This week, the Bureau of Labor Statistics (BLS) released data showing that the consumer price index (CPI) rose 0.5 percent in January compared to December 2022, reaching 6.4 percent over the prior 12 months. While inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. has trended down over the past six months, it will likely continue to be above the Federal Reserve’s target rate of 2 percent for some time, making it an area of concern for policymakers in 2023. A major way to reduce the impact of inflation on American households is to fully index the tax code for inflation.
The basic provisions within the individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. are adjusted for inflation, such as the personal income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. brackets, the standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. , and the earned income tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. (EITC). However, other important components are not adjusted, which hits taxpayers hardest when inflation is elevated.
One area where inflation hits taxpayers is the tax treatment of capital gains. When an asset is sold for a net gain, part of that gain is often from the rise in value due to inflation. This part of the asset’s gain should be exempt from capital gains taxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. Capital gains taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. by adjusting the basis to factor in the increase in the price level. However, indexing capital gains for inflation would be a complicated project and should be done in concert with a broader effort to index the tax code for inflation comprehensively.
Despite the complexity, lawmakers have proposed constructive ideas to adjust the tax code for inflation’s impact on capital gains. For example, Rep. Ralph Norman (R-SC) has proposed adjusting the capital loss limit against ordinary income up from $3,000 to $13,000 for all filers, adjusted for inflation thereafter. The original $3,000 limit was established in 1978, which is now worth less than $700 today in real terms.
The Child Tax Credit (CTC) is another area where the individual income tax is not factoring in inflation. The value of the CTC is set at $2,000 through the end of 2025 and $1,000 thereafter; the phaseout thresholds where the CTC value begins declining are not indexed to inflation. From 2003 to 2017, the CTC lost about 25 percent of its real value due to inflation, and the CTC has lost 15 percent of its real value since 2018. While the main focus in CTC debates surrounds the generosity of the credit, comparatively little is said about how inflation reduces the credit’s value over time.
Sen. Chuck Grassley (R-IA) proposed indexing the CTC’s value and phaseout thresholds for inflation along with the value of other credits such as the Child and Dependent Care Tax Credit (CDCTC) and credits for higher education expenses. Tax Foundation’s Growth and Opportunity tax plan would also index the CTC for inflation as part of a broader effort to stabilize the credit’s long-term value.
For higher earners, the net investment income tax (NIIT) is a notable unindexed part of the individual income tax. The NIIT applies a 3.8 percent tax on certain investment income for single filers earning over $200,000 or joint filers earning over $250,000. Because neither of the income thresholds are indexed to inflation, a growing segment of taxpayers are subject to this tax each year as nominal incomes rise. While we recommend repealing the NIIT entirely, indexing the NIIT thresholds would preserve the original intent of the tax to apply to higher earners. Relatedly, Sen. Grassley has proposed indexing the NIIT income thresholds for inflation.
Businesses feel the burden of elevated inflation because it erodes the real value of their depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. deductions for prior investments. Inflation reduces the present value of their deduction below the original cost of investment, reducing the incentive to invest. Efforts such as the CREATE JOBS Act introduced by Sen. Ted Cruz (R-TX) would allow full and immediate deductions on a permanent basis (or the equivalent treatment through neutral cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages. ), removing the penalty of inflation on depreciation deductions.
While hoping for inflation’s continued decline, policymakers should finish the job and index the tax code to prepare for future bouts of high inflation and as a contingency in case it takes longer to defeat elevated inflation than expected. More fully indexing the tax code would send a clear message that households should not be expected to pay taxes on phantom income produced by inflation.
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