Skip to main content

You are here

Bracket creep - inflation helps the government

By David Luhman on Sun, 06/28/2009 - 16:33

Bracket creep - inflation helps the government

As the biggest debtor, the US government doesn't mind seeing inflation reduce the value of the debt it owes. But the federal government also gains more tax revenues through higher inflation. This became especially obvious in the late 1970s.

The US federal government has a multi-bracket tax system whereby the so-called rich pay a higher percentage of their income in taxes. Currently, low-income workers face marginal rates of zero to 15 percent, while the highest income workers give about 40 percent of their last dollars to the federal government.

I cover other tax topics in my tape on income tax planning, but let's see how inflation can increase your tax burden.

Assume you're working in an environment where inflation is 20 percent. Last year you made $50,000 and were in the so-called "middle income" tax bracket of 28 percent.

This year you got a 20 percent raise to keep you even with inflation, so you're now making $60,000. In real terms, you're still making the same amount of money as you did last year.

However, according to the government, your $60,000 income now marks you as being one of "the rich", and since you're rich, you should pay more in taxes. So this year the government places you in the 31 percent marginal bracket, higher than the 28 percent bracket you were in last year.

This example is extreme because 20 percent inflation is high, but you get the same effect over three or so years of moderate inflation. However, inflation was so bad in the late 1970s that this bracket creep was hurting a lot of people.

To help remedy this, major sections of the tax code were indexed for inflation in the early 1980s. However, there are still many cases where the government is able to collect higher taxes through inflation, so the government still views inflation as its friend.

A good example is capital gains. Let's say you invest $10,000 in stocks. Over the next 10 years prices double due to inflation. Over 10 years your stocks also doubled in price, and you sell them for $20,000.

In real terms, you didn't make any money on your stock investment after inflation. But according to the government, you have a $10,000 taxable capital gain.

So the government likes inflation because it effectively reduces its debt burden while increasing tax receipts. But investors have come to understand this after being burned badly in the 1970s. Now investors are demanding a higher inflation premium before they'll lend to the government or anyone else.

Premium Drupal Themes by Adaptivethemes