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255 March 22, 1983 TAX INDEXING: AT LAST A BREAK FOR THE LITTLE GUY INTRODUCTION During the 1970s, bracket c reep became U.S. taxpayers' enemy No 1. Even if workers received pay raises keeping up with inflation real after-tax wages declined since many were pushed into higher tax brackets. The taxpayer found himself on an accelerating tax treadmill. Average- and l ower-income Americans routinely faced tax rates once reserved for the rich. while only some 3 percent of taxpayers faced marginal tax rates of 30 percent or above in 1960, by 1981 bracket creep had shoved 34 percent of them up to the 30 percent level or h igher.
Finally something was done about bracket creep. The Economic Recovery Tax Act (ERTA) of 1981 provides that all tax rate brackets the zero bracket amount (formerly the standard deduction). and personal exemptions are to be indexed for inflation, begi nning in 1985 simply because inflation increases their nominal income. Bracket creep in effect was to be buried No longer will taxpayers be pushed into higher tax brackets Now, some in Congress are having second thoughts and want to repeal the measure, be fore it even begins. They want to perpetuate bracket creep and, with it, their power to tax by the backdoor and enable the government to profit from inflation-causing programs.
Without indexing, every 10 percent inflation will give the govern ment a 17 per cent tax windfall. Paying for this, of course, will be the American taxpayer, particularly average Americans and the working poor. They have been the most hurt over the last decade as inflation has pushed them into higher tax brackets. They would be the m ost hurt should indexing be eliminated.
About 80 percent of the relief generated by tax indexing benefits taxpayers earning less than 50,000 a year. Those taxpayers making above 200,000 a year will get only about.1.2 percent of the tax relief. If Congress repeals indexing, the tax 2 liability of the lowest-income Americans would increase in one year by ten times the percentage increase of the highest income groups first year alone, but the $200,000 income groups would pay only about 1.3 percent higher taxe s income bracket would be 60 percent higher in 1988 than it would be with indexing. This would be balancing the budget on the backs of average Americans and the working poor eliminate the 25 percent income tax reductions for all taxpayers except the very r ich by 19
89. Tax rates on every income family In short, indexing is a break for the average American taxpayer.
To repeal indexing is to penalize the working man and woman The $10,000 bracket would face a 14 percent hike in the i Even with moderate inflat ion the tax liability of the lowest Repeal of indexing, according to a Department of Treasury study, essentially would I except the rich, would rise to record highs in only a few years. I I The campaign by some members of Congress to repeal indexing would nullify probably the most important tax reform provision of the Reagan economic program. This program, designed to stimulate the economy by allowing individuals to keep and save more of what they earn, is a complex mosaic. Among its many components 1. Pri v ate Capital Formation. Reducing the top rate of tax on individuals from 70 Dercent to 50 percent and expanding the eligibility for IRAs an: Keoghs were moves designed- to increase the capital available for new enterprises and investqent measures have alre a dy boosted confidence for business startups and generated tangible economic benefits: the savings rate has surged 30 percent to 6.9 percent of disposable personal income in the third quarter of 1982, the stock market is at a record high, funds in IUS and K eoghs have nearly doubled in just one year and the venture capital industry has grown rapid1y.l These 2. Business Tax Reform. Accelerating and simplifying the depreciation allowances available for machine tools and other capital equipment was enacted to s p ur American business to invest in new factory equipment and tools. Although about 70 percent of the 1981 business tax cuts were repealed in last summer's tax hike package, American business is still expected to enjoy a vigorous recovery and begin to hike capital investment significantly.
