Illustration by Mark Todd

Here’s a New Tax on Savings You Didn’t Know About

In the debate over the looming fiscal cliff, U.S. President Barack Obama often plays down any adverse economic impact from letting the 2001 and 2003 tax cuts expire for high-income Americans, claiming that the top tax rates would merely return to where they were during the Clinton years.

Unfortunately, the president’s claim is incorrect because he ignores the impending arrival of the unearned income Medicare contribution tax, which will further raise tax rates on income from saving.

Scheduled to take effect on Jan. 1, the tax, which was adopted as part of the 2010 health-care law, is a 3.8 percent levy on interest, dividends, capital gains and passive business income received by taxpayers with incomes exceeding $200,000 (or $250,000 for couples).

Because the new tax was added to the health-care law late in the process without congressional hearings, it received little attention at the time. With only a few weeks left before it takes effect, it remains largely unknown.

Its obscurity has allowed bizarre myths to circulate on the Internet -- despite what you may have read online, the tax is not a 3.8 percent levy on home sales.

One problem with the unearned income Medicare contribution tax is the name Congress chose for it, which is a triple misnomer. The income that will be subject to the tax isn’t unearned -- it is earned by savers who receive market rewards for delaying consumption and providing funds to finance business investment.

Also, because the proceeds will be paid into the general treasury, the tax will have no financial link to Medicare. And, of course, the tax will be a compulsory payment, not a voluntary contribution.

Intricate Regulations

Another concern is the complexity of the tax, as demonstrated by the intricate proposed regulations the Internal Revenue Service has had to develop to carry it out. The regulations, which still leave a few implementation issues unresolved, and the accompanying explanation filled 42 pages of the Dec. 5 Federal Register.

The biggest issue, however, is the additional penalty the tax will impose on the savings that finance investment and fuel long-run economic growth. It’s true that relatively few Americans have high enough incomes to be subject to the tax. But they account for a large portion of what the nation saves, magnifying the economic impact.

IRS data for 2010 reveal that the 3 percent of taxpayers with incomes of more than $200,000 received 45 percent of the interest income, 58 percent of the dividends and 88 percent of the capital gains (net of losses). More taxpayers and more saving will gradually become subject to the unearned income Medicare contribution tax in coming decades because its income thresholds won’t be adjusted for inflation.

Even if the high-income portions of the 2001 and 2003 tax cuts are fully extended, the unearned income Medicare contribution tax’s arrival next year will raise the top rates on interest, dividends and capital gains 3.8 percentage points above this year’s levels. Or, if the high-income provisions are allowed to expire, it will push the top rates on interest, dividends and capital gains 3.8 percentage points above Clinton- era levels.

Even if we can’t repeal this tax, we should at least keep in mind its burden on saving as we decide the fate of the 2001 and 2003 tax cuts.

Finally, if we keep the unearned income Medicare contribution tax, we should give it a more accurate name. The IRS is now calling it the “net investment income tax.” I prefer to call it a “tax on income earned by savers.”

(Alan D. Viard is a resident scholar at the American Enterprise Institute. The opinions expressed are his own.)

To contact the writer of this article: Alan D. Viard at aviard@aei.org.

To contact the editor responsible for this article: Katy Roberts at kroberts29@bloomberg.net.