2022 Inflation Could Cause Taxpayers Increased Tax Bills

What is one of the biggest taxes in the United States? Surprisingly, it’s what many call the “hidden tax.” What exactly is the hidden tax? Drum roll… the hidden tax is inflation! But make no mistake about it, inflation yields a literal tax increase as tax brackets don’t adjust for changes in consumer purchasing power. We’ll see this continue to play out over the coming year — it’s what experts call “bracket creep.”

How Bad Is Inflation Right Now?

According to the Consumer Price Index, over the past 12 months there’s been a 6.2% increase in inflation before seasonal adjustments. This means items such as energy, shelter, food and cars have all gotten more expensive over the past year. The 6.2% increase was the largest we’ve seen on a year-over-year basis since 1990.

When the dollar doesn’t go as far as it used to, it stretches the finances of ordinary Americans. This is why social security recipients are getting the largest increase in four decades. What’s overlooked, however, is the phenomenon of bracket creep.

Here’s what happens: When inflation increases, tax brackets lose some value if they are not adjusted accordingly. This drop in value can create increased tax bills because it causes more of a person’s income to fall within a higher tax bracket — artificially due to inflation, not because they made higher real earnings.

How Does Bracket Creep Affect Taxpayers?

To answer this question, let’s look at an example. Take, for instance, a man who made $61,000 in taxable income a year ago. This year, he will make $65,000. Due to inflation, he doesn’t actually have an increase in real income because he has the same purchasing power. The $65,000 has around the same value today that the $61,000 had in the past. But, if his state’s income tax bracket isn’t inflation-indexed, he could be in a higher tax bracket. Practically speaking, he will owe more in taxes but his purchasing power is the same.

There are 41 US states that tax wage income, and 15 of them don’t adjust brackets for inflation while 10 states don’t adjust their standard deduction. All in all, 22 states and DC have at least one unindexed position, and 13 states don’t index any major component.

Therefore, tax bracket creep is likely affecting taxpayers the most in the following states:

• Alabama
• Connecticut
• Delaware
• Georgia
• Hawaii
• Kansas
• Louisiana
• Mississippi
• New Jersey
• New York
• Oklahoma
• Virginia
• West Virginia

Bracket creep can be described as an unlegislated tax increase. It cuts into wage growth. It also happens with capital gains. For example, if you purchased $25,000 worth of shares in 2011 and sold them in 2021 for $50,000, it appears as a capital gain of $25,000.

But most states don’t provide a preferential rate on long-term capital gains. So, in real terms, the gain is far less than $25,000 because inflation over the past 10 years made the real gain worth much less.

States That Index for Inflation

The following states help prevent bracket creep by indexing for brackets, standard deduction and personal exemption:

• Arizona
• California
• Montana
• Nebraska
• Oregon
• Rhode Island
• Vermont

Other states index for either brackets, deduction or exemption but not all three. Still other states might index in one area but conform to federal policies in another — like how Idaho has indexed brackets but follows federal guidelines when it comes to the standard deduction. Taxpayers should look at the following table to see where their state stands:

Bracket Creep in 2022 Will Cause Increased Tax Bills

While nobody can say for sure what the exact inflation rate will be in 2022, many economists are ratcheting up their forecasts. With supply chain problems continuing, consumer price forecasts show it’s likely that inflation will remain a dominant issue well into next year.

Some economists expect government spending with the infrastructure package along with the Build Back Better package to give the country confidence moving forward, which will result in greater private investment and therefore more economic growth. With possible labor shortages persisting into 2022, employers will likely offer higher pay to attract workers, which could result in more inflation.

The question is, how hot will inflation run? Will it be a manageable 1%–2% or an out of control 8%–10% — or anywhere between those extremes? The higher the inflation rate in 2022, the more taxpayers will experience the hidden tax known as bracket creep when they file their taxes the following year.