Dealing With Inflation, Part 2 – “Tax Creep”

Categories : Financial, News
September 21, 2022

Presidential candidate Ronald Reagan campaigned for office in 1980 with several novel ideas appealing to American voters. Historically high-income taxes were among the most important issues of the era, and Reagan promised dramatic rate cuts, along with overall simplification. From the top tax rate of 70% at the time, he proposed (and got passed) an eventual (1988) top rate of 28%. There was only 1 other rate that year, 15%. Reagan’s argument to the American people and to Congress was identical to John F. Kennedy’s 1960 campaign argument; lower tax rates would result in higher government revenues.

They were both correct.

Last week, we explored the phenomenon known as Bracket Creep, whereby taxpayers who receive wage and salary increases, due solely to Cost-of-Living Adjustments (COLAs), could find themselves in a higher tax bracket. In an ideal world, this would not happen, and Reagan knew that. One of his legacies is indexed personal income tax brackets. Prior to his initiative, brackets were set by Congress, changing when, and only when, they felt like it.

Bracket Creep – the Correction” was born with a 1981 law passed at Reagan’s insistence. While personal income tax brackets have been indexed to inflation ever since indexing has been applied to only a fraction of the overall stated rate of inflation. Today, we are burdened with higher income tax brackets and 5 more rates than in 1988. In addition, we are experiencing slow and steady Bracket Creep.

Further impeding our goal of simply keeping up with inflation is what we dubbed “Tax Creep,” which receives no attention in the media. We hear from virtually every pundit and commentator that workers are failing to keep up with inflation. The problem, according to media observers, is that wages are rising less than the inflation rate, and only by matching the rate of inflation can families “keep up.”

They are short-sighted, as their simplistic analysis omits consideration of “Tax Creep.” Most household purchases are made from after-tax income or take-home pay. The amount of extra taxable income required to buy inflated necessities is equal to price increases of our goods and services, plus the percentage of taxes withheld before we receive the money. To afford a 10% increase in grocery prices, we need to generate closer to 13% additional pre-tax income.

Setting a personal goal of keeping up with inflation requires an understanding of the impact of Tax Creep on our purchasing power. Don’t be fooled by incomplete comparisons. 8.3% more income will not break even in our 8.3% annual inflationary environment.

Van Wie Financial is fee-only. For a reason.