As it was, despite the severe recession, business and industrial outlays for capital equipment (after an inflation adjustment shrunk only one-third of the amount experi,enced in the 1974-1975 economic downturn 3. Tax Relie f for Lower and Middle Income Americans. The 25 percent income tax cut and tax indexing provide average and See Thomas Humbert Reaganomics Making Gains ,I' Heritage Foundation Back grounder #239, January 21, 1983. 3 working Americans with much needed reli e f after nearly two decades of skyrocketing taxation. When indexing begins in 1985, it will force the government to tax openly and deliberately and to stimulate work savings, and jobs by lowering marginal tax rates Those aspects of the Reagan tax strategy t hat took effect upper-bracket Americans with the lion's share of the benefits 1 I during the first twelve months-the capital formation initiatives and the business tax cuts--generally provided corporations and Of course, even these early provisions genera t e important benefits for a broad range of income groups as a quickened pace of investment and saving activity stimulates economic growth. But the remainder of the program-and especially tax bracket indexing-is targeted directly at the grass-roots taxpayer will gain the most from the ten percent tax cut scheduled for July. And it is this group that will be the primary beneficiaries when individual tax brackets are indexed to the rate of inflation Only the 1983 income tax cut and indexing will save average a n d working Americans from the highest tax burden in history I It is this gsoup that THE IMPORTANCE OF INDEXING Bracket Creep is a Hidden Tax. Bracket creep is a hidden tax, requiring no action by Congress. Example: Under the terms of the 1984 tax code and without indexing a family of four making 25,000 a year in 1984 would have to make $27,500 one year later to earn the same pre-tax real income. With $27,500, the familyls real income is effectively the same, but its tax bill increases from $1,621 to $1,9
53 . Although the family's income has grown by 10 percent, bracket creep increases its federal taxes by over 20 percent. The family faces a marginal tax rate of 18 percent compared with the 16 percent it faced before, and its average tax rate has jumped from 6.5 percent to 7.1 percent If the family's taxes had remained constant with inflation it would have paid $1,783, instead of the $1,9
53. As such, even though pre-tax income kept abreast of inflation, the family's real after-tax purchasing power was reduced by $1
70. This repre sents an inflation tax, and the taxpayer's loss becomes the government% gain. In this case, the 10 percent inflation raised government revenues over 20 percent. In the aggregate, for all income classes, a 10 percent increase in infl ation generates a 17 percent increase in government revenue inflation rate, the higher the inflation tax.
The higher the This example is based on the 1984 tax code and assumes that the third year of the tax cut is not repealed. The calculations are based on a family of four with all income from wages and salaries and no tax pre ferences or adjustments to inco me 23 percent of income.
The 1983 Joint Economic Report on the February 1983 Economic Report of the President, Joint Economic Committee, March 3, 1983 Itemized deductions are assumed to be 4 I Indexing would eliminate this inflation tax by adjusting both t he top and bottom amounts of each tax bracket according to the inflation.rate. The zero bracket amount (formerly the, standard deduction) and the personal exemption also would be increased by the inflation rate. After indexing takes effect, every 10 perce n t increase in inflation would increase tax revenues by only 10 percent rather than 17 percent. In the case above, indexing would have ensured that the family's real after-tax income was unaffected by inflation-its marginal and average tax rates would be u n altered I I Indexinq Helps the Lower-Paid. Taxpayers in the lowest income categories suffer most from inflation and, accordingly will benefit disproportionately from indexing. The reasons 1) with so many upper-income Americans now in the maximum tax brack e t of 50 percent, bracket creep is of importance only to middle- and lower-income taxpayers 2) changes in marginal tax rates are more frequent in lower-income categories, especially $15,000-$30,000 than in higher ones 3) movement from one income tax bracke t to another is more common at lower-income levels because the width of the brackets increases as income rises 4) the zero bracket amount and personal exemptions erode in value as inflation rises, unlike most itemized deductions used by higher income group s Although all Americans are hurt by bracket creep, the effect In a year of 8 percent inflation, for is less at higher incomes instance, the average tax bite increases by a high of 26 percent for the $12,000 income earner, to just 9.6 percent for taxpayers making $150,000 The inflation tax accelerates over time, much like compound interest would increase the taxes of Americans by between 130 and 430 percent, with the largest tax increases reserved for lower incomes while money incomes would have increased o v er the same period by just 116 percent than ten times the one-year increase Taxes on the $18,000 income bracket, for example, increase 