Sunday, October 18, 2020

The Truth About Inflation Adjusted Tax Brackets

 At the post, Biden’s Tax Whopper, Mike Cee takes me to task for warning about price inflation bracket creep.

He writes:

This non-article ignores the fact that the IRS makes annual adjustments for inflation to dozens of tax provisions, specifically to prevent bracket creep. So no, it's not accurate to say that "bracket creep will eventually get you." 

Perhaps this would be true if we weren't dealing with government written regulations.

For example, The Wall Street Journal reports:

A new year brings new tax numbers.

For years Congress has had the Internal Revenue Service adjust tax brackets and other provisions for inflation. (Revisions for 2020 are in the accompanying tables, and now is a good time to review them.)

But it’s equally important to remember key tax numbers that aren’t changing for 2020—because Congress hasn’t indexed them for inflation.

As a result, millions of Americans are paying more to Uncle Sam because there’s no indexing for a variety of tax provisions, including homeowner benefits, tax thresholds on Social Security and investment benchmarks among others. The 2017 tax overhaul added more to this list.

The lack of an inflation adjustment is often intentional, says Len Burman, a tax economist who is a professor at Syracuse University and co-founder of the Tax Policy Center.

“A provision with a fixed-dollar limit is a good way for policy makers to phase in a tax increase slowly,” he says.

Consider tax benefits for homeowners over the past three decades. Once, home buyers could deduct the interest on any amount of mortgage debt. In 1987, Congress limited this break to deductions on up to $1 million of debt used to buy up to two homes, unindexed for inflation. If this limit had been adjusted, it would have been more than $2 million by 2017’s tax overhaul.

Instead of adjusting the $1 million limit upward, the overhaul pared it to $750,000, again unindexed for inflation. Lawmakers also capped write-offs for state and local property and income or sales taxes, or SALT, at $10,000 per return, with no inflation adjustment. A popular exemption of up to $500,000 per married couple of profit on the sale of a house ($250,000 for single filers) enacted in 1997 also isn’t adjusted for inflation.

Over time, these benefits will erode further...

The income thresholds for including Social Security payments in taxable income haven’t changed since they were enacted in the ‘80s and ‘90s.

For example, the income thresholds requiring filers to report 85% of payments on their tax return have been $44,000 for married couples and $34,000 for singles since 1994. Karen Smith, a retirement-policy specialist at the Urban Institute, estimates that with inflation adjustments, they would be about $77,000 for couples and $60,000 for singles in 2020...

[I]nflation adjustments remain missing from other investment provisions. The thresholds for the 3.8% surtax on investment income have been fixed at $250,000 for most married couples and $200,000 for most singles since 2013, when the surtax took effect.

The granddaddy of unindexed provisions may be one for capital losses. Since 1978, the tax code has allowed investors to deduct only $3,000 of net long-term investment losses against ordinary income like wages. Adjusted for inflation, that deduction would be more than $12,000. There’s also a marriage penalty because the $3,000 limit applies to both single and married filers. To fix that, the threshold should arguably be $24,000 for married filers.

In 2020, nearly 62 million adults will receive Social Security payments, and payments will be taxable for about 32 million of them. Ms. Smith estimates that about 24 million, or nearly 8 million fewer recipients, would have taxable benefits if the income thresholds had been adjusted for inflation...

For investors, the inflation picture is more complex. Many have called for adjusting the “cost basis” of investments so investors aren’t taxed on inflation. Cost basis is the starting point for measuring taxable profit or loss.

Here’s a simplified example. Say that an investor bought shares for $5,000 two decades ago and sold them this year for $15,000. The taxable profit is $10,000, but about $2,600 of that is from inflation. If the cost were adjusted to exclude inflation, the investor’s tax would go down, and—proponents say—it would more accurately reflect what happened.

And then there is the curiosity of how adjustments are made when they are made.

The Tax Foundation reports:

Every year, the IRS adjusts more than 40 tax provisions for inflation. This is done to prevent what is called “bracket creep.” This is the phenomenon by which people are pushed into higher income tax brackets or have reduced value from credits or deductions due to inflation instead of an actual increase in real income.

The IRS uses the Consumer Price Index (CPI) to adjust the value of the parameters. It does this by taking the tax parameter’s base value and multiplying it by the current year’s CPI and dividing it by the base year’s CPI. For example, the base value for the top of the 10 percent income tax bracket is $7,000 with a base year of 2002. This is multiplied by 2014’s CPI-U of 235.69 and divided by 2002’s value of 178.68. The result is $9,225 (after rounding).

The CPI-U is not the only way to adjust tax parameters. Tax brackets could be adjusted in a number of ways including average wage growth (as Social Security brackets are currently adjusted) or the Chained CPI-U, which is another measure of inflation.

The choice of adjustment, although an obscure public policy, is meaningful for taxpayers. It could mean higher or lower tax burdens over a long period of time...

As can be seen in the chart below, wage growth regularly climbs faster than CPI growth. The difference is all bracket creep as wage advances are detected more accurately than inflation in the CPI. It is not because wages are growing "faster" than general prices. It is too long an argument for a post but that thinking is a fallacy. It is all about government goods and services indexes being notorious laggards in detecting general price inflation.

Blue line shows annual change in wages. Red line shows annual change in CPI.


Bottom line: Whenever the government claims it is giving a benefit to the people, such as inflation-adjusted tax brackets, always be suspicious. The government is in the business of saying one thing at the headline level and doing the exact opposite at the detail level.

There is a tremendous amount of potential bracket creep built into the tax structure.


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