In a recent post, I discussed the nontaxation of imputed rent – the income homeowners receive from themselves by virtue of being both landlord and renter – which, judging by the comments, many readers found bizarre. In my continuing series on tax expenditures, this week I want to discuss another form of income that few people recognize as being “income” – the nontaxation of Medicare benefits.

First, few people probably think of any government benefits as income in any sense of the term. But if one gets back benefits far in excess of what one pays into a program like Medicare, then one is receiving income.

Those who acknowledge this point probably think it doesn’t matter, because they themselves are only getting back about the same as they paid into the Medicare trust fund from the Medicare portion of the payroll tax.

That tax is 1.45 percent of wages on both workers and employers (2.9 percent total). Unlike the Social Security tax, there is no wage cap for the Medicare tax. Additionally, starting this year, those with incomes above $200,000 ($250,000 for couples) pay an additional Medicare tax of 0.9 percent.

The payroll tax covers only hospitalization. Doctors’ visits are paid for by Medicare Part B premiums, which recipients have deducted from their Social Security benefits on a monthly basis. Most people pay $104.90 a month, with higher premiums based on income.

According to a May 2013 poll by the Harvard School of Public Health, two-thirds of people believe their lifetime taxes and premiums at least cover the cost of all their Medicare benefits; 27 percent believe their benefits equal their contributions, while 41 percent think they get back fewer Medicare benefits than they paid for.

In reality, almost everyone gets back far more in Medicare benefits than they ever pay into the system. What follows below are new data from the Urban Institute on lifetime benefits and taxes for those with average lifetime wages. The figures are a “present value” calculation – all future benefits discounted to today – in inflation-adjusted 2013 dollars.


Urban Institute

As one can see, even single men, who get back the lowest amount of benefits for their Medicare contributions, receive almost three times what they pay in; single women get back more because of longer longevity; and one-earner couples get back six times what they pay in because they are getting twice the benefits for the same contribution single people make.

If Medicare were self-financing in the aggregate, it would not matter that some people get back more than they pay in because others would get less; that is the way life insurance works. In such a case, there would be no aggregate income.

But because Medicare systematically pays out far more in aggregate benefits than beneficiaries pay for, economists consider these excess benefits to be a form of income that theoretically should be taxed.

Interestingly, the Treasury Department does not include Medicare on its list of tax expenditures, because it considers this to be a normal feature of the tax system rather than an exception, but Congress’s Joint Committee on Taxation does. (See Page 39 in “Estimates of Federal Tax Expenditures for Fiscal Years 2012-17.”)

The committee calculates the taxes that ought to be levied on Medicare benefits in excess of taxes and premiums paid. This year, the tax expenditure for the hospitalization portion of Medicare is $34 billion, $26.4 billion for Medicare Part B and $6.6 billion for Medicare Part D, which provides prescription drugs. That is a total tax benefit to Medicare beneficiaries of $67 billion in 2013.

Obviously, it would make no sense to tax people on the actual receipt of Medicare benefits. That would have the perverse effect of taxing those who are sickest and most in need of benefits. Whatever is done needs to be done on a systemwide basis. The Urban Institute economist C. Eugene Steuerle has suggested several options for doing this.

In 2001, the Congressional Budget Office suggested including some percentage of the insurance value of Medicare benefits in income for beneficiaries over a certain threshold that would exclude most taxpayers. (See Page 412 in “Budget Options.”) As it explained:

Subjecting some portion of Medicare benefits to taxation could have several positive effects beyond increasing revenues. A tax on supplementary medical insurance benefits would shift some of that program’s costs from taxpayers to enrollees. Administering this option would be straightforward because a mechanism is already in place for taxing Social Security benefits. In addition, as a counterbalance to concerns about the option’s effects on lower-income enrollees, the use of income thresholds would be a plus because it would leave those enrollees unaffected. In fact, because many Medicare enrollees do not have to pay income taxes, this approach would affect only about 35 percent of them in 2002.

The most straightforward way of “taxing” Medicare beneficiaries on the “income” they receive from it would be simply to raise Medicare Part B premiums. These were set at 50 percent of the program’s cost when it was created in 1966. But over time, they have fallen to just 25 percent, a percentage now set in law. (See Appendix A in the Congressional Research Service report, “Medicare Part B Premiums.”) That is why premiums rise automatically almost yearly. Just going back to a 50 percent taxpayer subsidy would substantially reduce Medicare’s deficit.

In terms of tax reform, taxing some portion of excess Medicare benefits could provide revenue to pay for tax rate reductions. This would not be the case if Medicare Part B premiums were raised, however, because they are classified as an “offsetting receipt” in the budget. That is, higher premiums would be scored as lower Medicare spending rather than increased government revenue.

While I do not expect that the taxation of Medicare benefits will be on the table when Congress considers tax reform, it might be one way of raising revenue from high-income taxpayers who would be the primary beneficiaries of lower tax rates.


Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul. He is the author of “The Benefit and the Burden: Tax Reform – Why We Need It and What It Will Take.”