In times of inflation, like we are experiencing now, a review of the tax code shows that some provisions are automatically indexed, or adjusted, to match inflation, while others are not. And that creates unfair burdens for taxpayers. But it’s not always as simple as just “adjusting for inflation.” That works for some structural components of the tax code, like tax brackets. But other inflation-related problems, especially ones related to capital gains, require a deeper consideration of how the income tax should work, ideally by moving to a consumption tax base where all income is taxed only once.
The most basic provisions, namely, personal income tax brackets and the standard deduction, are adjusted for inflation. Additionally, the minimum income threshold for the alternative minimum tax, capital gains tax brackets, the maximum values of the Earned Income Tax Credit (EITC), limits on the 20 percent pass-through business income deduction, and the annual exclusion for gifts received all get adjusted for inflation. The refundable portion of the Child Tax Credit (CTC) gets indexed for inflation too, but the maximum value does not.
Several other provisions are not indexed. For example, the Net Investment Income Tax levies a 3.8 percent tax on investment income for single filers with over $200,000 in income, or joint filers earning over $250,000. When considering cumulative inflation since the tax was first enacted in 2013, the NIIT would be expected to apply to single filers making over roughly $246,000, or joint filers making over roughly $308,000. Indexing the thresholds for the NIIT would be a simple fix.
For many other individual income tax provisions, whether it makes sense to adjust them for inflation varies according to how one thinks the income tax should be structured. Under a saving-consumption neutral income tax, income is only taxed when it is consumed. In other words, saving is deducted when earned but taxed when realized. Effectively, this could be achieved by creating universal savings accounts, where all saving would be eligible for 401(k) tax treatment and taxed at ordinary income rates when realized (or alternatively, taxed like Roth IRAs).
However, the alternative perspective is that the income tax should tax changes in net worth—so saving would not be deductible and returns to saving would be taxed as ordinary income. Income saved is taxed twice under this scenario: when it is earned and later when it is consumed, while income consumed immediately only faces one layer of tax.
The introduction of a saving-consumption neutral income tax would address inflation-related issues with capital gains taxation more broadly. Under current law, taxpayers owe capital gains taxes even if in real terms they aren’t earning any income because their gains are wiped out by inflation. One proposed fix is adjusting the basis (the value of the original investment) for inflation so the capital gains tax only falls on real increases in income. Indexing gains, however, poses several issues: fixed-income assets such as bonds or annuities and perpetuities are far more sensitive to inflation than stocks are. Indexing some types of gains, but not others, would create problems.
Replacing the current income tax with a saving-consumption neutral tax would fully address the inflation problem without the complexities of indexing. Consider a system where all saving is eligible for 401(k) tax treatment—deducted when it’s first earned, taxed only when it is used for consumption. Under such a system, the taxpayer only owes taxes based on the change in the real value rather than inflation.
Consider a taxpayer who invested $100 of income in one year, and 10 years later sold the investment for $125. Cumulative inflation over the decade is 50 percent, so that $125 can purchase less in real goods and services than the $100 could 10 years earlier. Under the current system, the taxpayer would owe tax both on the $100 when earned initially and on the $25 in nominal gains 10 years later. But under the universal 401(k) system, the taxpayer would only be taxed on the full $125 in year 10, which in real terms is worth less than the $100 he originally invested.
Ultimately, the basic bracket structure of the individual income tax adapts to inflation reasonably well. For other provisions, particularly related to capital income, the question is whether the income tax system should be neutral between saving and consumption. In such a case, where all saving is deductible when earned but taxed when realized (or vice versa), there is no need to index capital gains for inflation.