How the Tax Code Handles Inflation (and How It Doesn’t)

June 28, 2021

A temporary gas shortage, caused by a hack attack, on much of the East Coast last month and fear of rising inflation have led some people to wonder if the 1970s are back. The Bureau of Economic Analysis report released last week did little to settle this fear, finding that the Personal Consumption Expenditures (PCE) price index rose 3.9 percent since last May, the highest annual increase since August 2008. Fortunately, since the 1970s, the tax code is better structured to account for inflation. In other ways, though, a return of inflation would create tax problems for the real economy.

In the 1970s, “bracket creep” in the tax code was a major source of concern. Under a progressive income tax, with several tax brackets where rates rise based on nominal income, increases in incomes due to inflation push taxpayers into higher tax brackets, even without an increase in real income. When annual inflation averaged above 5 percent each year, this was a real problem. Effectively, this meant paying more tax in real terms without any accompanying legislation.

Here is an example from Tax Foundation’s Tax Basics resource:

Imagine Beth has an annual income of $50,000 in 2000 and that her income grows to $75,000 by 2020. One might point out that Beth’s salary grew by 50 percent in nominal terms. However, the cumulative rate of inflation between 2000 and 2020 was about 50 percent. That means Beth’s higher 2020 salary actually buys her the same amount of goods and services in today’s economy. In other words, her purchasing power has stayed the same.

Now, imagine Beth faces a simple, two-rate tax schedule where a 10 percent rate is levied on the first $50,000 of her income, and a 20 percent tax rate is levied on income above $50,000. Suppose, now, that these bracket thresholds were adopted 20 years ago and have not changed since Beth was making $50,000. Even though Beth’s 2020 salary now buys her the same amount of goods and services, she has been pushed into a higher tax bracket, resulting in higher tax liability. The bracket thresholds have not kept pace with inflation.

These stealth tax increases helped drive passage of the Economic Recovery Tax Act of 1981 (ERTA), which included inflation indexing for tax brackets starting in 1985. Under inflation indexing, each tax bracket increases according to the change in overall prices. Under Beth’s example, the 10 percent bracket that applied to all income below $50,000 in 2000 would apply to all income under $75,000 in 2020.

Inflation also matters for how companies deduct the cost of their capital investments.  When companies pay corporate income tax, they subtract their costs as they are taxed on their profits. However, companies cannot deduct all their costs right away—most notably, the amount they spend on capital investments such as buildings and machinery may need to be deducted over several years based on an approximation of the life expectancy of the asset. For example, trucks are deducted over five years, office furniture is deducted over seven years, and a warehouse is deducted over 39 years.

Because of inflation and the time value of money, the present value of write-offs under these depreciation schedules is less than the original cost of the investment. If a company spends $39,000 to purchase a building, the deduction for $1,000 in year 39 is worth a lot less than the $1,000 deduction in year 1. That’s due to both the time value of money, as companies would prefer to take a deduction sooner rather than later, and inflation, because even a low and stable level of inflation significantly reduces the real value of money over long periods of time.

Not allowing companies to deduct the full cost of investment means that investment costs are disadvantaged relative to other expenses. The result of this imbalance is lower capital investment. Lower investment means fewer productivity gains, slowing economic growth and wage growth.

The table below shows the present value of delayed deductions decreases as inflation rises, using the standard MACRS (Modified Accelerated Cost Recovery System) rules for depreciation allowances. Even before 2020, when inflation was historically low, deductions for long-lived assets lost over half their value over the long term thanks to the combination of the still-low inflation rate and the time value of money. With inflation expected to increase, companies will be able to deduct an even smaller share of their investments in physical capital over time.

Present Value of Future Deductions under MACRS
  5-year asset 10-year asset 15-year asset 20-year asset 39-year asset
Full Expensing $100.00 $100.00 $100.00 $100.00 $100.00
MACRS if inflation rate is undershot (1.5%) $89.68 $80.75 $73.00 $66.26 $47.50
MACRS if inflation rate is consistent with Federal Reserve target (2%) $88.63 $78.94 $70.66 $63.56 $44.38
MACRS with Federal Reserve projected 2021 inflation rate (3.4%) $85.81 $74.22 $64.71 $56,87 $37.23
MACRS with higher than expected rate of inflation (5%) $82.78 $69.37 $58.85 $50.53 $31.20

Note: Assumes straight line depreciation, half-year convention, 3 percent real discount rate, plus inflation.

Source: Authors’ calculations.

Full and immediate expensing, when investment costs can be deducted the year they are incurred, eliminates this problem. Evidence from the United States and abroad has shown that allowing firms to deduct investment sooner has driven increases in investment, output, and wages. The Tax Cuts and Jobs Act of 2017 (TCJA) allowed companies to expense the cost of short-lived assets, but this policy will begin to phase out next year. With fears of inflation rising, making those provisions permanent is becoming more urgent.

Expensing is the simplest way to make the income tax code more resistant to the problems associated with inflation. There are some policy arguments that taxes on capital gains and interest should also be indexed to inflation. However, that is much more difficult to administer, and those changes have a much smaller impact on economic growth relative to full expensing.

In sum, while parts of the tax code can handle inflation, full expensing of capital investment would be a major improvement along these lines.

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A 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.

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.

Full 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.

Depreciation 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.

Bracket 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.