Medicare News: Medicare Tax May Soon Rise for Certain High Earners

Closing a Longstanding Loophole Could Lead to More Money for Medicare

Medicare is a hot topic in Congress lately, as the Senate discusses how the longstanding insurance program can continue to cover its expenses. Traditionally, Medicare is funded through payroll contributions, which are automatically deducted from the paychecks of working Americans. However, projections indicate that this current system is insufficient to keep Medicare out of debt. A new Medicare tax proposed by Senate Democrats aims to address this issue by closing a long-standing loophole affecting certain high earners, though its effects may ripple throughout the population.

The Pass Through Exception

The proposed change would apply a 3.8 percent income tax on certain individuals who earn more than $400k a year or couples whose collective income exceeds $500k. Specifically, it targets income obtained via pass through entities. A pass through is a type of business in which the profits are “passed through” directly to owners, shareholders, and investments. As such, the owners do not have to pay corporate taxes. This is intended to protect the owners of smaller pass throughs, like family-owned businesses, from double taxation. 

However, certain high earning individuals can use pass through entities as tax havens: either because they see very high profits due to the services they provide, or because the pass through entity exists solely as a tax haven. 

Taxes and Medicare

The new Medicare tax is expected to raise an estimated $203 billion over the next decade. Yet why is this change required in the first place? How is Medicare taxed, and why isn’t the existing system sufficient to cover its budget?

As mentioned previously, we pay a Medicare income tax. A portion of this money goes into a trust, which funds Medicare Part A: Medicare’s hospital insurance plan. This is why most Americans don’t have to pay for Part A insurance: you’ve been paying for it your whole adult life. 

Like any financial trust, Medicare is affected by economic factors such as stock market performance, inflation, and interest rates. Between the 2008 recession and the COVID-19 pandemic wreaking havoc on the market, the world has been experiencing an unprecedented period of economic instability. For a significant portion of 2020, a large portion of the population was unemployed due to pandemic restrictions, meaning many people were not paying their Medicare income tax. This, among many other factors, means that Medicare Part A is expected to go insolvent by 2028. 

Insolvency means an entity (be it a person, corporation, or organization) is unable to pay its debts according to the agreed upon payment schedule. There are two types of insolvency: cash-flow, in which an entity lacks the funds to pay off their debts, and balance-sheet, in which an entity lacks the assets to pay a debt. Cash-flow insolvency can be solved by sale of assets, such as your car or home. Balance-sheet insolvency, conversely, means your total liability (what you owe) exceeds what you could possibly pay if you sold off your assets. 

Insolvency is distinct from bankruptcy, though the concepts are closely related. An entity is considered bankrupt when they are declared insolvent by a court of law. The government then takes steps, determined by jurisdiction, to resolve the bankruptcy, often by seizing assets. However, as the government cannot seize its own assets on behalf of its debtors, government agencies like Medicare cannot legally declare bankruptcy. Instead, they must restructure their debt, often by borrowing more money or issuing more currency, which leads to inflation. 

The introduction of this Medicare tax is expected to delay insolvency by three years, giving Congress until 2031 to come up with a long-term solution. However, it is not without additional cost. While this new law will not affect most Americans directly, owners of certain pass-through entities like law firms, private doctors offices, and other independently owned businesses may respond by raising prices to compensate, though this is not a guarantee. Even so, proponents of the change believe that the benefits of protecting Medicare solvency far outweigh the potential risks to consumers.

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