What Is Bracket Creep?
Bracket creep is a situation where inflation pushes income into higher tax brackets. The result is an increase in income taxes but no increase in real purchasing power. This is a problem during periods of high inflation, as income tax codes typically take longer to change than the rate of inflation.
- Inflation in the economy reduces the purchasing power of your money, and it can increase the amount of money you pay in taxes.
- In an inflationary environment, your salary increases as the prices of goods you consume increase. You have more money nominally, but practically, it's the same amount.
- Government taxes are in fixed amounts set by statute, however, so the government takes more of your paycheck, even though you don't have more money to spend.
Understanding Bracket Creep
Bracket creep can occur on an ongoing basis if the overall economy grows yet taxpayers do not see substantial increases to their income. In other words, their taxes are higher even though they did not see any real improvement in income. This can create a financial drag on the economy as taxpayers spend more money on taxes though they have not reaped any benefits of a tangibly higher salary rate.
Salaries may see nominal increases where the take-home pay shows no real change; however, if the Internal Revenue Service has not made adjustments to the brackets, it can force taxpayers into paying higher rates. Bracket creep essentially increases taxes for individuals without any legislation for a tax increase.
The loss of money to this form of taxation can amount to trillions of dollars over a twenty-year period. This can be particularly challenging for individuals and households in lower-income segments because the taxes they must pay can escalate rapidly the larger the salary they begin to earn.
Furthermore, there may be expenses, such as rent, that are floating and prone to increase faster than income. There is some debate over how bracket creep affects taxpayers in the higher-earnings brackets, because of the higher tax rates they may already be charged, the push to an even pricier bracket can drastically reduce their net income. This, in turn, can encourage the use of tax planning services in order to curtail the progression of bracket creep.
Real World Examples of Bracket Creep
Typically, the IRS relies on the Consumer Price Index to scale its adjustments by taking into account base-year versus current-year indicators. The calculation for the adjustments can be made multiplying the base value of a tax parameter by the current Consumer Price Index, then dividing that by the CPI of the base year.
There are other ways the IRS may adjust the brackets, such as measuring the average wage growth in order to get a sense of inflation. As bracket creep affects personal wealth, there is often debate regarding tax cuts and how adjustments are made to tax brackets to better account for the increases.
Every year the IRS posts the ways it has adjusted the tax code to account for inflation on its website. Starting in the year 2019, the tax inflation adjustments are built on the Tax Cuts and Jobs Act of 2017.