Tax code

How the tax code handles inflation (and how it doesn’t)

A temporary gas shortage, caused by a computer attack, across much of the east coast last month and fears of rising inflation have left some people wondering if the 1970s are back. The Bureau of Economic Analysis report released last week did little to allay this fear, finding that the personal consumption expenditure (PCE) price index rose 3.9% since last May, the largest annual increase since August 2008. Fortunately, since the 1970s, the tax code has been better structured to account for inflation. In other respects, however, a return to inflation would create fiscal problems for the real economy.

In the 1970s, the “slice drift” in the tax code was a major cause for concern. Under a progressive income tax, with multiple tax brackets where rates rise with nominal income, increases in income due to inflation push taxpayers into higher tax brackets, even with no increase in real income. When annual inflation averaged over 5 percent every year, that was a real problem. In fact, it meant paying more taxes in real terms without any accompanying legislation.

Here’s an example from the Tax Foundation’s Tax Basics resource:

Imagine that Beth has an annual income of $ 50,000 in 2000 and her income increases to $ 75,000 by 2020. It could be pointed out that Beth’s salary has increased by 50% in nominal terms. However, the cumulative inflation rate between 2000 and 2020 was around 50%. This means that Beth’s higher salary in 2020 actually buys her the same amount of goods and services in today’s economy. In other words, its purchasing power has remained the same.

Now imagine that Beth is faced with a simple two-rate tax schedule where a 10% rate is taken on the first $ 50,000 of her income and a 20% tax rate is taken on income above. $ 50,000. Now suppose these bracket thresholds were passed 20 years ago and haven’t changed since Beth made $ 50,000. Even though Beth’s salary in 2020 now buys her the same amount of goods and services, she has been pushed into a higher tax bracket, resulting in a higher tax burden. The tranche thresholds have not kept pace with inflation.

These stealthy tax increases contributed to the passage of the Economic Recovery Tax Act of 1981 (ERTA), which included indexation to inflation for tax brackets from 1985. As part of the indexation to inflation, each tax bracket increases according to the evolution of overall prices. In Beth’s example, the 10% range that applied to all income below $ 50,000 in 2000 would apply to all income below $ 75,000 in 2020.

Inflation is also important for how companies deduct the cost of their capital investments. When companies pay corporate tax, they subtract their costs because they are taxed on their profits. However, companies cannot deduct all of their costs immediately, especially the amount they spend on capital investments such as buildings and machinery may need to be deducted over several years based on an approximation of life expectancy. of the asset. For example, trucks are deducted over five years, office furniture is deducted over seven years, and a warehouse is deducted over 39 years.

Due to inflation and the time value of money, the present value of depreciation according to these depreciation schedules is lower than the initial cost of the investment. If a business spends $ 39,000 to buy a building, the $ 1,000 deduction in year 39 is worth much less than the $ 1,000 deduction in year 1. This is due to both the time value of money, because companies would rather take a deduction sooner rather than later, and inflation, because even low and stable inflation dramatically reduces the real value of money over long periods of time.

Not allowing companies to deduct the full cost of the investment means that the investment costs are at a disadvantage compared to other expenses. The result of this imbalance is a decrease in capital investment. Lower investments mean less productivity gains, which slows economic growth and wage growth.

The table below shows that the present value of deferred deductions decreases as inflation increases, using standard Modified Accelerated Cost Recovery System (MACRS) rules for depreciation. Even before 2020, when inflation was historically low, deductions for long-term assets lost more than half of their long-term value thanks to the combination of still low inflation and time value. money. With the expected increase in inflation, companies will be able to deduct an even smaller share of their physical capital investments over time.

Present value of future deductions under MACRS
Active 5 years Active 10 years Active over 15 years Active 20 years Active 39 years old
Full expenses $ 100.00 $ 100.00 $ 100.00 $ 100.00 $ 100.00
MACRS if the inflation rate is under-exceeded (1.5%) $ 89.68 $ 80.75 $ 73.00 $ 66.26 $ 47.50
MACRS if the inflation rate is in line with the Federal Reserve’s target (2%) $ 88.63 $ 78.94 $ 70.66 $ 63.56 $ 44.38
MACRS with the inflation rate forecast by the Federal Reserve for 2021 (3.4%) $ 85.81 $ 74.22 $ 64.71 $ 56.87 $ 37.23
MACRS with a higher inflation rate than expected (5%) $ 82.78 $ 69.37 $ 58.85 $ 50.53 $ 31.20

Note: Assuming straight-line depreciation, half-yearly convention, real discount rate of 3%, plus inflation.

Source: authors’ calculations.

Full and immediate expensing, where capital costs can be deducted in the year they are incurred, eliminates this problem. Data collected in the United States and abroad has shown that allowing companies to deduct investments earlier has resulted in increased investment, output, and wages. The 2017 Tax Cuts and Jobs Act (TCJA) allowed companies to expense the cost of short-term assets, but this policy will start to disappear next year. With fears of rising inflation, it becomes more urgent to make these arrangements permanent.

Charging is the easiest way to make the income tax code more resistant to inflation problems. Some political arguments maintain that taxes on capital gains and interest should also be indexed to inflation. However, it is much more difficult to administer, and these changes have a much smaller impact on economic growth compared to full expensing.

In summary, while parts of the tax code can handle inflation, fully expensing capital investments would be a major improvement in this direction.

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