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Tax Indexing

Tax Indexing

What Is Tax Indexing?

Tax indexing is the adjustment of the different rates of taxation in response to inflation and to stay away from bracket creep. Bracket creep happens when inflation drives income into higher tax brackets, bringing about higher income taxes however no real increase in purchasing power. Tax indexing endeavors to dispense with the potential for bracket creep by changing the tax rates before the creep happens.

How Tax Indexing Works

Tax indexing is a method of tying taxes, wages, or different rates to an index to protect the public's purchasing power during periods of inflation. During periods of inflation, bracket creep is probably going to happen since tax codes generally don't answer rapidly to changing economic conditions. Tax indexing is meant to be a proactive solution to bracket creep. By utilizing a form of indexation, it assists taxpayers with keeping up with their equivalent purchasing power and stay away from higher tax rates brought on by inflation.

In the U.S., the government is permitted to utilize tax indexing consistently, so this change doesn't need to look out for legislative endorsement. Most highlights of the federal income tax are as of now indexed for inflation. Consequently, states that tie their income taxes closely to federal rules will find it more straightforward to keep away from inflationary tax hikes.

A government that has a system of tax indexing in place can change the tax rates in lockstep with inflation so that bracket creep doesn't happen. Tax indexing is especially important during periods of high inflation when there is a need to balance out economic growth.

Illustration of Tax Indexing

For the 2019 tax year, an individual that acquires $39,475 falls in the 12% marginal tax bracket. The 12% tax bracket catches income inside the scope of $9,701 and $39,475. The next bracket is 22% which catches income in the scope of $39,476 to $84,200. Assuming that this taxpayer's income is increased to $40,000 in 2019, he will be taxed 22%. In any case, due to inflation, this taxpayer's annual income ($40,000) purchases the very amount of goods and services that their previous $39,475 did. Moreover, his take-home pay in 2020 after taxes have been kept is not as much as his 2019 net income even with no real increase in his purchasing power. In this case, bracket creep has happened, pushing this taxpayer into a higher tax bracket.

In the model above, indexing taxes for inflation would mean that the $39,475 cutoff for the 12% tax bracket will be adjusted consistently by the level of inflation. Thus, assuming inflation is 4%, the cutoff will naturally increase to $39,475 x 1.04 = $41,054 in the next year. In this manner, the taxpayer in the model will in any case fall in the 12% tax bracket after his earnings increase to $40,000. Indexing income taxes for inflation guarantees that the tax system treats individuals in generally the same manner from one year to another.

Highlights

  • Tax indexing is the adjustment of the different rates of taxation in response to inflation and to stay away from bracket creep.
  • Bracket creep happens when inflation drives income into higher tax brackets, bringing about higher income taxes however no real increase in purchasing power.
  • A government that has a system of tax indexing in place can change the tax rates in lockstep with inflation so that bracket creep doesn't happen; in the U.S., the government is permitted to utilize tax indexing consistently, so this change doesn't need to look out for legislative endorsement.