One important, common-sense taxpayer protection built into the federal 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. code is 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. . 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. indexing means that tax brackets (and other important dollar-amount features of 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. , like standard deductions or personal exemptions) are revised annually to reflect nominal price and wage increases that result from inflation. Thanks in part to my colleague Steve Entin, the federal income tax code has been inflation-indexed since the 1980s. However, states vary with regard to how well they adjust their income tax brackets, as you can see in the map below:
When tax brackets aren’t indexed for inflation, it results in what economists call “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. .” Higher income can bump a taxpayer into the next 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. , even if that higher income is merely keeping pace with inflation. A lack of inflation adjustment can also push more of a taxpayer’s income into the highest bracket for which they qualify. The final result is a tax increase that occurs without any legislation being passed. Indexing addresses this by altering each bracket level each year by the level of annual inflation.
Here’s an example under Virginia’s individual income tax:
Take a single individual who earns $40,000. Currently, that person takes a 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 (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. of $3,000 and a personal exemption of $930, leaving $36,070 as 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. . After applying the tax table, he would owe $1,816 in state income tax. If the taxpayer gets a 2 percent raise next year because of inflation, his income rises to $40,800 and his tax bill rises to $1,863. Because Virginia doesn’t index its tax brackets, its standard deduction, or its personal exemption, this tax bill is a 2.53 percent increase over the previous year. An inflation-indexed code would only raise his income tax liability by 2 percent—which is not a hike at all in real terms.
Which states include this important tax policy feature in their tax codes? Surprisingly, not enough of them:
- Only 24 states fully index brackets to inflation (this includes the nine states with single-rate income taxes, which are by definition inflation-indexed)
- California and Oregon partially index their brackets.
- 17 states plus D.C. with multiple brackets do not index at all.
Also important, but not pictured in the map are details about which states inflation-index their standard deductions and personal exemptions. For a list of these, see page 73 of our 2016 State Business Tax Climate Index.Share