One important, common-sense taxpayer protection built into the federal income tax code is inflation indexing. Inflation indexing means that tax brackets (and other important dollar-amount features of the individual income tax, like standard deductions or personal exemptions) are revised annually to reflect nominal price and wage increases that result from inflation. Thanks in part to my colleague Steve Entin, the federal income tax code has been inflation-indexed since the 1980s. However, states vary with regard to how well they adjust their income tax brackets, as you can see in the map below:
When tax brackets aren’t indexed for inflation, it results in what economists call “bracket creep.” Higher income can bump a taxpayer into the next tax bracket, even if that higher income is merely keeping pace with inflation. A lack of inflation adjustment can also push more of a taxpayer’s income into the highest bracket for which they qualify. The final result is a tax increase that occurs without any legislation being passed. Indexing addresses this by altering each bracket level each year by the level of annual inflation.
Here’s an example under Virginia’s individual income tax:
Take a single individual who earns $40,000. Currently, that person takes a standard deduction of $3,000 and a personal exemption of $930, leaving $36,070 as taxable income. After applying the tax table, he would owe $1,816 in state income tax. If the taxpayer gets a 2 percent raise next year because of inflation, his income rises to $40,800 and his tax bill rises to $1,863. Because Virginia doesn’t index its tax brackets, its standard deduction, or its personal exemption, this tax bill is a 2.53 percent increase over the previous year. An inflation-indexed code would only raise his income tax liability by 2 percent—which is not a hike at all in real terms.
Which states include this important tax policy feature in their tax codes? Surprisingly, not enough of them:
- Only 24 states fully index brackets to inflation (this includes the nine states with single-rate income taxes, which are by definition inflation-indexed)
- California and Oregon partially index their brackets.
- 17 states plus D.C. with multiple brackets do not index at all.
Also important, but not pictured in the map are details about which states inflation-index their standard deductions and personal exemptions. For a list of these, see page 73 of our 2016 State Business Tax Climate Index.