Health Care Fix Bill Taxes ‘Unearned’ Income, Capital Gains Rate Soars

By Christopher Neefus | March 24, 2010 | 3:18 PM EDT

House Speaker Nancy Pelosi of Calif. acknowledges applause from fellow House Democrats after signing health reform legislation on Monday, March 22, 2010. (AP Photo/Manuel Balce Ceneta)

( – The package of fixes to the health care bill passed by the House on Sunday includes a tax on “unearned” income, which House Speaker Nancy Pelosi (D-Calif.) says will help keep Medicare solvent a bit longer and improve affordability for the middle class. Conservatives, however, say the new tax will hurt the stock market and will not save Medicare.
The Health Care and Education Affordability Reconciliation Act of 2010 — the package of fixes House members require to make the Senate health care bill acceptable—includes a chapter titled “Medicare Tax.” That chapter provides for the government to level a 3.8 percent surtax on any “unearned” income for individuals making over $200,000 and couples making over $250,000.
Section 1411 of the bill, “Imposition of Tax,” also provides that the surtax would be applicable to any estates or trusts held by taxpayers falling into those brackets.
Unearned income is comprised of funds gained outside of a paycheck from an employer—largely from capital gains, dividends, annuities, and rental income.
Ryan Ellis, tax policy director at Americans for Tax Reform (ATR), said that while the designation of “unearned income” is nothing new in tax code, it is relatively novel to tax all of the money under that umbrella. “I can’t really think of an instance it has been taxed all at once,” he said. 
Pelosi said last week that the new tax was a “victory” for her caucus, who disliked the Senate’s proposition for raising money – a steep excise tax on so-called “Cadillac” (high cost) insurance plans.
House Democrats, many of whom lean more liberal than their Senate counterparts, disliked the Cadillac tax, because it would affect a significant number of union members, whose leaders had bargained for top-notch health insurance plans instead of additional income.
In that way, Pelosi claimed, the tax would hurt the middle class and had to be partially replaced.
“One of the victories that we have in the House is that our members did not like the excise tax on insurance plans. We thought it hurt the middle class. There was a debate about that,” Pelosi explained at a press conference last Thursday. “So the higher end of that is left in the plan. I call it the platinum Rolls Royce piece of it. The rest will be covered by a Medicare fee on unearned income.
“We did not believe that the Senate bill had enough on affordability. So there’s more affordability for the middle class in the reconciliation package that we’ll pass,” Pelosi told reporters.
The Joint Committee on Taxation, which analyzes and helps prepare tax policy for Congress, projected that the surtax would fund a significant portion of the new revenue should the reconciliation bill become law.
They estimated that of $409 billion in cost-offsetting revenue, the unearned income surtax plus a 0.9 percent earned income surtax would drum up over $210 billion within the first 10-year window of measurement. Alone, Ellis said the unearned income surtax would raise about $132 billion.
Conservative groups, however, say taxing unearned income will further discourage investment during an economic slump and that the money, originally called a “Medicare tax” may not necessarily go to shoring up Medicare.
ATR, which opposes all tax increases, has warned that the tax policy in the reconciliation package would significantly raise the marginal tax rates that investors pay.
The top marginal tax rates on capital gains and dividends would each hit 23.8 percent in 2013, up from 20 percent in 2011 and 15 percent in 2010.
For other unearned income—from interest, annuities, royalties, net rental, and passive income in partnerships or Subchapter-S corporations—the marginal tax rate would jump to 43.4 percent in 2013. That figure is also up significantly from the 2011 rate of 39.6 percent and the 2010 rate of 35 percent.
Alan Reynolds, a tax fellow at the libertarian CATO Institute who assisted the Office of Management and Budget during the Reagan transition, said those numbers would depress certain economic activity.
Blogging for CATO during debate on the bill Sunday, Reynolds wrote, “(T)he accumulating penalties on reporting joint incomes above $250,000 … would greatly discourage any activity that would push income above $250,000.
“Most obviously, no sensible family whose income is normally below that pain threshold would be so foolish as to sell enough assets to let capital gains push them over the line,” he wrote.
Ellis also told Pelosi’s notion that switching to this surtax would help the middle class was untrue. “You cannot think that taxing capital gains and dividends will not affect the middle class,” he said, “unless you don’t believe the middle class owns stocks or has an IRA.”
Driving home the point, he said, “You cannot increase taxes on capital gains and dividends without hurting the whole stock market.
“The day after (the law) is signed, the value of your portfolio or IRA goes down,” Ellis added.
The $132 billion would also not go directly into Medicare, as Reynolds pointed out. “The 3.8% tax on both labor and investment income is not a ‘Medicare tax,’ he wrote. “It’s surtax on income that goes into the slush fund, not the Medicare trust.”
The “slush fund” in this case is the general Treasury fund. Chapter 2A of the reconciliation bill provides that the Treasury Secretary can “from time to time” transfer as much money as is raised by the surtax out of the general fund and into the Medicare Trust Fund.
Asked to evaluate Pelosi’s claim that the money would go to shore up Medicare and extend its solvency, Ellis concurred with Reynolds. “That is just absurd,” he said.
Ellis pointed out that similar to the $500 billion in Medicare cuts, the surtax money is used both as a deficit reducer and as an investment in Medicare. “You can’t double count the money.”
Pelosi, however, says the savings and investments in Medicare will increase the life of the entitlement for nearly a decade. “This is essential in order to strengthen Medicare and in this legislation we will make it solvent for nine more years,” she said.
Last year, the Medicare Board of Trustees projected the trust fund would become insolvent in 2017.
The Senate will consider the reconciliation package—including the unearned income surtax—this week and is expected to approve the measure by the weekend.