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. is often called a hidden 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. , but in many states it yields a far more literal tax increase as tax brackets fail to adjust for changes in consumer purchasing power. This phenomenon is called “bracket creepBracket creep occurs when inflation pushes taxpayers into higher income tax brackets or reduces the value of credits, deductions, and exemptions. Bracket creep results in an increase in income taxes without an increase in real income. Many tax provisions—both at the federal and state level—are adjusted for inflation. ,” and it’s far creepier than the décor beginning to pop up in people’s front yards as we enter the final weeks of October.
Inflation currently stands at 5.4 percent over the past 12 months, the highest increase in decades, and is about 6.3 percent higher than when the pandemic began. A dollar doesn’t go quite as far these days, and compensating measures have been taken in a variety of sectors. Social Security recipients, for instance, will see a 5.9 percent Cost of Living Adjustment (COLA) next year, the largest increase in about four decades. Wages are up about 7.3 percent during the pandemic, offsetting higher costs—though that may be cold comfort for those who didn’t see their own wages rise, or who saw the value of their investments decline.
Often overlooked, however, is what happens to state tax burdens when inflation is high. When tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. s, 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. , or personal exemptions are not inflation-adjusted, they lose value due to inflation, raising tax burdens in real terms. Bracket creep occurs when more of a person’s income is in higher tax brackets because of inflation rather than higher real earnings.
Imagine, for instance, a Delaware resident who made $60,000 in taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. in 2019, and who now makes $64,000. Due to inflation, she hasn’t seen an increase in real income: her $64,000 today has about the same purchasing power as her $60,000 in 2019. But if her state’s income tax brackets aren’t inflation-indexed, whereas her top marginal rate was previously 5.55 percent (on income between $25,000 and $60,000), she now has $4,000 taxed at the higher rate of 6.6 percent. Her tax bill rose by $264 even though her purchasing power remained constant.
Forty-one states and the District of Columbia tax wage income, while New Hampshire taxes just income and dividend income. Of these, 15 states and D.C. fail to adjust brackets for inflation, 10 states leave their standard deduction (if they have one) unadjusted, and 18 have an unindexed personal exemption. Taken together, 22 states and the District of Columbia have at least one major unindexed provision. Thirteen states fail to index any relevant major component. (In some cases, they may forgo a standard deduction or personal exemption, but all relevant provisions are unindexed.) They are Alabama, Connecticut, Delaware, Georgia, Hawaii, Kansas, Louisiana, Mississippi, New Jersey, New York, Oklahoma, Virginia, and West Virginia.
The absence or insufficiency of cost-of-living adjustments in many state tax codes is always an issue, as it constitutes an unlegislated tax increase every year, cutting into wage growth and reducing return on investment. During a period of higher inflation, however, the impact is particularly significant.
To see how significant inflation can be, consider capital gains. Let’s say that you purchased $10,000 worth of shares in 2001 and sold them for $20,000 at the start of 2021. Both the federal and state government would treat this as capital gains income of $10,000. The federal government provides a preferential rate on long-term capital gains, while most states do not. In real terms, however, the gain is far less than $10,000 because cumulative inflation during that period was nearly 55 percent, making the real gain $4,502. Note that inflation indexingInflation indexing refers to automatic cost-of-living adjustments built into tax provisions to keep pace with inflation. Absent these adjustments, income taxes are subject to “bracket creep” and stealth increases on taxpayers, while excise taxes are vulnerable to erosion as taxes expressed in marginal dollars, rather than rates, slowly lose value. of tax codes alone cannot solve the problem of over-taxation of capital gains income, but it is at least illustrative of the broader issue.
The following table shows which provisions in each state are indexed for inflation. For states which fall short, there is no time like the present to remedy the problem. Most states are currently flush with cash, and if policymakers fail to act, taxpayers will get a one-two punch from inflation, an explicit tax increase piled atop the implicit one.
|State||Brackets||Standard Deduction||Personal Exemption|
|Alaska||No Income Tax|
|Colorado||Flat Tax||Conforms to Federal||n/a|
|Florida||No Income Tax|
|Idaho||Indexed||Conforms to Federal||n/a|
|Maine||Indexed||Conforms to Federal||n/a|
|Minnesota||Indexed||Conforms to Federal||Conforms to Federal|
|Missouri||Indexed||Conforms to Federal||n/a|
|Nevada||No Income Tax|
|New Hampshire||Flat Tax (b)||n/a||—|
|New Mexico||—||Conforms to Federal||n/a|
|North Carolina||Flat Tax||—||n/a|
|North Dakota||Indexed||Conforms to Federal||n/a|
|South Carolina||Indexed||Conforms to Federal||Indexed|
|South Dakota||No Income Tax|
|Tennessee||No Income Tax|
|Texas||No Income Tax|
|Utah||Flat Tax||Percentage of Federal||n/a|
|Washington||No Income Tax|
|Wyoming||No Income Tax|
|District of Columbia||—||—||n/a|
(a) California and Oregon do not fully index their top brackets.
(b) New Hampshire taxes interest and dividend income only.
Sources: State statutes; Tax Foundation research.
For a full accounting of states’ approaches to inflation indexing, along with a discussion of best practices for adding cost-of-living adjustments to state tax codes, see our primer on this topic.