Posts Tagged ‘indexation’

The cost of bracket creep

July 15, 2012 Comments off

Each year the government increases income tax rates, and most people don’t notice. They do this through “bracket creep” where workers are moved into higher tax brackets due to inflation. For example, if your income jumps from $37k to $38k to compensate you for higher prices, then you will be pushed up a tax bracket so that you are now paying a 35.5% marginal rate (instead of 20.5%) leaving you with less disposable real income.

This implicit tax increase could be easily removed by indexing the tax brackets to inflation.

To work out a rough estimate of the size of bracket creep, we can make the simplifying assumption that income tax should grow at the same rate as nominal GDP growth. Looking at the coming three years, nominal GDP is expected to increase by 16.9%, while income tax is expected to grow by 25% over the same three years. The difference can be attributed to bracket creep, and amounts to a total secret tax increase of $13 billion over three years.

If the government does not offer at least $13 billion worth of income tax “cuts” over the next three years, then they will actually be increasing income taxes.

Historically, the government has been happy to allow bracket creep to continue as it gives them extra tax revenue each year which they can then give away to special interest groups or loud lobby groups in the hope of buying an election victory. Because the tax increase is not well publicized and not well understood, the government is able to increase the tax burden with a relatively low political cost. But while it might make for good politics, the continuous increase in income taxes has been squeezing family budgets, reducing work incentives, and slowing down our economy.

In the long run we need to have income tax indexation. In the meantime, we need to demand at least a $13 billion income tax cut.

Note: If the government introduced an inflation indexation on income tax rates, that would ensure that nobody was pushed into a higher marginal tax bracket due to inflation. However, there would still be a gradual increase in average tax rates as real economic growth pushed more people into higher tax brackets. To ensure that there is no increase in average income tax rates it would be necessary to index tax brackets to nominal wage growth. But that is a topic for another day.