What is bracket creep?
Bracket creep occurs when inflation causes wages to increase, but the tax brackets remain the same. This means that even though a taxpayer's income has not increased in real terms, they are pushed into a higher tax bracket and pay more in taxes.
Bracket creep is a problem during periods of high inflation because it can lead to taxpayers paying more in taxes than they would have if the tax brackets had been adjusted to account for inflation. This can lead to taxpayers feeling like they are being unfairly taxed and can lead to a decrease in consumer spending, which can have a negative impact on the economy.
Stagnant tax brackets
Income tax codes are complex and can take a long time to change. This is because the government must consider the impact of any changes on the entire population, and must also ensure that any changes are fair and equitable. In addition, the government must consider the economic implications of any changes, and must ensure that any changes are consistent with its overall fiscal policy. As a result, the tax brackets may be stagnant.
In contrast, the rate of inflation can change quickly, as it is based on the cost of goods and services in the economy. As prices rise, the purchasing power of a given amount of money decreases. This means that even if income tax rates remain the same, taxpayers may still end up paying more in taxes due to inflation. This can lead to an increase in income taxes without an increase in real purchasing power.
Understanding tax brackets and tax rates
Tax brackets and tax rates are used to determine how much tax a taxpayer owes. Tax brackets are based on income levels and are used to determine the tax rate that applies to a taxpayer’s income.
Tax rates are the percentage of income that is owed in taxes. The United States has a progressive income tax. Under this system, the higher the income, the higher the tax rate. Tax brackets and tax rates are designed to ensure that taxpayers with higher incomes pay a larger portion of their income in taxes than those with lower incomes.
The federal income tax rates for single filers in 2023 (for filing in 2024) are as follows:
10%: Taxable income up to $11,000 |
12%: Taxable income between $11,001 and $44,725 |
22%: Taxable income between $44,726 and $95,375 |
24%: Taxable income between $95,376 and $182,100 |
32%: Taxable income between $182,101 and $231,250 |
35%: Taxable income between $231,251 and $578,125 |
37%: Taxable income over $578,126 |
Bracket creep occurs when inflation causes taxpayers to move into higher tax brackets even though their real income has not increased. This means that taxpayers are paying more in taxes even though their real income has not changed.
How the IRS addresses bracket creep
Every year, the Internal Revenue Service (IRS) adjusts more than 60 tax provisions for inflation in an attempt to minimize bracket creep. Some of the tax provisions the IRS adjusts include:
- Tax rates (bracket widths)
- Tax bases (deductions, exemptions, and other provisions)
- The Standard Deduction
- The Earned Income Tax Credit (EITC)
The Chained Consumer Price Index
Prior to 2018, the IRS relied on the Consumer Price Index (CPI) to measure inflation and adjust tax brackets to prevent bracket creep. However, the Tax Cuts and Jobs Act of 2017 (TCJA) changed this, and the IRS now uses the Chained Consumer Price Index (C-CPI) to adjust income thresholds, deductions, and credits.
The Chained Consumer Price Index (C-CPI) is a measure of inflation calculated by the U.S. Bureau of Labor Statistics. It is intended to provide a more accurate picture of how consumers respond to changes in prices. Unlike the standard Consumer Price Index (CPI), which simply measures the average change in prices for a fixed basket of goods and services, the C-CPI takes into account the fact that consumers often adjust their spending habits in response to changes in prices.
For example, if the price of beef goes up, consumers might start buying more chicken instead. This "substitution effect" is factored into the C-CPI, but not the standard CPI. As such, the C-CPI usually shows a slower pace of price increases (lower inflation) than the standard CPI. The IRS uses the C-CPI to adjust tax brackets and other tax parameters to account for inflation, which helps prevent bracket creep.
Fiscal drag: the underlying cost
Bracket creep can contribute to a phenomenon known as fiscal drag. Fiscal drag is the process by which the government’s tax revenues increase as a result of inflation. This occurs when the government does not adjust its tax brackets for inflation, meaning that as wages and prices rise, more income is taxed at higher rates. This results in an increase in the overall tax burden on individuals and businesses, reducing their disposable income and thus their ability to spend and invest.
The underlying cost of fiscal drag is that it reduces economic growth. As disposable income is reduced, consumer spending and investment are both reduced, leading to slower economic growth. This can have a negative effect on employment, wages, and overall economic activity.
How to lower your tax bracket
There are several steps you can take to lower your tax bracket. These include:
Contributing to retirement accounts: Contributing to a retirement account such as a 401(k) or IRA can help lower your taxable income and reduce your tax bracket. The contributions you make to your 401(k) come out of your salary. These contributions are made with pre-tax dollars. As a result, your employer doesn’t include these amounts in your taxable income for the year. At the end of the year, your wages subject to federal income tax are lower because of your 401(k) plan contributions, reducing your taxable income.Your traditional IRA contributions may be tax-deductible, although they maybe be limited if you or your spouse is covered by a retirement plan at work and your income exceeds certain levels.
Maximizing charitable donations: Making charitable donations can also help lower your tax burden. Donations to qualified charities are tax-deductible, meaning that the amount you donate is subtracted from your taxable income. This can help lower your overall tax burden and put you in a lower tax bracket.
Utilizing tax credits: Taking advantage of tax credits can also help lower your tax burden. Education tax credits such as the American Opportunity Tax Credit and the Lifetime Learning Credit can help reduce the amount of taxes you owe. These credits are available for qualified tuition and related expenses for higher education. The Child Tax Credit (CTC) can reduce the amount of tax you owe by up to $2,000 per qualifying child. The CTC is refundable, meaning that if you owe less tax than the amount of the CTC, you may be able to get a refund for the unused amount of your Child Tax Credit up to $1,600 per qualifying child (tax year 2023 and 2024).
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