16% percent in one year of 8 percent inflation, but taxes over ten years under such an inflation rate increase by 33 per c ent-twenty times the first year's tax hike With the inflation rate in the 1970s averaging about 6.5 percent a year, tax liabilities increased substantially for all income levels. On the average, taxes increased by 1.7 times faster than the inflation rate A s Chart I shows, ten years of 8 percent inflation Taxes for all income brackets increase by more Because of this, the nine major 5 I tax reductions enacted by Congress in the 1960s and 1970s did not reduce taxes at all. They simply offset about half of th e cumula- tive tax increase due to inflation credit for cutting taxes, it actually was collecting tax windfalls from inflation. With this windfall, it enacted more programs and bloated the federal bureaucracy enterprise, investment, and saving Why work, in v est, or save when the government takes such a large chunk of profits or wages It is no wonder that the American economy began sputtering and eventually fell into the worst recession in four decades While Congress claimed These skyrocketing taxes have exac t ed a heavy punishment on CHART 1 the portions of the increases due to bracket creep Percentage increases in federal income taxes due to salary increases and 8% annual inflation rate Initial Increase in Portion due to salary federal tax bracket creep Part A after an interval of 1 year 12,000 25.8 15,000 18.1 18,000 16.5 21,000 16.3 24,000 16.7 27,000 15.8 50,000 15.3 100,000 10.6 150,000 9.6 30,000 1.5 -5 Part B after an interval of 10 years 12,000 15,000 18,000 21,000 24,000 27,000 30,000 50,000 150,000 10 0 ,000 438.1 361.5 337.1 332.2 325.8 316.8 305.7 224.9 153.8 138.7 68.9% 55.8 51.6 51.0 52.0 49.3 48.4 47.7 24.7 16.4 73.5 67.9 65.6 65.1 64.4 63.4 62.1 48.5 24.6 16.4 I Source: Journal of Accountancy, January 1982. 6 THE IMPACT OF REPEALING INDEXING Indexi n g was designed to arrest the steep climb Of marginal tax rates with its damaging effects on incentives and enterprise taxpayer's revolt, representing the most far-reaching tax reform for the lower-bracket taxpayer=-the little guy-in the past two decades i n flation increases nominal income Indexing is, in effect, the most significant achievement of the I bigger tax bite out of the workingman's paycheck just because i I It is a guarantee that Washington no longer will take a I CHART I1 I I The Effect of Repea l ing Indexing Distributed by Adjusted Gross Income Class 1981 Levels, 1984 Law Adjusted gross income class Share of all taxes Share of benefits dues indexing (assuming 4.5 paid as of 1984 percent inflation 000 Less than 10 10 15 15 20 20 30 30 50 50 100 10 0 200 200 and over Total Source: Office of Office of percent 2.1% 5.8 8.1 20.7 29.9 17.7 8.6 7.1 100.0 the Secretary of the Treasury Tax Analysis percent 6.5 7.4 9.2 22.2 32.4 16.3 4.8 1.2 100.0 With inflation expected to range betwen 4 and 5 percent a yea r after 1985, indexing will give taxpayers about $98 billion in relief from the inflation tax between 1985 and 19
88. Taxpayers making below $50,000 a year will receive the lion's share of the relief-about $78 billion. Currently, this group pays about two- thirds of all income taxes and will receive about 80 percent of the tax relief from indexing. Taxpayers earning below $15,000 contribute 7.9 percent of the total taxes, but will receive 13.9 percent of the benefits from indexing. The wealthy, on the other hand will receive much smaller benefits. Just 1.2 percent of the tax relief from indexing will go to taxpayers making $200,000 or more, although they contribute 7.1 percent of total taxes (see Chart I1 If Congress repeals tax indexing, the tax liability o f low- and middle-income Americans would increase in the first year by a far greater percentage than that of Americans with income over $50,0
00. After only one year of an unindexed tax code, a wage earner making 10,000 would pay 14 percent higher taxes; t he 30,000 tax bracket, 3 percent higher taxes; and the $200,000 bracket, only 1.3 percent higher (see Chart 111). 7 I I This would occur in the first year years, Americans, especially lower-income groups, would face even higher average and marginal taxes t he $0 to $5,000 income class would be 60 percent higher in 1988 than with indexing; taxes on the $15,000 to $20,000 income group group would be just 3 percent higher liability, if indexing were repealed, would increase by 3 percent in 1985, 6.5 percent in 1986, almost 9 percent in 1987, and over 11 percent in 1988.4 After four unindexed Without indexing, taxes on I I would be 14 percent higher; taxes for the $200,000 to $500,000 i The overall taxpayer Chart I11 Change in Income Tax Liability Due to Repeali n g the Indexing Provision Enacted in ERTA Four-Person, One-Earner Family dollars Tax liability Change in tax liability Income under 1984 due to repealing indexing law Percentage Amount 10,000 20,000 30,000 40,000 50,000 100,000 200,000 291 1,549 3,003 4,87 4 7, I65 22,056 58,190 41 41 94 169 249 463 777 14.1 2.7 3.1 3.5 3.5 2.1 1.3 Source: Office of the Secretary of the Treasury Office of Tax Analysis Note: Tax liabilities are calculated assuming that deductible expenses equal 23 percent of gross income and that all income is wages Repeal of indexing would mean an enormous increase in taxes.
