Ever hear of bracket creep? With inflation on the rise, you soon will. Especially if Obama’s tax plans as they’re currently outlined become enacted.

Bracket creep is the process where people’s taxes are raised because their salaries rise due to inflation and they are thus pushed into a higher tax bracket. So say your salary doubles due to inflation. You’re not any richer, and you’re certainly not rich, but suddenly you’re in a tax bracket for rich people because your nominal salary doubled in terms of dollars, even though it stayed the same in terms of wealth. That’s bracket creep.

One of the great triumphs of the Reagan legacy was that they got rid of bracket creep by indexing the tax brackets for inflation. Now obviously this gives the government every incentive to underestimate the effects of inflation, but it’s better than nothing. Now, apparently, there was no such provision written into the Bush tax cuts when they expire, meaning that the brackets revert back to the way they were in 2000 or so, before Bush took office, before all this inflation took place. Scared yet? Andrew Biggs comments:

Tax revenues would skyrocket if the tax cuts expire, due to “bracket creep.” Average incomes are higher today than in the 1990s, but income-tax brackets aren’t adjusted for the growth of earnings. As a result, Americans will shift into higher tax brackets and pay a greater share of their incomes in taxes.

Going back to the tax rates of the 1990s doesn’t mean that households will pay 1990s taxes. Because the tax brackets haven’t risen along with incomes, average taxes would be significantly higher, and grow each year.

If the tax cuts expire, income-tax revenues by 2018 will rise to 10.8% of the total economy from 8.7% today – an increase of 24%. Compared to the average over the last 50 years, allowing the rates to rise would increase tax revenues by 32%.

Believe it or not, income taxes will rise even if the tax cuts remain in place, because the revenue-increasing effects of bracket creep more than offset the lower rates. With the lower rates, total income-tax revenues will increase to 9.3% of GDP by 2018. This level is 7% higher than today, and 13% above the 1957-2007 average.

Obama had best address this issue if he wants to let the Bush tax cuts expire, because otherwise he is suggesting an enormous tax increase on the American people. Furthermore, he should also suggest indexing capital gains taxes for inflation in exchange for raising the rate as he wants to. That would at least be a fair trade-off.

Read Andrew Biggs.

Tags: Barack Obama, Bracket Creep, Bush Tax Cuts, Inflation

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