Inflation Indexing

Inflation 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 nominal dollars, rather than rates, slowly lose value.

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Which Tax Provisions Can Be Indexed?

Any tax provision tied to a specific dollar amount can potentially be inflation-adjusted. Motor fuel taxes are a good example as they are typically levied in terms of cents per gallon. Within the individual income tax, brackets, standard deductions, personal exemptions, and other features can all be indexed to avoid the imposition of a hidden inflation tax, which occurs when a greater share of a taxpayer’s income is taxed even if their real income has not increased. With excise taxes, indexing is generally intended to benefit the government, taking volume-based levies like a motor fuel tax and adjusting them to maintain their value in real terms.

Importance of Inflation Indexing

Indexing has important implications for tax equity, political accountability, and the rate of growth of government revenues. Without indexing, inflation can distort tax liability because inflation changes do not affect all taxpayers equally and are not in line with legislative intentions. Without changes to state tax provisions, inflation increases state income tax collections significantly faster than the real growth of state income, or erodes excise tax collections as inflation reduces the value of a volume-based levy expressed in dollar terms. This means the tax code changes without a vote being taken, which creates a lack of political accountability.

Design of Inflation Indexing

States use different measures of inflation, different equations for their calculations, different rounding conventions, and even different dates for calculating a given year’s inflation adjustment. Some states make cumulative adjustments from a base year, while others upwardly revise the figures from the prior year’s brackets. Some use fiscal years, others calendar years, and others their own state-defined periods, while many follow the federal convention of a 12-month period running from September to August. Methods differ not only state-to-state, but even provision-to-provision within a given state. Ideally, mechanisms should be consistent within a state, and should be simple and easily replicable, with fair rounding conventions that do not invariably favor the government over the taxpayer.

The federal government also uses different measures of inflation. For instance, the US Bureau of Labor Statistics (BLS) produces an index, called the Consumer Price Index (CPI), which measures the average change over time in prices paid by consumers for goods and services, such as food and energy. The index is used to calculate the real wages and earnings of urban consumers. Many tax parameters, such as the thresholds for income tax brackets, are indexed to this measure. Some agencies, like the Social Security Administration (SSA), use this monthly measure to adjust the dollar value of benefits it pays out to disabled and retired workers and their families, so their value keeps pace with inflation.

However, not everything is designed using inflation indexing. For instance, the cap on mortgage interest deductibility set under the Tax Cuts and Jobs Act is not indexed to inflation. Furthermore, Congress sets the federal minimum wage using current, non-inflation-adjusted dollars per hour of work. Congress last raised the federal minimum wage in 2009 to $7.25 per hour. That means real wages have fallen since that time, as price levels have continued to increase.

Inflation indexing also occurs at the international level. However, the methodology varies significantly across nations and has never been universally adopted. In general, countries with advanced economies are more likely to index expenditure. Pensions and social assistance programs tend to be particularly popular items for indexing. For instance, most European countries index their public finance and social programs using the European Union’s Harmonized Index of Consumer Prices (HICP), an index like the CPI used to measure inflation in the eurozone.

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