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‘Bracket Creep’ Squeezes Some Taxpayers Amid High Inflation

March 11, 2022, 9:45 AM

Millions of Americans are facing hidden tax increases in their paychecks because they live in one of more than a dozen states that don’t adjust their tax brackets for surging inflation.

Rising prices are sapping consumers’ purchasing power and setting the stage for the Federal Reserve to begin raising interest rates at next week’s meeting. U.S. consumer prices jumped 7.9% in February from a year earlier to a fresh 40-year high, Labor Department data showed Thursday.

But along with record gasoline prices, skyrocketing rents and food costs, residents of New York, New Jersey, Connecticut, West Virginia and nine other states are facing an additional wage squeeze: state fiscal policies that fail to index any part of their personal income taxes for inflation.

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“Given the highest inflation in four decades and the glut of federal cash and state budgetary surpluses that most states are sitting on, there’s a real argument for those remaining 13 states that have yet to index their income tax brackets for inflation to go ahead and do so,” said Patrick Gleason, vice president of state affairs for Americans for Tax Reform.

A Few Proposals

In just two of the 13 states that don’t index tax brackets for inflation—New Jersey and Connecticut—Republican lawmakers have recently introduced legislation to change that, according to a review by Bloomberg Tax. Maryland’s Legislature is considering a narrower bill for seniors only. New York is weighing a cost-of-living adjustment for former government employees’ pensions, and West Virginia is looking to wipe out its personal income tax entirely.

“We’re seeing this heightened interest in providing tax relief, because they know their constituents need relief from this very high inflation,” Gleason said.

While the Internal Revenue Service regularly adjusts federal income tax brackets, states act at their own discretion. That results in tax variance across the country, with states such as Alaska, South Dakota, and Florida not imposing any personal income tax, while others like Maryland and Oregon only indexing the individual standard deduction. Meanwhile, Georgia and Oklahoma are among states that don’t provide any inflation accommodation at all.

When states don’t index for inflation, real effective tax rates rise over time. “Bracket creep,” as it is known, means that American workers may be paying more in personal income tax every year, even when inflation is low.

“Many people are not even aware that they are experiencing this bracket creep,” said Katherine Loughead, a senior policy analyst for the Tax Foundation. “The percentage of their total income that they are paying in taxes is creeping up from year-to-year unbeknownst to them.”

State Budgets Win Big

One reason for the reluctance by lawmakers to adjust rates is that bracket creep bolsters state and local tax budgets, especially in jurisdictions with progressive income tax structures.

Over the course of the pandemic, higher wages and other boosts in income—from capital gains to retention bonuses—have pushed taxpayers into higher brackets and fueled revenue, tax experts say.

“People have jumped from one income tax group to another,” said Lucy Dadayan, a senior research associate with the Urban-Brookings Tax Policy Center at the Urban Institute. “It’s a critical moment and I hope the states will finally come to the realization that they need to do changes to their tax structures.”

State revenue collections have surged since the pandemic, with higher wages and sales tax collections, as well as federal aid, helping to create revenue surpluses. Tax policy experts argue that now is the best time to unwind a decades-old practice that hurts taxpayers.

“This is a really, really opportune time, frankly, for states to do this,” said Gleason. “They’re well-positioned in their finances and their constituents are in great need of this relief.”

Rolling Out Tax Relief

Across the country, state lawmakers in recent weeks have been proposing relief —from freezing gas taxes to reducing sales tax on groceries. But indexing income tax brackets would be more valuable to residents in some states than the other proposals that have been floated, according to tax policy experts

“Politicians like to cut taxes that are the most high profile,” said Chris Edwards, director of tax policy studies at Cato Institute. “So, they’re proposing gas tax cuts now because they think it will be popular with the voters, whereas the inflation impact will provide years of benefits to voters. But it probably doesn’t simplify to a sound bite as well.”

In New Jersey, state Sen. Anthony Bucco (R) has introduced a bill targeting the additional $4.6 billion in tax collections New Jersey has surprisingly recouped. Workers need additional tax relief for the small cost-of-living raises given by employers to account for inflation, he argues.

“It’s shocking that Gov. Murphy (D)would add to that burden by allowing unnecessary tax and toll increases to take effect when he already has billions he wasn’t expecting in the bank,” Bucco said shortly after Murphy gave his budget address at the state capitol Tuesday.

Murphy has proposed property tax relief beginning in fiscal 2023, with residents receiving as much as a $700 rebate. A spokesman for the governor declined to comment on Bucco’s pending proposal.

Other state lawmakers are likely to follow suit, tax experts say, especially if they are on the receiving end of the greatest public pressure on the issue since the 1970s and 1980s.

“Sometimes it takes high inflation for the public to realize what’s going on and to get angry and for the government to index,” Edwards said. “I suspect the high inflation we’re experiencing now will alert more state taxpayers and voters to the issues of indexing.”

To contact the reporter on this story: Donna Borak in New York at dborak@bloombergindustry.com

To contact the editors responsible for this story: Jeff Harrington at jharrington@bloombergindustry.com; David Jolly at djolly@bloombergindustry.com