Tax Indexing Definition

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Tax Indexing Definition

What Is Tax Indexing?

Tax indexing is the process of adjusting different tax rates in response to inflation and to minimize bracket creep. When inflation pushes income into higher tax rates, bracket creep occurs, resulting in greater income taxes but no meaningful rise in buying power. Tax indexing aims to prevent the possibility of bracket creep by changing tax rates before the creep happens.

Key Takeaways

  • Tax indexing is the process of adjusting different tax rates in response to inflation and to minimize bracket creep.
  • When inflation pushes income into higher tax rates, bracket creep occurs, resulting in greater income taxes but no meaningful rise in buying power.
  • A government with a tax indexing system in place may increase tax rates in lockstep with inflation to prevent bracket creep; in the United States, the government is permitted to utilize tax indexing every year, thus this move does not need parliamentary permission.

How Tax Indexing Works

Tax indexing is a way of connecting taxes, wages, or other rates to an index in order to protect the buying power of the public during times of inflation. Because tax regimes often do not adjust rapidly to changing economic circumstances, bracket creep is likely to occur during times of inflation. Tax indexing is intended to be a preventative measure against bracket creep. It uses indexation to assist taxpayers keep their buying power and avoid rising tax rates caused by inflation.

In the United States, the government is permitted to employ tax indexing every year, therefore this adjustment does not need congressional permission. Most aspects of the federal income tax are already inflation-indexed. As a result, states that closely align their income taxes with federal laws will find it simpler to prevent inflationary tax increases.

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A government with a tax indexing system in place may change tax rates in lockstep with inflation, preventing bracket creep. Tax indexing is especially significant during times of excessive inflation when economic growth must be stabilized.

Example of Tax Indexing

An person earning $39,475 falls into the 12% marginal tax band for the 2019 tax year. The 12% tax rate applies to income between $9,701 and $39,475. The next bracket is 22%, which covers income ranging from $39,476 to $84,200. If this taxpayer’s income rises to $40,000 in 2019, he will be taxed at a rate of 22%. However, because of inflation, this taxpayer’s yearly income ($40,000) now buys the same amount of goods and services as their prior $39,475 income. Furthermore, even with no actual gain in buying power, his take-home pay in 2020 after taxes is less than his net income in 2019. Rate creep has happened in this example, putting this taxpayer into a higher tax bracket.

In the above example, indexing taxes for inflation means that the $39,475 limit for the 12% tax band will be updated for inflation each year. So, if inflation is 4%, the threshold will automatically raise the next year to $39,475 x 1.04 = $41,054. As a result, even if his wages climb to $40,000, the taxpayer in the case will remain in the 12% tax rate. Indexing income taxes for inflation helps guarantee that the tax system treats individuals fairly from year to year.

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