How the tax code deals (and how not) with inflation

A temporary shortage of gas caused by a hack attack on much of the east coast last month and fears of rising inflation have made some people wonder if the 1970s are back. The Bureau of Economic Analysis report released last week did little to allay these fears. He found that the personal consumption expenditure (PCE) price index is up 3.9 percent since last May, the highest annual increase since August 2008. Fortunately, since the 1970s the tax code has been better structured to account for inflation . Otherwise, however, a return in inflation would create tax problems for the real economy.

In the 1970s, the “creep of brackets” in the tax code was a major cause for concern. In a progressive income tax with multiple tax brackets, where rates rise based on nominal income, inflation-related income increases drive taxpayers into higher tax brackets without real income rising. With annual inflation averaging over 5 percent, this was a real problem. Ultimately, this meant paying more taxes without accompanying legislation.

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

Imagine if Beth had an annual income of $ 50,000 in 2000 and her income grows to $ 75,000 by 2020. One could point out that Beth’s salary has increased nominally by 50 percent. However, the cumulative inflation rate between 2000 and 2020 was around 50 percent. That means Beth’s higher salary in 2020 will actually buy her the same amount of goods and services in today’s economy. In other words, their purchasing power has stayed the same.

Now imagine that Beth is faced with a simple two-rate tax plan that charges a 10 percent tax rate on the first $ 50,000 of her income and a 20 percent tax rate on income over $ 50,000. For example, suppose these thresholds were introduced 20 years ago and haven’t changed since Beth made $ 50,000. Although Beth is now buying the same amount of goods and services with her 2020 salary, she has been pushed into a higher tax bracket, resulting in a higher tax liability. The category thresholds have not kept pace with inflation.

These clandestine tax increases contributed to the passage of the Economic Recovery Tax Act of 1981 (ERTA), which from 1985 provided for inflation indexation for tax brackets. With inflation indexation, each tax bracket increases in line with the change in total prices. In Beth’s example, the 10 percent range that applied to all incomes under $ 50,000 in 2000 would apply to all incomes under $ 75,000 in 2020.

Inflation also plays a role in how companies deduct the cost of their investments. When companies pay corporation tax, they deduct their costs as they are taxed on their profits. However, companies cannot immediately deduct all of their costs – especially the amount they spend on investments like buildings and machinery may need to be deducted over several years based on an approximate 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 under these depreciation plans is less than the original cost of the investment. If a company 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. That is both in the time value of money and business would rather make a deduction sooner than later and inflation, because even a low and stable level of inflation significantly reduces the real monetary value over long periods of time.

If companies are not allowed to deduct the full investment costs, the investment costs are disadvantaged compared to other expenses. The consequence of this imbalance is lower capital investment. Less investment means less productivity gains, slowing economic growth and wage growth.

The following table shows how the present value of late deductions decreases as inflation rises, using the standard MACRS (Modified Accelerated Cost Recovery System) rules for depreciation allowances. Even before 2020, when inflation was historically low, the long-term asset deductions lost more than half their value due to the combination of the still low inflation rate and the time value of money. With inflation expected to rise, companies can withdraw an even smaller proportion of their physical capital investment over time.

Present value of future deductions under MACRS

5 year asset 10 year asset 15 year asset 20 year asset 39 year old asset
Full cost accounting $ 100.00 $ 100.00 $ 100.00 $ 100.00 $ 100.00
MACRS if the inflation rate falls below (1.5%) $ 89.68 $ 80.75 $ 73.00 $ 66.26 $ 47.50
MACRS when 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 US Federal Reserve forecast inflation rate 2021 (3.4%) $ 85.81 $ 74.22 $ 64.71 $ 56.87 $ 37.23
MACRS with a higher than expected inflation rate (5%) $ 82.78 $ 69.37 $ 58.85 $ 50.53 $ 31.20

Note: Assumes straight-line depreciation, semi-annual convention, 3 percent real discount rate plus inflation.

Source: authors’ calculations.

The complete and immediate crediting, in which the investment costs can be deducted in the year in which they arise, eliminates this problem. Evidence from the United States and abroad has shown that the ability to withdraw investment earlier has led to increases in investment, production, and wages. The Tax Cuts and Jobs Act of 2017 (TCJA) allowed companies to bear the cost of short-lived assets as an expense, but that policy will expire next year. With fears of inflation mounting, it becomes more urgent to make these provisions permanent.

Crediting is the easiest way to make the Income Tax Act more resilient to inflation problems. There are some political arguments that taxes on capital gains and interest should also be linked to inflation. However, this is much more difficult to manage, and these changes have a much smaller impact on economic growth compared to the full spending.

In summary, while some tax legislation can deal with inflation, fully accounting for capital investments would be a major improvement in this regard.

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