Two things that have been front and center on the minds of many Americans lately are taxes and inflation. However, few have likely given much thought to how the two are related — particularly regarding how some provisions of the tax code are adjusted to match inflation, but others are not.
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Basic provisions such as personal income tax brackets and standard deductions are adjusted for inflation, according to the Tax Foundation, an independent nonprofit tax policy organization.
Other inflation-adjusted provisions include minimum income threshold for alternative minimum tax; capital gains tax brackets; Earned Income Tax Credit (EITC) maximum values; the limits of the 20% deduction for business income passed on; and the annual exclusion for gifts received. The refundable portion of the Child Tax Credit (CTC) is also adjusted for inflation, but not the maximum value of the CTC.
But several other provisions are not adjusted or indexed to inflation. The Tax Foundation cites the Net Investment Income Tax (NIIT), which levies a 3.8% tax on investment income for single filers whose annual income exceeds $200,000 or joint filers whose income exceeds $250,000.
If you take into account cumulative inflation since the tax took effect in 2013, the current NIIT should apply to single filers earning more than $246,000 per year or joint filers earning more than $308,000. To remedy this, it would suffice to index the NIIT thresholds to inflation and adjust them if necessary.
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Some tax experts argue that a better tax model in terms of inflation is a “savings and consumption-neutral income tax”. Under this model, your income is taxed only when it is consumed, which means savings are deducted when earned and taxed when realized. Proponents say this could be achieved by creating universal savings accounts in which all savings would be eligible for 401(k) tax treatment and taxed at ordinary income rates when earned.
Alex Muresianu, a federal policy analyst for the Tax Foundation, wrote that introducing a neutral income tax on savings and consumption would address inflation-related issues “broadly,” particularly in terms of capital gains tax.
“Under current law, taxpayers owe capital gains taxes even if, in real terms, they earn no income because their gains are wiped out by inflation,” Muresianu noted. “One proposed solution is to adjust the base – the value of the initial investment – for inflation so that capital gains tax only falls on real increases in income.”
The problem is that fixed-income assets like bonds or annuities are “much more inflation-sensitive” than stocks, Muresianu added. “Indexing some types of earnings, but not others, would create problems…Ultimately, the basic structure of personal income tax brackets adjusts reasonably well for inflation .”
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