Bracket Creep - Explained
What is Bracket Creep?
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Table of ContentsWhat is Bracket Creep?How Does Bracket Creep Work? Academic Research on Bracket Creep
What is Bracket Creep?
The term Bracket Creep is used for describing a situation when inflation drives the wages and salaries into higher tax brackets. In effect, the taxpayers need to pay a higher tax without any increase in the real value of the wage of salary.
How Does Bracket Creep Work?
The Bracket Creep occurs during the time of high inflation. The tax rates are not generally adjusted immediately, as a result, the taxpayers cannot realize any substantial increase in their income or purchasing power, but they fall into a higher tax bracket. This may lead to a fiscal drag, as more money is spent on tax but no increase in purchase power. For example, Nikki earns $200,000 a year and falls into the 28% tax bracket. Lets assume she is liable to 30% tax on earnings above a threshold of $202,000. Now, over the years her salary is adjusted up to $204,000. Due to the inflation, with her $203,000 salary, she can purchase the same amount of goods and services that her $200,000 salary could buy, but with this salary hike, she falls into the 30% tax bracket. So, even if she got a $4,000 salary hike, but due to the higher tax rate and inflation, her purchase power remains the same. In this form of taxation, the loss of money can go up to trillions of dollars over a twenty-year period. The Bracket Creep can particularly be harsh on the people with lower income. The tax can escalate rapidly, without increasing the value of the salary. The rents and other expenses may increase faster than the wage and salary. The impact of bracket creep on the higher income group can be a bit tricky. If the people who are already paying a higher tax rate are pushed to a costlier tax bracket, they may choose to use tax planning services to slow down the progression of bracket creep. Governments generally use tax indexing to solve the problem of bracket creep. The tax rates are adjusted in lockstep with inflation to avoid a bracket creep situation. However, usually, it takes a significantly long time to change the tax code. Also, the government may not want to use tax indexing so that they can increase the tax revenue. In this way, the government earns a higher revenue from inflation by collecting higher tax rates from inflated incomes. In the United States of America, every year more than 40 tax provisions are adjusted by the Internal Revenue Services for inflation. To prevent the bracket creep the IRS uses the Consumer Price Index (CPI) for adjusting the value of the parameters. The tax parameters base value is multiplied by the current years Consumer Price Index and divided by the base years Consumer Price Index. For example, in the base year of 2002, the base value for the top of the 10% income tax bracket is $7,000. This is multiplied by 2019s Consumer Price Index and divided by 2002s Consumer Price Index. However, this is not the only method to adjust tax parameters. Average wage growth adjustments of the chained CPI-U method can be used for adjusting the tax rate.