Recently, the Bureau of Labor Statistics (BLS) released data that showed a 0.5 percent increase in the consumer price index (CPI) in January compared to December 2022, resulting in a 6.4 percent rise over the previous 12 months. Despite the decline in inflation over the last six months, it is anticipated that it will continue to surpass the Federal Reserve’s target rate of 2 percent, presenting a significant challenge for policymakers in 2023. To reduce the impact of inflation on American households, it is critical to fully index the tax code for inflation.
Several provisions in the individual income tax are adjusted for inflation, including personal income tax brackets, the standard deduction, and the earned income tax credit (EITC). Nevertheless, some essential components are not adjusted, which places a greater burden on taxpayers when inflation is high.
Inflation affects taxpayers’ tax treatment of capital gains. When an asset is sold for a net gain, some of the profit is frequently due to the increase in value caused by inflation. To factor in the rise in the price level, the basis should be adjusted to exclude this portion of the asset’s gain from the capital gains tax. However, indexing capital gains for inflation is a complex undertaking that should be accomplished in conjunction with a more extensive effort to comprehensively index the tax code for inflation.
Despite the complexity, lawmakers have proposed constructive ideas to adjust the tax code for inflation’s impact on capital gains. For example, Rep. Ralph Norman (R-SC) has proposed adjusting the capital loss limit against ordinary income up from $3,000 to $13,000 for all filers, adjusted for inflation thereafter. The original $3,000 limit was established in 1978, which is now worth less than $700 today in real terms.
The Child Tax Credit (CTC) is another area where the individual income tax is not factoring in inflation. The value of the CTC is set at $2,000 through the end of 2025 and $1,000 thereafter; the phaseout thresholds where the CTC value begins declining are not indexed to inflation. From 2003 to 2017, the CTC lost about 25 percent of its real value due to inflation, and the CTC has lost 15 percent of its real value since 2018. While the main focus in CTC debates surrounds the generosity of the credit, comparatively little is said about how inflation reduces the credit’s value over time.
Sen. Chuck Grassley (R-IA) proposed indexing the CTC’s value and phaseout thresholds for inflation along with the value of other credits such as the Child and Dependent Care Tax Credit (CDCTC) and credits for higher education expenses. Tax Foundation’s Growth and Opportunity tax plan would also index the CTC for inflation as part of a broader effort to stabilize the credit’s long-term value.
For higher earners, the net investment income tax (NIIT) is a notable unindexed part of the individual income tax. The NIIT applies a 3.8 percent tax on certain investment income for single filers earning over $200,000 or joint filers earning over $250,000. Because neither of the income thresholds are indexed to inflation, a growing segment of taxpayers are subject to this tax each year as nominal incomes rise. While we recommend repealing the NIIT entirely, indexing the NIIT thresholds would preserve the original intent of the tax to apply to higher earners. Relatedly, Sen. Grassley has proposed indexing the NIIT income thresholds for inflation.
Businesses feel the burden of elevated inflation because it erodes the real value of their depreciation deductions for prior investments. Inflation reduces the present value of their deduction below the original cost of investment, reducing the incentive to invest. Efforts such as the CREATE JOBS Act introduced by Sen. Ted Cruz (R-TX) would allow full and immediate deductions on a permanent basis (or the equivalent treatment through neutral cost recovery), removing the penalty of inflation on depreciation deductions.
While hoping for inflation’s continued decline, policymakers should finish the job and index the tax code to prepare for future bouts of high inflation and as a contingency in case it takes longer to defeat elevated inflation than expected. More fully indexing the tax code would send a clear message that households should not be expected to pay taxes on phantom income produced by inflation.
The individual income tax incorporates adjustments for inflation in certain basic provisions, including personal income tax brackets, the standard deduction, and the earned income tax credit (EITC). However, other significant elements are not adjusted, resulting in a greater burden on taxpayers when inflation rates are high.
One such area where taxpayers feel the impact of inflation is the tax treatment of capital gains. When an asset’s value rises due to inflation and is sold for a net gain, a portion of the gain is attributable to the increase in price levels. Adjusting the basis to reflect the price level rise would exempt this portion of the gain from capital gains tax. However, indexing capital gains for inflation would be a complicated process and should be done comprehensively as part of a broader effort to index the tax code for inflation.
Lawmakers have proposed constructive ideas to address the impact of inflation on capital gains. For instance, Rep. Ralph Norman (R-SC) proposed increasing the capital loss limit against ordinary income from $3,000 to $13,000 for all filers, adjusted for inflation thereafter. This limit was set in 1978, and its real value has declined to less than $700 today.
The Child Tax Credit (CTC) is another area where the individual income tax does not account for inflation. The value of the CTC is $2,000 through 2025 and $1,000 thereafter, and the phaseout thresholds where the CTC value starts declining are not adjusted for inflation. Inflation reduced the CTC’s real value by about 25% between 2003 and 2017, and it has lost 15% of its real value since 2018. Indexing the CTC’s value and phaseout thresholds for inflation has been proposed by Sen. Chuck Grassley (R-IA) and the Tax Foundation’s Growth and Opportunity tax plan.
The net investment income tax (NIIT) is an unindexed component of the individual income tax that higher earners are subject to. Single filers earning over $200,000 or joint filers earning over $250,000 are subject to a 3.8% tax on certain investment income. As nominal incomes rise, a growing number of taxpayers are affected by this tax since neither of the income thresholds is adjusted for inflation. While the NIIT should be repealed entirely, indexing its income thresholds has been proposed by Sen. Grassley.
Elevated inflation also affects businesses, as it reduces the real value of their depreciation deductions for prior investments, lowering the present value of the deduction below the original cost of investment and reducing the incentive to invest. The CREATE JOBS Act introduced by Sen. Ted Cruz (R-TX) proposes full and immediate deductions on a permanent basis or equivalent treatment through neutral cost recovery, which would remove the penalty of inflation on depreciation deductions.
While policymakers hope for inflation to continue declining, indexing the tax code is essential to prepare for future bouts of high inflation and to safeguard against prolonged elevated inflation. Indexing the tax code more comprehensively sends a clear message that taxpayers should not be required to pay taxes on phantom income caused by inflation.