High Inflation Means Rising Tax Bills

The current run of price and wage increases could tip taxpayers into higher brackets, where they will owe larger slices of their income to the government.

Sharply rising inflation has already eroded Americans' purchasing power. Now it's poised to raise a lot of tax bills too.

In more than a dozen states where income tax brackets are not indexed to inflation—as they are at the federal level—the current run of price increases could tip taxpayers into higher brackets, where they will owe larger slices of their income to the government. That's because wages will likely continue to increase throughout this year to offset rising prices, while other forms of income, such as Social Security benefits, are obliged to increase in line with inflation.

Jared Walczak, a vice president at the Tax Foundation, calls this "an unlegislated tax increase." While so-called "bracket creep" can affect some taxpayers even when inflation is running at low levels, it becomes particularly pernicious when prices are rising at 40-year highs, as they are right now.

A resident of Delaware who earned $60,000 in 2019 and earns $64,000 this year, for example, hasn't seen her purchasing power increase at all. But because Delaware's highest tax bracket applies to income above $60,000 and the state doesn't automatically adjust its brackets to reflect inflation, the last $4,000 is taxed at a higher rate and so her overall tax bill jumps upwards too.

It's like the sticker shock many consumers are experiencing at the grocery store, except you don't get a choice about paying it.

"Inflation is often called a 'hidden tax,' but in many states it yields a far more literal tax increase as tax brackets fail to adjust for changes in consumer purchasing power," writes Walczak.

According to the Tax Foundation, 22 states and the District of Columbia fail to fully adjust their tax codes for inflation—either by not indexing income tax brackets to inflation or by leaving other major components such as the standard deduction unindexed. Of those, 13 fail to index any major component of their income tax codes. If state lawmakers wish to spare their constituents a nasty surprise next year, they should consider changing that.

At the federal level, earned income tax brackets do automatically rise with inflation—thanks to a change made in 1981, the last time America faced inflation on par with what we're seeing today. But the federal tax on capital gains is not indexed to inflation.

Capital gains taxes are paid on investment income. For assets that have been owned longer than a year, tax rates range from nothing to 20 percent, depending on the taxpayer's overall income level for the year. (Assets owned less than a year are taxed like regular income.) The 20 percent bracket applies to gains earned by individuals who make more than $445,850 and by married couples who make more than $501,600. The lower bracket triggers a 15 percent tax that applies to anyone who earned more than $40,400, regardless of marital status.

Those brackets are adjusted for inflation, but the tax does not take into account the effect of inflation on the capital gains themselves.

Consider our hypothetical resident of Delaware once more. If she bought $1,000 worth of stock in 2000 and sold it last year for $2,000, she would pocket $1,000 in capital gains. Because she earned more than $40,401 last year, she's obligated to pay a 15 percent tax on that $1,000 gain—a $150 bill.

But that $1,000 she invested in 2000 is the equivalent of $1,670 today. She may have earned $1,000 in profits, but she's really gained just $330 in value. And now nearly half of that profit must be paid to the government.

"Americans are taxed on illusory income as the result of economy-wide price-level increases, being punished for the existence of inflation," argues Isabelle Morales, a policy communications specialist for Americans for Tax Reform.

That compounds the more basic problem with capital gains taxes, which is that they result in the same dollar being taxed twice—once as corporate income and once as a capital gain for an investor.

Another aspect of the capital gains tax impacted by inflation is the carve-out for home sales. Individuals can exclude up to $250,000 (and married couples can exclude up to $500,000) in profit from the sale of their primary home from capital gains taxes. But those thresholds aren't indexed to inflation, and they haven't changed since 1997, despite a huge rise in the average home sale price since then.

Indexing the capital gains tax for inflation is not without complications. At the very least, instructing the Treasury to index capital gains—an idea that the Trump administration batted around but never implemented—would require an act of Congress.

Still, there would be benefits from such a change—and not just for the wealthiest Americans. As Morales points out, more than 25 million American households had capital gain filings in 2019 (the most recent year for which complete IRS data is available) and more than half reported earning less than $100,000 that year.

Without changes, such taxpayers may feel the sting of inflation in unexpected ways. Your money is worth less than it used to be, and everything costs more—and now the government is going to take a bigger cut too.