President’s Budget Would Strengthen Medicare Taxes Paid by the Wealthy

As part of his new budget plan, President Biden is asking the richest Americans to pay a little bit more to strengthen Medicare. The proposal includes raising taxes related to Medicare very slightly for the highest earners and closing a loophole that some wealthy individuals use to avoid Medicare taxes altogether. The President’s proposal is a prudent approach toward balancing the federal budget without cutting essential public services. The White House estimates that the new tax revenue would help extend the solvency of Medicare for at least another generation.

Currently, high-income people pay a 3.8 percent tax on most types of income to help fund Medicare. This is accomplished with two different taxes. One is the Medicare payroll tax on earnings, which effectively has a top rate of 3.8 percent. The other is a 3.8 percent tax on investment income that only applies to high-income people. The President’s proposal would add a 5 percent bracket to both taxes for people making more than $400,000, requiring them to pay an additional 1.2 percent compared to what they pay now.

Equally important, the President’s proposal to shore up Medicare would close a loophole often used by the wealthy to avoid these taxes, a reform he included in his first budget plan. This loophole allows certain business profits – including income routed through business entities established for this very purpose – to escape both the Medicare payroll tax and the 3.8 percent tax on investment income.

Medicare Taxes Under Current Law

Most people are familiar with paying taxes to fund Medicare with every paycheck. As millions of American families currently file their taxes, they will see the “Medicare tax withheld” on their W-2s that refers to the 1.45 percent payroll tax that funds our nation’s most essential public health program. Employers also pay an additional 1.45 percent, which economists generally agree is passed on to employees in the form of lower wages. This means that most people pay a Medicare payroll tax equal to 2.9 percent of their earnings.

In 2013, the Affordable Care Act (ACA) implemented two changes for the highest earners to strengthen Medicare funding. Households earning more than $250,000 (or $200,000 for non-married filers) now pay an additional 0.9 percent on their wage and salary income exceeding that amount. This brings the total Medicare payroll tax rate paid by these households to 3.8 percent.

Since the wealthiest people often make more money through investments than wages and salaries, the ACA also implemented a surtax on investment income. This surtax, called the Net Investment Income Tax (NIIT), applies at a rate of 3.8 percent on whatever portion of a household’s general income over $250,000 (or over $200,000 for non-married filers) is investment income.

Together, these two ACA changes ensure most people with high incomes pay a little more to fund Medicare. (While the NIIT requires rich people to pay a rate on their investments equivalent to the combined Medicare payroll taxes, the revenue technically does not currently go to the Medicare trust fund. The President’s budget would change this.)

The ACA left a loophole in place for some well-off business owners though. The “Gingrich-Edwards loophole”—so-named for the many members of Congress who have exploited it—allows owners of certain businesses to categorize their income in a way to avoid paying either tax.

Pass-through business owners can classify income from their business as salary if they are working in the company and managing its affairs or they can classify it as business profits distributed to them as an owner, much like corporate dividends. The distinction may seem trifling to most people—after all, the same business owner is receiving the same income from the same business either way. But when the income is categorized as profit distribution, they do not pay either the Medicare payroll tax or the NIIT.

The savings can be enormous for high-income business owners who use this loophole. Consider a partner in a law firm who earns $10 million in a year through their practice. If all of their income is salary, they owe nearly $380,000 in Medicare taxes. However, if they claim $200,000 as their salary and the rest as profit distribution, then they only pay $5,800 in Medicare taxes. This loophole grants an avenue for avoiding Medicare taxes to the people who are most able to pay them.

President Biden’s Proposal Would Require the Most Well-Off to Chip in Slightly More for Medicare

The President’s proposal would close this loophole by ensuring all business income is subject to either the Medicare payroll tax or the NIIT, meaning rich people would pay a 3.8 percent tax on this income one way or the other. This proposal was included in the House-approved Build Back Better bill in 2021. At the time, the Joint Committee on Taxation, Congress’ official revenue estimator, expected that closing the loophole would raise about $250 billion over the next decade.

The White House would go a step further than the 2021 proposal by raising the rate for people making more than $400,000 by 1.2 percent. This is a very small and reasonable ask of those who have been most fortunate in our economy, and it keeps the President’s promise not to raise taxes on anyone making less than $400,000. Extending the solvency of Medicare is essential, and rather than cutting benefits or jeopardizing the future of the program every five years as some Republicans have proposed, the President’s budget would protect the nation’s healthcare through sensible, progressive tax reform.

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