Income Taxes Individual Tax Brackets and Fixed Dollar Allowances As inflation causes prices and incomes to rise, our progressive tax structure places taxpayers in higher marginal tax brackets, which results in their paying a greater portion of their income in tax to the federal government each year. This increase in tax beyond the rate of inflation is known as the inflation tax. To illustrate this tax, consider the example of a family of four whose money income has increased from $15,000 to $16,500 to keep pace with one year of 10 percent inflation. Although the family's pretax purchasing power is the same—that is, its real income before taxes in economic terms has not changed-the family has jumped from an 18 percent marginal tax bracket to a 20 percent marginal tax bracket. In total, the family's federal income tax burden has increased from $1,242 to $1,530. The net result is an increase in tax liability of 23 percent, based on a money increase of only 10 percent and a decrease in after-tax real income.7 If the tax liability had risen at the same rate as inflation, 10 percent in our example, then the total tax liability would have increased only $124 (from $1,242 to $1,366) and neither the family nor the federal government would have had economic gain or loss because of inflation. Instead, the tax liability increased $288 (from $1,242 to $1,530). Although the family's income before taxes rose sufficiently to keep pace with inflation, the family now pays a larger portion of its income in taxes and its after-tax purchasing power is reduced by $164, the amount of the inflation tax. If the family's money income had remained constant, the purchasing power of that income would have been reduced by inflation. Indexation would at least reduce the tax cost, thereby mitigating the loss of real income. In conclusion, under an indexed tax code, the validity of a progressive tax structure would be maintained. There would continue to be greater tax liability at higher levels of income, but the increase in tax liability would result from increases in real income or purchasing power, not just from inflation, and the added tax associated with inflation-related increases in income would be eliminated. Tax Equity Inflation distorts the legislated distribution of the tax burden. Under the present system, inflation significantly increases tax liabil7. "The Inflation Tax," p. 2. ities at all income levels, but the greatest burden is borne by lowerincome groups. Indexing the tax code would maintain an equitable distribution of the tax burden by tying the tax base to real income, thus avoiding the shift in the tax burden caused by inflation. This would give greater credibility to the notion that our system of taxation really embraces an "ability-to-pay" concept. For example, the tax increase generated by one year of 7 percent inflation is as high as 15.5 percent at the $15,000-level and as low as 11.1 percent at the $25,000-level. At this rate, the tax liability on $15,000 of real income will more than double by 1984. The disproportionate impact of the inflation tax on low-income families is presented graphically in Figure 1.8 The tax increase caused by inflation is highest at the $10,000- and $15,000-income levels and declines gradually as income increases until the $35,000-income level, at which point it accelerates again. There are really two components of the inflation tax that explain the disparity in the effect of inflation on various groups. First, inflation erodes fixed dollar amounts. Low-income groups are most affected by the loss in value of personal exemptions since their personal exemptions are larger in proportion to income. Also, lowincome taxpayers generally do not itemize deductions. They usually use the zero bracket amount (formerly the standard deduction), another fixed dollar amount that is being eroded by inflation. Itemized deductions are more likely to be used by taxpayers at higher income levels. Since itemized deductions are based on actual expenditures, they tend to increase with inflation. (To the extent this is so, itemized deductions are self-indexing.) Second, as income increases, taxpayers are placed in higher marginal tax rate brackets, a phenomenon known as "bracket creep." This is especially true if the relative width of the tax brackets narrows, as happens for taxable income between $20,000 and $45,000. Indexing Tax Brackets Indexing the income tax brackets need not make the tax code more complicated, nor would it make the completion of tax forms more difficult. An inflation factor, generally based on the U.S. Consumer Price Index (CPI, see the section entitled "Measurement" in this statement), would be computed for the change in the CPI for a twelve-month period ending prior to the commencement of the tax year. Thus, the tax brackets in any particular year would be adjusted by the rate of inflation for the prior year. As of each January 1, the brackets should be known for such purposes as withholding and estimated tax payments. To allow sufficient time to calculate the inflation factor and publish new rate tables, the CPI for the twelvemonth period ending with the third quarter of each calendar year should be used to adjust the rates of the succeeding year. This use of the third quarter CPI from the prior year would result in an inflation factor that is "lagged" by fifteen months. Using the figures provided below as an example, the inflation factor would be determined in the following manner: Assuming that indexation began in 1980 and using 1980 as the base year, the marginal tax brackets for 1981 would be determined by adjusting the 1980 marginal tax brackets by the percentage increase in the CPI from 1979 (200) to 1980 (220), which is 10 percent (20/200). Marginal tax brackets for 1982 would involve adjusting the 1980 marginal tax brackets by 25 percent (50/200). The inflation factor would then be applied to the upper and lower boundaries of each marginal income tax bracket. For example, assume that during the base year taxable income between $6,200 and $7,200 is taxed at $450 plus 17 percent of the excess over $6,200. After the CPI has increased 10 percent, the marginal tax brackets would be adjusted so that income between $6,820 (110 × $6,200) and $7,920 (110 × $7,200) would be taxed at $495 (110 x 450) plus 17 percent of the excess over $6,820. To avoid working with unwieldy amounts the revised figures should be rounded to the nearest hundred dollars. Since annual adjustments are made in terms of the base year and not the previous year, rounding errors would not be compounded. If Congress decides to change the structure of the tax brackets, it could issue a new set of tax tables. These could then be indexed, with the year of enactment as the new base year. Indexing Fixed Dollar Amounts Indexing the fixed dollar amounts in the tax code is not conceptually or mechanically different from indexing tax brackets. The difference lies in the variety of fixed dollar amounts contained in the code and the wide range of purposes they serve. Regardless of whether a single inflation factor or special purpose indexes are used, fixed dollar amounts must be indexed to alleviate the effects of inflation. The following is a representative listing of fixed dollar amounts contained in the tax code, with an explanation of the effects of inflation (measured by changes in the Consumer Price Index) from the dates these provisions were enacted through March 1979.10 Dividend Exclusion. Section 116, as amended in 1964, allows an individual to exclude $100 of dividends from gross income. Inflation effectively eroded 56 percent of the benefits of the provision. Accordingly, the exclusion is equivalent to $44 rather than $100. Death Benefits. Section 101, introduced in 1954, excludes $5,000 of employee death benefits from gross income. This amount has never been revised, and inflation has effectively reduced the benefit of the exclusion by 62 percent (an effective exclusion of $1,900). Fellowship Exclusion. Section 117, introduced in 1954, excludes from gross income $300 "per month" of fellowship grants received by a nondegree candidate. This exclusion has never been increased and the benefit has effectively been eroded by 62 percent (an effective exclusion of $114). Group Term Life Insurance. Section 79, introduced in 1964, provides that an employee need not include in gross income the cost of $50,000 of group term life insurance provided by his employer. The amount has never been adjusted and is effectively reduced 56 percent by inflation to $22,000. Casualty Loss. Section 165(c)(3), introduced in 1964, limits casualty losses of individuals to amounts in excess of $100. This amount has never been adjusted, resulting in a 56 percent effective reduction. Here inflation benefits the taxpayer using the provision. Medical Insurance. Section 213(a)(2) has allowed a deduction of $150 for health insurance premiums since 1967. This amount has not been revised and has effectively been reduced 52 percent by inflation. 10. Kevin J. O'Brien and Jerry A. Menikoff, “Aspects of Indexing Taxes for Inflation" in Tax Notes, 21 January 1980, p. 59. Taxation With Representation Special Report, January 1980. |