The Relationship Between Inflation and Tax Bills

Inflation is commonly referred to as a hidden tax. But, in many places it results in a much more literal tax rise because tax brackets do not adapt to changes in consumer buying power. This tendency is “bracket creep.” It’s far creepier than the Halloween decorations that are appearing in people’s front yards as we approach the end of October.

Inflation now stands at 5.4 percent in the last year, the most effective rate in decades. However, it is now around 6.3 percent higher than when the outbreak started. Since a dollar doesn’t travel as far as it used to, compensatory measures get implemented in a range of industries. For example, next year Social Security retirees will receive a 5.9% Cost of Living Adjustment (COLA), the most significant rise in nearly four decades. Income has increased by roughly 7.3 percent throughout the pandemic, offsetting greater costs. Nevertheless, this may be little consolation to those who haven’t seen their wages grow or whose investments have lost value.

When does Bracket Creep Occur?

When the inflation is quite high, how does it impact the state tax burdens? Also, when personal exemptions, the standard deduction and tax brackets don’t get adjusted for inflation, they lose their value over time. As a result, it increases tax loads in real terms. Bracket creep occurs when inflation, rather than increasing actual earnings, causes more of a person’s income to fall into higher tax bands.

Consider a Delaware person who earned $60,000 in taxable income last year and now earns $64,000. She hasn’t seen a rise in real income because of inflation. Her $64,000 now has roughly the same buying power as her $60,000 in 2019. If her state’s income tax bracket isn’t inflation-indexed, she’ll get taxed higher of 6.6 percent on $4,000. At the same time, her top marginal rate was formerly 5.55 percent (on income between $25,000 and $60,000). Her tax burden increased by $264, even though her buying power remained unchanged.

New Hampshire taxes only dividend income and income. While the District of Columbia and 41 states tax wage income. Out of these the District of Columbia and 15 states do not update brackets for inflation. Ten states do not increase their standard deduction (if they have one). Further, 18 states have an uncategorized personal exemption. 

At least one significant unindexed provision exists in 22 states and the District of Columbia. Thirteen states do not have any relevant key components. They may opt-out of a personal exemption or standard deduction in some situations, but all applicable rules are unindexed. West Virginia, Virginia, Oklahoma, New York, New Jersey, Mississippi, Louisiana, Kansas, Hawaii, Georgia, Delaware, Connecticut and Alabama are the states they represent.

The Relationship Between Inflation and Tax Bills

The lack of or inadequacy of cost-of-living adjustments in several state tax laws is always a problem. This amounts to an annual unlegislated tax increase, stifling wage gains and lowering the return on investment. However, during periods of increased inflation, the impact is most noticeable.

Consider capital gains to illustrate how substantial inflation might be. Assume you bought $10,000 worth of stock in 2001 and sold it for $20,000 at the beginning of 2021. Both the state and federal governments would consider this $10,000 in capital gains income. Most regions do not offer a preferential rate on long-term capital gains. Perhaps, the federal government does.

Nevertheless, the gain is significantly less than $10,000. This is due to approximately 55 percent cumulative inflation throughout that period. Thus, the actual gain results as $4,502. It’s worth noting that indexing tax laws to inflation won’t fix the problem of over-taxation of capital gains income. It’s illustrative of the more significant issue.

There is no better time than the present for nations that are falling short. Most states are presently cash-rich. If policymakers do nothing, taxpayers will face a one-two punch from inflation. There will be an apparent tax rise on top of an implicit one.

It sometimes gets overwhelming to understand the governing rules and regulations. You may not be aware of the taxation policies, and it is completely fine. We, at Platinum Tax Defenders, will help you with any taxation issues. 

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