Inflation tax | As inflation rises, tax bills will also rise in many states

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Inflation is often referred to as a hidden tax, but in many states it results in a much more literal tax increase because tax brackets do not adjust to changes in the purchasing power of consumers. This phenomenon is called “media creep” and it is far scarier than the scenery that begins to appear in people’s front yards as we move into the final weeks of October.

Inflation currently stands at 5.4% in the past 12 months, the biggest increase in decades, and is about 6.3% higher than at the start of the pandemic. A dollar does not go that far these days and compensatory measures have been taken in various sectors. Social Security recipients, for example, will see a cost of living adjustment (COLA) of 5.9% next year, the biggest increase in about four decades. Salaries have risen by around 7.3% during the pandemic, offsetting rising costs, although this can be cold comfort to those who have not seen their own salaries rise or have seen the value of their investments. to lower.

However, we often forget what happens to state tax burdens when inflation is high. When tax brackets, standard deduction or personal exemptions are not corrected for inflation, they lose value due to inflation, which increases tax burdens in real terms. Tax bracket drift occurs when more of a person’s income falls in higher tax brackets due to inflation rather than higher real incomes.

Imagine, for example, a Delaware resident who earned $ 60,000 in taxable income in 2019 and now earns $ 64,000. Due to inflation, she hasn’t seen an increase in her real income: her $ 64,000 today has roughly the same purchasing power as her $ 60,000 in 2019. But if the brackets state taxes are not indexed to inflation, while her top marginal rate was previously 5.55% (on income between $ 25,000 and $ 60,000), she now has $ 4,000 taxed at the higher rate of 6.6%. His tax bill increased by $ 264 even though his purchasing power remained constant.

Forty-one states and the District of Columbia tax salary income, while New Hampshire taxes only income and dividends. Of these, 15 states and DCs fail to adjust the brackets for inflation, 10 states leave their standard deduction (if they have one) unadjusted, and 18 have a non-indexed personal exemption. Together, 22 states and the District of Columbia have at least one major non-indexed provision. Thirteen states do not index any relevant major component. (In some cases, they may forgo a standard deduction or personal exemption, but not all of the relevant provisions are indexed.) They are Alabama, Connecticut, Delaware, Georgia, Hawaii, Kansas, Louisiana, Mississippi, New Jersey, New York, Oklahoma, Virginia, and West Virginia.

The absence or insufficiency of cost-of-living adjustments in many state tax codes is still a problem, as it constitutes a non-legislative tax increase each year, reducing wage growth and reducing the return on investment. During a period of higher inflation, however, the impact is particularly large.

To see how important inflation can be, consider capital gains. Let’s say you bought $ 10,000 of shares in 2001 and sold them for $ 20,000 in early 2021. The federal and state governments would consider this to be capital gains income of $ 10. $ 000. The federal government offers a preferential rate on long-term capital gains, unlike most states. In real terms, however, the gain is much less than $ 10,000, as cumulative inflation over this period was nearly 55%, which is a real gain of $ 4,502. Note that indexing tax codes to inflation alone cannot solve the problem of over-taxation of capital gains income, but it at least illustrates the larger problem.

The following table shows which provisions in each state are indexed for inflation. For states that fail, there is no time like the present to remedy the problem. Most states are currently overflowing with cash, and if policymakers don’t act, taxpayers will get a double hit from inflation, with an explicit tax increase on top of the implicit.

State indexation of the main characteristics of personal income tax
State Supports Standard deduction Personal exemption
Alabama
Alaska No income tax
Arizona Indexed Indexed Indexed
Arkansas Indexed
California Indexed (a) Indexed Indexed
Colorado Flat rate tax Federal Compliant n / A
Connecticut n / A
Delaware
Florida No income tax
Georgia
Hawaii
Idaho Indexed Federal Compliant n / A
Illinois Flat rate tax n / A Indexed
Indiana Flat rate tax n / A
Iowa Indexed Indexed
Kansas
Kentucky Flat rate tax Indexed n / A
Louisiana n / A
Maine Indexed Federal Compliant n / A
Maryland Indexed
Massachusetts Flat rate tax n / A
Michigan Flat rate tax n / A Indexed
Minnesota Indexed Federal Compliant Federal Compliant
Mississippi
Missouri Indexed Federal Compliant n / A
Montana Indexed Indexed Indexed
Nebraska Indexed Indexed Indexed
Nevada No income tax
New Hampshire Flat rate tax (b) n / A
New Jersey n / A
New Mexico Federal Compliant n / A
new York n / A
North Carolina Flat rate tax n / A
North Dakota Indexed Federal Compliant n / A
Ohio Indexed n / A Indexed
Oklahoma
Oregon Indexed (a) Indexed Indexed
Pennsylvania Flat rate tax n / A n / A
Rhode Island Indexed Indexed Indexed
Caroline from the south Indexed Federal Compliant Indexed
South Dakota No income tax
Tennessee No income tax
Texas No income tax
Utah Flat rate tax Federal percentage n / A
Vermont Indexed Indexed Indexed
Virginia
Washington No income tax
West Virginia n / A
Wisconsin Indexed Indexed
Wyoming No income tax
District of Colombia n / A

(a) California and Oregon do not fully index their top brackets.

(b) New Hampshire only taxes interest and dividend income.

Sources: State statutes; Search for the Fiscal Foundation.

For a full account of state approaches to inflation indexing, as well as a discussion of best practices for adding cost-of-living adjustments to state tax codes, see our introduction on this topic.

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