actuary, "Contribution and Benefit Base," https://www.segurosocial.gov/OACT/COLA/cbb.html.
[5] Cordes, Joseph J., Ebel, Robert D., and Gravelle, Jane G., Eds., The Encyclopedia of Taxation and Tax Policy, Second Edition, "Payroll Tax, Federal," https://www.taxpolicycenter.org/taxtopics/encyclopedia/Payroll-Tax.cfm.
[6] Joint Economic Committee of the U.S. Congress, "Estimated Revenue Effects of the Manager's Amendment to the Revenue Provisions Contained in the 'Patient Protection and Affordable Care Act,'" JCX-61-09, December 19, 2009, https://www.jct.gov/publications.html?func=startdown&id=3641.
[7] Boards of Trustees of the Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds, "2009 Annual Report, Section II: Overview," https://www.cms.hhs.gov/ReportsTrustFunds/downloads/tr2009.pdf.
[8] Humbert, Thomas M., "Tax Indexing: At Last a Break for the Little Guy," Heritage Foundation Backgrounder, March 22, 1983.
[9] Keating, David L., "Tax Indexing – The Middle Class Tax Reform," National Taxpayers Union Foundation, 1989.
[10] U.S. Office of Management and Budget, Budget of the U.S. Government for Fiscal Year 2011: Analytical Perspectives, "Economic and Budget Analyses," https://www.whitehouse.gov/omb/budget/fy2011/assets/econ_analyses.pdf
[11] Social Security Administration, Office of the Chief Actuary, "2009 Trustees Report," Section 5. B., "Economic Assumptions and Methods," https://www.ssa.gov/OACT/TR/2009/V_economic.html#131323.
[12] U.S. Census Bureau, "Table H-1: Income Limits for Each Fifth and Top 5 Percent of All Households: 1967 to 2008," |
https://www.census.gov/hhes/www/income/histinc/h01AR.xls.
[13] Padgitt, Kail, "Testimony to the Maryland Ways and Means Committee on HB238, the Taxpayer Protection Act – State Income Tax CPI Adjustments," March 4, 2010, https://www.taxfoundation.org/publications/show/25934.
[14] Staley, Samuel, and Lawson, Robert, "Ohio Keeps Poor Down with Unfair Taxes," Buckeye Institute Perspective, April 1997, p.1.
[15] Keating, David L., "A Taxing Trend: The Rise in Complexity, Forms, and Paperwork Burdens," National Taxpayers Union Issue Brief #125, April 15, 2008, https://www.ntu.org/news-and-issues/taxes/income-tax/a-taxing-trend-the-rise-in-complexity-2008.html.
[16]Ibid.
[17] Internal Revenue Service, Statistics of Income Division, "Table 1.4: All Returns: Sources of Income, Adjustments, and Tax Items, by Size of Adjusted Gross Income, Tax Year 2007: Returns with Itemized Deductions: Sources of Income, Adjustments, Itemized Deductions by Type, Exemptions, and Tax Items, by Size of Adjusted Gross Income, Tax Year 2007," https://www.irs.gov/pub/irs-soi/07in14ar.xls.
[18] Congressional Budget Office, "Data on the Distribution of Federal Taxes and Household Income, Table 3: Number of Households, Average Income and Income Shares, and Income Category Minimums for All Households, by Household Income Category, 1979 to 2005," https://www.cbo.gov/ftpdocs/98xx/doc9884/spreadsheet.xls.
[19] Internal Revenue Service, Statistics of Income Division, "Table 1.4: All Returns: Sources of Income, Adjustments, and Tax Items, by Size of Adjusted Gross Income, Tax Year 2007," https://www.irs.gov/pub/irs-soi/07in14ar.xls.
[20] Congressional Budget Office, "Data on the Distribution of Federal Taxes and Household Income, Table 4:
Sources of Income for All Households, by Household Income Category, 1979 to 2005," https://www.cbo.gov/ftpdocs/98xx/doc9884/spreadsheet.xls.
[21] U.S. Census Bureau, "Table H-1: Income Limits for Each Fifth and Top 5 Percent of All Households: 1967 to 2008," |
https://www.census.gov/hhes/www/income/histinc/h01AR.xls.