Indexation and the Inflation Tax

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In 1913, following the passage of the Sixteenth Amendmentto the United States Constitution, only one-half of 1 percentof the population paid any individual income tax. The tax formwas two pages long, and it was accompanied by two pages of simpleinstructions. At that time the highest marginal tax rate wasonly 7 percent for those fortunate enough to earn the princelysum of $500,000 a year, which is the equivalent today of anannual income of over $2 million.[1]

Today, even after the tax reductions of the Economic Recovery Act of 1981, about 80 percent of the population file incometax returns. It is not uncommon for a taxpayer to fill out 15to 20 pages of forms, while reading several hundred pages ofIRS instructions, government publications, and privately purchased tax guides. For those families with a taxable income ofover $106,000, the marginal rate is 50 percent. In additionthe first $32,800 of wage payments are subject to the socialsecurity (FICA) taxes, which require employers to "contribute"7 percent and employees to "contribute" 6.7 percent of wageincome .

In addition to legislative changes in the tax code following 1913 (there have been nine revisions of the tax code since1954), inflation has altered fundamentally the structure of theindividual income tax. During the last half of the 1970s theinflation rate averaged 8.9 percent annually, and taxpayersmoved into higher and higher brackets as nominal incomes increased with inflation. By the end of that decade, middle classAmericans were facing marginal income tax brackets that Congress had intended for the wealthy. To combat this so-calledbracket creep, Congress in 1981 voted to index personal exemptions and rate brackets, effective in 1985, based on changes inthe Consumer Price Index (CPI) for years ending in September ofthe calendar year preceding the tax year.

Recent concerns about the $200 billion budget deficit andthe inability of Congress and the Reagan administration to agreeon expenditure reductions of that magnitude have led many observers to suggest tax increases to reduce the deficit. Becausefew elective officials want to be held responsible for tax increases, there has been considerable talk about eliminating theindexation of the personal income tax that is due to begin in1985. This measure would result in an indirect tax increase.In addition to increasing tax revenues through the inflationtax, the repeal of indexation would have several arbitraryeffects. By pushing more and more taxpayers into higher taxbrackets, inflation would magnify the tax distortions createdby the progressive personal income tax. In addition it wouldprovide an incentive for government to inflate the currency,while most Americans prefer stable prices.

This analysis examines in some detail the effects of inflation without an indexed tax system, and it provides evidencethat the inflation tax is not a satisfactory means of raisingfederal revenues. More specifically, our analysis focuses onthe history of the inflation tax and provides projections ofthe inflation tax through 1990 in the event that current indexation laws are repealed.

Our evidence indicates that the inflation tax grew tenfoldduring the 1970s. By 1980 the average American family neededroughly 50 percent more income than in 1958 just to be able topay the inflation tax. Moreover, the inflation tax is not uniformly paid by individuals in different income classes. Whileinflation pushes the poor and middle class into higher tax brackets, the wealthy remain in the 50 percent bracket. Our projections through 1990 suggest that the real tax bill of a familywith $5,000 in taxable income in 1985 will increase by 92.8percent in just five years under an unindexed tax system and a10 percent annual inflation rate. In contrast, the real taxbill of a family with $200,000 in taxable income will increaseonly 8.7 percent under the same conditions of five years of 10percent inflation.

Michael R. Baye and Dan Black

Michael R. Baye and Dan A. Black are assistant professors of economics at the University of Kentucky.