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 marginal dollars, rather than rates, slowly lose value.
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.
|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||Indexed|
|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||Flat Tax (b)||n/a||—|
|Texas||No Income Tax|
|Utah||Flat Tax||Percentage of Federal||n/a|
|Washington||No Income Tax|
|Wyoming||No Income Tax|
|District of Columbia||—||Indexed||n/a|
(a) California and Oregon do not fully index their top brackets. (b) New Hampshire and Tennessee tax interest and dividend income only.
Sources: State statutes; Tax Foundation research