The median income family of four, earning $24,000 in 1982, would pay $1,000 in additional taxes between 1985 and 1988 if indexing were repealed. As Chart IV shows, the fa mily's average tax rate would increase from 9.17 percent in 1984 to 10.41 percent by after only four years of moderate inflation stay ahead of the game 19
88. This means that the Reagan tax cuts would be wiped out Only the rich would Figures are 1982 adju sted gross income levels, and 1984 law. a CHART V I 9 THE OBJECTIONS To INDEXING Deficits Opponents argue that indexing will contribute to the burgeon ing budget deficit society. Yet indexing would not prevent Congress from increasing taxes if needed. It s imply assures that legislators must go on record and vote for hikes, rather than simply depend on inflation to do it for them. And even with indexing and the Reagan tax cuts, taxes will not decrease. At best, they will remain at 1981's historically high l e vels thanks to bracket creep, new social security taxes, and the 1982 tax bill hike, which, combined will wipe out most of Reagan's $600 billion tax relief measure of 1981 Some even claim that the U.S. is an undertaxed Without the Reagan tax cuts, of cour s e, things would be much worse. Marginal tax rates would be from 4 to 10 percentage points higher, and tax revenues as a percentage of GNP would be up 3 to 4 percentage points. Americans in all income bracket will pay about the same percentage of their inc ome in 1988 as they did in 19
81. Chart V indicates that those in the half median income bracket, for example, in 1981 paid 20.11 percent of their income for income and social security taxes and will pay an estimated 20.9 percent in 1988 No tax cut there i ncome in income and social security taxes in 1981, and will artill pay 24.74 percent in 1988 goes from 26.87 percent in 1981 to about 25.83 by 19
88. This hardly amounts to a huge tax cut are not causing the deficit- because taxes have not been cut very m uch But even with the Reagan Cuts The median income taxpayer paid 25 percent of The twice median income earner Clearly, the Reagan tax cuts Chart V Average Tax Rates Under FICA and Individual Income Tax half median median twice median 1980 1981 1985 1988 1 8.28 20.11 20.60 20.92 23.68 25.09 24.36 24.74 24.77 26.87 25.24 25.83 Source: Office of the Secretary of Treasury, Office of Tax Analysis Inflation Opponents of indexing claim that, if taxpayers are protected from the harmful effects of inflation induced bracket creep, the resolve to fight inflation will weaken counter that the reverse is true. Without indexing, the government has an incentive to encourage inflation since it receives the tax windfall from bracket creep. Indexing takes away this incentive by eliminating the windfalls Indexing supporters 10 CONCLUSfON Indexing provides, at long last, a tax break or the little guy U.S. tax system.
American democratic process higher taxes, each member must go on record and vote to increase taxes openly and del iberately No longer can Congress depend on the subterfuge of bracket creep to raise taxes silently does it freeze revenues at a specific level. It is simply a procedural reform to guarantee tax honesty by the nation's legisla tors. The integrity of ,Ameri c an democratic institutions and elementary notions of fairness are at stake Yet some Republicans and Democrats want to eliminate index ing-ironically in the name of fairness. when tax rates once reserved for the rich are imposed on middle and even lower-in c ome taxpayers government gains from inflation at the expense of those American working men and women least able to pay? can raise taxes without recording a vote men clah credit for cutting taxes when they are simply returning some of the revenue bonus fro m the inflation tax? Of course not. If Congress repeals indexing, it will overturn one of the fairest and most beneficial tax reforms in recent U.S. history. The little guy needs a tax break. Congress and President Reagan gave it to hint in 1981. back It i n troduces an extraordinary measure of fairness into the Indexing also preserves the integrity of the It means that if Congress desires I Indexing does not mandate a level of government spending nor But is it fairness Is it fair that the federal Is it fair that Congress Is it fair that Congress It would be unfair for Congress to take it Thomas M. Humbert Walker Fellow in Economics x oi k 2 W s c a c x 3 K 3 v W F W 0 K 3 0 cn a a