Tax Indexing Definition

What Is Tax Indexing?

Tax indexing is the adjustment of the various rates of taxation in response to inflation and to avoid bracket creep. Bracket creep occurs when inflation drives income into higher tax brackets, resulting in higher income taxes but no real increase in purchasing power. Tax indexing attempts to eliminate the potential for bracket creep by altering the tax rates before the creep occurs.

How Tax Indexing Works

Tax indexing is a method of tying taxes, wages, or other rates to an index to preserve the public’s purchasing power during periods of inflation. During periods of inflation, bracket creep is likely to occur since tax codes generally do not respond very quickly to changing economic conditions. Tax indexing is meant to be a proactive solution to bracket creep. By using a form of indexation, it helps taxpayers maintain their same purchasing power and avoid higher tax rates brought on by inflation.

In the U.S., the government is allowed to use tax indexing every year, so this change does not have to wait on legislative approval. Most features of the federal income tax are already indexed for inflation. Thus, states that tie their income taxes closely to federal rules will find it easier to avoid inflationary tax hikes.

A government that has a system of tax indexing in place can adjust the tax rates in lockstep with inflation so that bracket creep doesn’t occur. Tax indexing is particularly important during periods of high inflation when there is a need to stabilize economic growth.

Example of Tax Indexing

For the 2019 tax year, an individual that earns $39,475 falls in the 12% marginal tax bracket. The 12% tax bracket captures income within the range of $9,701 and $39,475. The next bracket is 22% which captures income in the range of $39,476 to $84,200. If this taxpayer’s income is increased to $40,000 in 2019, he will be taxed 22%. But due to inflation, this taxpayer’s annual income ($40,000) buys the same amount of goods and services that their previous $39,475 did. Furthermore, his take-home pay in 2020 after taxes have been withheld is less than his 2019 net income even with no real increase in his purchasing power. In this case, bracket creep has occurred, pushing this taxpayer into a higher tax bracket.

In the example above, indexing taxes for inflation would mean that the $39,475 cutoff for the 12% tax bracket will be adjusted every year by the level of inflation. So, if inflation is 4%, the cutoff will automatically increase to $39,475 x 1.04 = $41,054 in the following year. Therefore, the taxpayer in the example will still fall in the 12% tax bracket after his earnings increase to $40,000. Indexing income taxes for inflation helps ensure that the tax system treats people in roughly the same way from year to year.