Health-care reform's 'back-door' tax

WASHINGTON (Fortune) -- The big talk on Capitol Hill may be about health-care reform, but as part of this massive undertaking, the Democrats are quietly reshaping the tax system too. Tucked inside President Obama's latest health-care proposal is a major change to the Medicare tax.

Since its conception, the Medicare tax has always been tied to payrolls. Every paycheck, employers and employees each chip in 1.45%, regardless of how much someone makes. Under Obama's proposal -- which should be very close to what Congress winds up enacting -- a Medicare tax would now be applied to investment income too: Individuals who earn more than $200,000 and couples over $250,000 would pay an additional 2.9% surtax on unearned income from interest, dividends, annuities, royalties and rents.

Two things happen here. The first one is that the Medicare tax would go from being a payroll tax (like Social Security) to an income tax.

"You can certainly make the argument that [payroll is] really not appropriate anymore and we may as well tax all income," says Howard Gleckman, a senior research associate at the Urban Institute and editor TaxVox, the center's tax and budget policy blog. "But this is kind of a back-door way to do it."

The Democrats found their way to this "back door" because they couldn't agree on how to pay for the health-care bill: House Dems don't like the Senate's proposal to tax so-called Cadillac plans, and Senate Democrats don't like the House bill's inclusion of an income tax on the wealthy to pay for health care.

That paves the way for the second change. The Medicare tax has long been set at a flat rate -- the idea being that everyone pays into the system at the same rate and then receives the same amount of medical benefits later in life.

But by giving the Medicare tax the qualities of an income tax, Democrats can raise taxes on high-earners without explicitly calling it an income tax hike. The proposal also targets this group by adding 0.9% to their payroll portion of the Medicare tax too. Adding a tax just for households making over $250,000 would make the tax progressive for the first time.

The Obama administration says taxing the wealthy on unearned income is only fair because anyone who lives off their dividends and interest should have that money treated as wages too.

Gleckman points out that because the tax is being changed indirectly via health-care reform, the policy design is a bit unorthodox. "Usually we have tax brackets rather than this cliff, where suddenly if you make a dollar more you're subject to this additional tax," he says. But there are ways around it: Taxpayers who want to avoid getting bumped up to the higher rate could easily wait a little longer to sell their stock after the new-year cutoff.

The Center for Tax Justice points out the changes would only affect 2.3% of taxpayers in 2014. And the tax would not apply to income earned through tax-deferred retirement accounts.

Still, those higher-income taxpayers would foot a significant chunk of the bill's revenue streams. The non-partisan Joint Committee on Taxation estimates that Obama's proposal to raise the Medicare payroll tax and expand the tax to unearned income would bring in $183.6 billion in revenues from 2010 to 2019. That's 44% of estimated total revenues needed to pay for health care, making it the biggest portion of all the proposed changes.

There is confusion over whether the Medicare tax on unearned income would apply to capital gains too. In Obama's proposal, the only forms of unearned income listed are interest, dividends, annuities, royalties and rents.

But the plan does make it clear that unearned income, not just wage income, is now fair game. If capital gains income is indeed included, the wealthy would effectively be facing a cap gains tax rate of 22.9%. (The rate is already due to go from 15% to 20% next year) As of this writing, the White House had not responded to a request for comment.

The Democrats have to figure out some way to pay for health care to pass their bill, and this "back-door" tax could be their best hope at a workable compromise. But as they consider how to reshape the country's medical system, watch out for how they're changing the tax system too. If Obama's proposal goes through, other taxes could start popping up in some new, unexpected places.