Personal income tax adjusts for inflation, but it could do better


In times of inflation, such as the one we are currently experiencing, a review of the tax code shows that some provisions are automatically indexed, or adjusted, to match inflation, while others are not. And that creates unfair burdens on taxpayers. But it’s not always as simple as “adjusting to inflation”. This works for some structural elements of the tax code, like tax brackets. But other inflation-related issues, especially those related to capital gains, require more thought about how income tax works, ideally moving to a consumption tax base where all income is taxed only once.

The most basic provisions, namely personal income tax brackets and standard deduction, are adjusted for inflation. In addition, minimum income threshold for alternative minimum tax, capital gains tax brackets, earned income tax credit (EITC) maximum values, 20% deduction limits on business income and the annual exclusion for gifts received be adjusted for inflation. The refundable portion of the Child Tax Credit (CTC) is also indexed to inflation, but not the maximum value.

Several other provisions are not indexed. For example, the Net Investment Income Tax levies a 3.8% tax on investment income for single filers earning more than $200,000 or joint filers earning more than $250,000. Considering cumulative inflation since the tax was first enacted in 2013, the NIIT should apply to single filers earning more than approximately $246,000 or joint filers earning more than approximately $308,000. Indexing the thresholds for the NIIT would be a simple solution.

For many other personal income tax provisions, the appropriateness of adjusting them for inflation varies depending on how one thinks the income tax should be structured. Under a savings-consumption-neutral income tax, income is only taxed when it is consumed. In other words, savings are deducted when earned but taxed when realized. In fact, this could be achieved by creating Universal Savings Accounts, where all savings would be eligible for 401(k) tax treatment and taxed at ordinary income rates when realized (or alternatively, taxed like the Roths). IRA).

However, the other view is that income tax should tax changes in net worth, so savings would not be deductible and savings returns would be taxed as ordinary income. Saved income is taxed twice in this scenario: when earned and later when consumed, while income consumed immediately faces only one layer of tax.

Introducing a savings- and consumption-neutral income tax would more broadly address inflation-related problems with the taxation of capital gains. Under current law, taxpayers owe capital gains taxes even if, in real terms, they earn no income because their gains are wiped out by inflation. A proposed solution is to adjust the base (the value of the initial investment) for inflation so that capital gains tax only falls on real increases in income. There are several problems with indexing earnings, however: fixed-income assets such as bonds or annuities and perpetuities are much more sensitive to inflation than stocks. Indexing some types of earnings, but not others, would create problems.

Replacing the current income tax with a neutral tax on savings and consumption would fully solve the inflation problem without the complexities of indexation. Consider a system where all savings are eligible for 401(k) tax treatment – ​​deducted when first earned, taxed only when used for consumption. In such a system, the taxpayer only owes taxes based on the change in real value rather than inflation.

Consider the example of a taxpayer who invested $100 of income in one year and 10 years later sold the investment for $125. Cumulative inflation over the decade is 50%, so $125 can buy less real goods and services than $100 10 years earlier. Under the current system, the taxpayer would have to pay tax on both the $100 when initially earned and the $25 of nominal earnings 10 years later. But under the universal 401(k) system, the taxpayer would only be taxed on the full $125 in the 10th year, which in real terms is worth less than the $100 they originally invested.

All in all, the basic structure of personal income tax brackets adjusts reasonably well to inflation. For the other provisions, in particular related to capital income, the question is whether the income tax system should be neutral between savings and consumption. In such a case, where all savings are deductible when earned but taxed when realized (or vice versa), there is no need to index capital gains to inflation.

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