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State Tax Policy as an Inflation Response

7 min readBy: Jared Walczak

The rate of 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 slowed markedly in recent months, even declining slightly in December—but at year’s end, prices were still 14.6 percent higher than they were two years prior. That’s the fastest inflation rate over any two calendar years since the stagflation era of the late 1970s. State policymakers are understandably interested in bringing any tools at their disposal to bear on the problem. And many of them are reaching for 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. policy solutions.

Are Tax Rebates and Tax Holidays the Answer?

Most states are still flush with cash, while taxpayers continue to face high prices for everyday goods. It’s little wonder that 19 states have adopted some form of temporary tax rebate program since 2021, with the potential for another wave of checks to go out this year. But as we’ve explained before, good intentions do not always make for good policy:

Consumers aren’t just paying more—they’re buying more. Despite—and in fact contributing to—supply chain breakdowns, container throughput in major U.S. ports broke records in 2021. Prices are high, in part, because supply is having trouble keeping up with demand, especially for physical goods. Additional one-time transfers put even more pressure on the system. Even if taxpayers put only a fraction of the money toward additional consumption, the result is more demand-side pressures when there are already supply shortages.

Long-term tax relief also puts more money in taxpayers’ pockets, of course, but with a very different incentive structure. Permanent rate reductions or structural reforms create a higher return to labor and investment, and thus promote economic growth. By contrast, while a one-time payment induces some economic changes, it does not, by definition, change long-term planning. More money retained by taxpayers under long-term reforms will be accompanied by changes in labor supply, productivity, and capital investment, increasing supply as well as demand.

Even if one-time tax rebates are not particularly economically efficient, it isn’t unreasonable for policymakers to prefer them to unnecessary one-time government spending, or—worse—to use one-time revenue gains for long-term spending increases. Such policies can have their place. But their ordinary inefficiencies are magnified in a high inflation environment.

Can 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. Provide Relief?

Inflation-adjusting income taxes is always sound policy, but it’s particularly important in today’s high inflation environment. Inflation indexing helps prevent taxpayers from being bumped into higher tax brackets due to inflation-induced wage increases that haven’t increased their purchasing power, a process known as 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. . Here’s an example drawn from our prior analysis:

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 indexing 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.

When states fail to index brackets, deductions, and exemptions for inflation, they permit an unlegislated tax increase to go through each year. The federal government created much of the inflation under which taxpayers are currently suffering; states shouldn’t add insult to injury by using inflation as an excuse to increase effective income tax rates.

What about Property TaxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. es?

Property values have risen dramatically since the start of the pandemic, and that means property tax burdens have gone up as well. It makes sense that property value would be the basis of a homeowner’s tax bill, but it doesn’t make sense to allow tax collections to soar just because property values are rising. In many states, assessed values are up 25 to 40 percent over the past two years. The cost of local government has not risen by that amount, and residents are not getting 25 to 40 percent more, or better, government services for their money.

This is where property tax limitations can come in. These limitations come in three flavors: levy (revenue) limits, rate limits, and assessment limits. Often, states default to assessment limits, following the trail blazed by California’s Proposition 13 but, as we explained recently, that is a mistake:

Proposition 13 and other property tax assessment limits have done their job, keeping incumbent property owners’ taxes in check. But they’ve come with hidden costs. They discourage homeowners from renovating or adding onto their homes, for fear of incurring a dramatic tax increase. They make it less attractive for growing families to move past their starter homes or for empty nesters to downsize. They interfere with efforts to change a property’s use. And, over time, they shift costs to newer, younger homeowners—the rising generation that [state] lawmakers want to keep in-state.

As we’ve discussed in the past, lawmakers would be better served by adopting levy limits, which allow property tax burdens to change in relative terms based on changes in a given property’s assessed value, but avoid allowing overall property taxes to rise too far, too fast.

Should Groceries Be Exempt from Sales TaxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. ?

Spend a few minutes pushing a shopping cart these days and you might be clamoring for any savings at all on groceries. No wonder there’s been a renewed push to exempt groceries from the sales tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. . Unfortunately, the exemption erodes a relatively pro-growth tax, leaving states to generate more of their revenue from less economically efficient sources, and it doesn’t accomplish what it sets out to do. As our research has revealed:

It is commonly assumed that the exemption of groceries from state sales tax bases has a progressive effect, with a distribution of benefits which favors low- and middle-income taxpayers. It is primarily upon this basis that lawmakers in most states have carved groceries out of the sales tax base. The assumption is simple and, on the surface, reasonable—and it is wrong. As counterintuitive as it may seem, the lowest decile of households experiences 9 percent more sales tax liability under a sales tax with a grocery exemption than one with groceries in the base, assuming that rates are adjusted to generate the same amount of revenue from each tax base.

Our report goes into detail on the reasons for this surprising result, which includes the existing exemption for SNAP purchases (which increases the relative importance of the tax on non-food items for the lowest-income households), how groceries are defined for tax purposes, and the distribution of grocery costs. The bottom line is that states would not only make their tax codes more efficient, but also do better by their lowest-income households if they took any revenue they were willing to forgo to carve groceries out of the sales tax base and instead directed it toward a general rate cut.

Can States Implement Any Tax Policies to Combat Inflation?

States can respond to inflationary pressures on taxpayers, but because inflation is essentially a monetary phenomenon, there is relatively little that any state can do to curb inflation itself rather than dampen its effects on their residents. Yet states do have one valuable tool available to them that not only promotes in-state economic growth but also helps bring down prices.

Our economy has changed since the start of the pandemic. We’re consuming differently, and businesses are being forced to adapt to these changes in demand. Retooling takes time—and investment. Unfortunately, a recent change in the federal tax code means that inflation drives up the cost of the very business investments that can boost supply, address supply chain bottlenecks, and start bending the cost curve down. Here’s the issue:

When a business pays taxes, it deducts ordinary business expenses from revenue to determine 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. and its tax liability. Ordinary business expenses include labor costs (wages and salaries) as well as operational costs. When a business makes a capital investment, however—in land, facilities, machinery, or equipment—then under traditional rules, the deduction is spread over multiple years, sometimes decades. (There are different 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. schedules for different classes of capital investment.) By denying a full deduction for the costs of capital investment, the tax code yields taxable income in excess of actual income on a cash-flow basis.

This increases the cost of investment even though the business will eventually take the full deduction, since the value of future tax savings is reduced by both inflation and the time value of money. On the margin, some investments are no longer profitable and will not take place.

States can’t force the federal government to make full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. permanent, but they can use their 2023 legislative sessions to ensure that a pro-investment tax policy does not disappear at the state level just when it is most needed.