Paying for ObamaCare: Payroll taxes on non-payroll income

The Wall Street Journal asserts that provisions in the House reconciliation bill designed to "fix" the Senate health care bill breaches a longtime barrier between payroll and investment income:

To help pay for Democrats' sweeping health-care plan, the House version of the bill would impose a 3.8% Medicare tax on investment income for upper-bracket taxpayers.

The levy, which would be effective in 2013 and apply to interest, dividends, capital gains, rents and royalties, represents a U-turn in tax policy. As recently as the administration of former President George W. Bush, Congress lowered the tax rate for capital gains and dividends on the grounds it would stimulate investment in the economy.

The tax on investment income shouldn't be confused with another Medicare tax increase the House plans to vote on as part of the health-care bill. That is a 0.9% increase in the Medicare payroll tax for upper-income workers. If lawmakers approve the 0.9% increase, it could be sent to the president for signing right away with other elements of the health-care package.

The tax on investment income is part of a group of changes that must also be approved by the Senate, which could address it as early as next week.

If enacted, the tax could affect investment decisions of some four million couples and one million individual filers.

Income from taxable bonds would be less attractive, because it is taxed at ordinary income rates. So if the top income tax rate returns to 39.6%—as President Barack Obama has proposed—investors in the top brackets would pay a total 43.4% rate on bond interest, including the proposed 3.8% investment tax.

Investors are likely to favor tax-free municipal bonds and, where possible, Roth IRAs. Experts say muni income appears not to be subject to the tax. Assets held in Roth IRAs grow tax-free and payouts are tax-free as well.

In addition to the historic u-turn of imposing payroll taxes on non-payroll income, this provision will discourage investment in the stock market and the corporate bond market, resulting in higher interest rates.  During the Carter administration, we call this stagflation.