High Inflation Means Rising Tax Bills

Americans’ purchasing power has been eroded by sharply rising inflation. The government is now poised for a significant increase in tax bills.

In more than a dozen states where income tax brackets are not indexed to inflation—as they are at the federal level—the current run of price increases could tip taxpayers into higher brackets, where they will owe larger slices of their income to the government. This is because wage increases will continue throughout the year to compensate for rising prices. However, other income sources, like Social Security, must increase with inflation.

Jared Walczak (Vice President, Tax Foundation) calls it an “unlegislated tax rise.” Although “bracket creep,” can be harmful to some taxpayers when inflation is low, it’s especially dangerous when prices rise at 40-year-highs as they are now.

Delaware residents who earn $64,000 each year but earned $60,000 in 2019 have not had their purchasing power grow. The highest income bracket in Delaware applies to those earning more than $60,000, and since the state does not automatically adjust their brackets for inflation, her tax bill goes up because the $4,000 she has earned is subject to a higher tax.

This is similar to the sticker shock that many shoppers experience at grocery stores, but you can’t choose how much.

Walczak says that although inflation is commonly called a hidden tax, in fact it causes a much more literal tax rise in states where tax brackets are unable to adapt for fluctuations in consumers’ purchasing power.

According to the Tax Foundation, 22 states and the District of Columbia fail to fully adjust their tax codes for inflation—either by not indexing income tax brackets to inflation or by leaving other major components such as the standard deduction unindexed. 13 out of those fail to index. Any This is a major part of the income tax codes. They should reconsider this change if state legislators want to save their constituents from a bad surprise next year.

At the federal level, earned income tax brackets do automatically rise with inflation—thanks to a change made in 1981, the last time America faced inflation on par with what we’re seeing today. However, the federal capital gains tax is exempted from this. NotIndexed to inflation

Capital gains tax is paid on income earned from investments. Tax rates for assets held longer than one year are zero to 20% depending on the individual’s annual income. Assets that are less than one year old are subject to regular income tax. Individuals who earn more than $445,850 or married couples with more than 501,600 are eligible for the 20% bracket. A 15 percent tax applies to those who earn more than $40,000.

These brackets These are Adjusted for inflation. However, the tax doesn’t take into consideration the impact of inflation on capital gains.

Think about our Delaware resident once again. She would be able to make $1,000 in capital gains if she had $1,000 of stock bought in 2000, and then sold the stock last year for $2,000 Because she earned more than $40,401 last year, she’s obligated to pay a 15 percent tax on that $1,000 gain—a $150 bill.

The $1,000 she saved in 2000 equals $1,670 now. While she might have been able to make $1,000 in profit, the real amount of her investment was only $330. Nearly half that amount must now be paid to government.

Isabelle Morales (a policy communication specialist from Americans for Tax Reform) argues, “Americans are taxed upon illusory Income as the result economy-wide prices-level rises, and being punished for existence of inflation.”

That compounds the more basic problem with capital gains taxes, which is that they result in the same dollar being taxed twice—once as corporate income and once as a capital gain for an investor.

The carve-out to home sales is another aspect of capital gains taxes that are affected by inflation. The capital gains tax on profit from the sale or purchase of primary home can be excluded by individuals up to $250,000 and couples up to $500,000 respectively. These thresholds, however, aren’t adjusted for inflation. They haven’t changed from 1997 to 2017, despite the huge increase in home prices.

It is difficult to index the capital gains tax in order to combat inflation. At the very least, instructing the Treasury to index capital gains—an idea that the Trump administration batted around but never implemented—would require an act of Congress.

Still, there would be benefits from such a change—and not just for the wealthiest Americans. Morales points to the fact that more than 25,000,000 households in America had filed capital gains filings for 2019, which is the most recent available year of data from IRS. More than half also reported earning below $100,000.

Taxpayers who do not make changes to their tax code may experience inflation’s unexpected effects. Your money is worth less than it used to be, and everything costs more—and now the government is going to take a bigger cut too.