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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Tax Indexing

What it is:

Tax indexing is method for adjusting tax rates to account for inflation-related increases in income.

How it works (Example):

For example, let's say that John makes $100,000 a year and is in the 28% federal income tax bracket. Let's further assume that the tax rate is 30% for income that is $102,000 and higher. 

John is in the 28% tax bracket, but over the course of a few years his salary adjusts up to $103,000 due to a series of cost-of-living allowances. Because of inflation, John's $103,000 salary buys the same amount of goods and services that his $100,000 salary did, but now he's in the 30% tax bracket. 

John has experienced "bracket creep," which happens when inflation drives income up and into higher tax brackets. As a result, John may have gotten a $3,000 raise from his original $100,000 job, but after factoring in the effects of inflation and the higher tax rate, he's gotten no real increase in his purchasing power

Part of the problem is that the tax code has stayed the same during this time of inflation. But if the government practices tax indexing, then it adjusts the tax rates in lockstep with inflation so that bracket creep does not occur.

Why it Matters:

Tax indexing is particularly important when inflation is high, though in the real world tax codes can take a very long time to change. Regardless, tax indexing is an attempt to stimulate the economy, or at the very least, not hinder economic growth. Taxing authorities that wish to increase tax revenues, however, might refrain from tax indexing, thereby helping the government financially benefit from inflation by allowing inflated incomes to be taxed at higher rates.

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