DEFINITION of 'Tax Indexing'

Tax indexing is the adjustment of the various rates of taxation in response to inflation and to avoid bracket creep. Bracket creep occurs when inflation drives income into higher tax brackets, resulting in higher income taxes but no real increase in purchasing power. Tax indexing attempts to eliminate the potential for bracket creep by altering the tax rates before the creep occurs.

BREAKING DOWN 'Tax Indexing'

Tax indexing is a method of tying taxes, wages, or other rates to an index to preserve the public's purchasing power during periods of inflation when bracket creep is likely to occur since tax codes generally do not respond quickly to changing conditions. Tax indexing is meant to provide a proactive solution by using a form of indexation to maintain purchasing power and avoid higher taxation brought on by inflation.

For example, as of 2018, an individual that earns $38,700 falls in the 12% marginal tax bracket. To be more precise, the 12% tax bracket captures income within the range of $9,526 and $38,700. The next bracket is 22% which captures income in the range $38,701 to $82,500. If this taxpayer’s income is increased to $40,000 in 2019, he will be taxed 22%. But due to inflation his $40,000 annual income buys the same amount of goods and services that his previous $38,700 did. Furthermore, his take home pay in 2019 after taxes have been withheld is less than his 2018 net income even with no real increase in his purchasing power. In this case, a bracket creep has occurred, pushing this employee into a higher tax bracket.

A government that has a system of tax indexing in place can adjust the tax rates in lockstep with inflation so that bracket creep does not occur. This is particularly important during periods when inflation is high and there is a need to stabilize economy growth. Following our example above, indexing taxes for inflation would mean that the $38,700 cutoff for the 12% tax bracket will be adjusted every year by the level of inflation. So, if inflation is 4%, the cutoff will automatically increase to $38,700 x 1.04 = $40,248 in the following year. Therefore, the taxpayer in the example will still fall in the 12% tax bracket after his earnings increase to $40,000. In effect, indexing income taxes for inflation helps ensure that the tax system treats people in roughly the same way from year to year.

Typically, the government is allowed to use tax indexing every year, so that this task is not waiting on legislative approval. Most features of the federal income tax are already indexed for inflation. Thus, states that tie their income taxes closely to federal rules will find it easier to avoid inflationary tax hikes.

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