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April 30, 1 982

Indexation and Bracket Creep
Section 1 04 of the Economic Recovery Tax
Act of 1 981 , with its description of incometax indexation, is one of the more crucial
sections ofthat key piece of legislation. However, that section does not become effective
u nti I 1 985, when settlement for 1984 tax
liabilities must be made: The drafters of
the legislation chose that date because 1984
would be the first year under the new tax
structure-that is, the first year following
the completion of the 1 981 -83 income-tax
reductions.
The Federal Government in recent years has
come to use indexation for a number of programs, such as social security and other
income-maintenance programs, as well as
Federal wages and retirement benefits. Indeed, the government now adjusts upwards
of two-thirds of all Federal payments to individuals for increases in the costofliving. Until
the 1981 legislation, however, the Federal
Government did nothing to eliminate the
effects of "bracket creep" on income-tax
payments.
The states have led the way in this area; for
example, California voters thisJunewili have
the chance to make a measure of this type
(now temporary) a permanent part of the
state's tax code. Yet in view of the serious
impact of indexation on tax revenues, and
thereby on the Federal deficit, many Congressionalleaders are now questioning the wisdom of allowing the indexation procedure to
take effect in 1 985, as scheduled.

Bracket creep
In drawing up the income-tax laws, Congress
has defined the limits of individual incometax brackets in terms of current (nominal)
dollars. Moreover, it has determined that the
income-tax structure should be progressive,
with a rise in marginal tax applicable to individual income brackets as taxable income
falls into higher brackets. Considerations of
equity, based upon the ability to pay, have

accounted for this progressive nature of the
tax structure.
In a period of inflation, such as the 1970's,
wages and income follow prices upward, but
with a certain time lag. With the tax structure
specified in t,rms of nominal dollars, inflation-boosted incomes push the taxpayer into
higher brackets, with progressively higher
marginal-bracket rates. The personal exemption, also specified in nominal dollars, at the
same time becomes progressively smaller.
The taxpayer thus pays a higher average tax,
because his or her income becomes exposed
to higher bracket rates because of inflation.
Bracket creep, by imposing a steeplyprogressive tax structure on individuals, also
hands the Treasury a windfall gain. According
to Congressional Budget Office calcu lations,
bracket creep alone without legislation cou Id
have led to a $1 15 billion cumulative increase in income-tax payments between
1 979 and 1985. Thus, the combination of
sustained inflation and a progressive tax
structure can result in a sharp increase in tax
liabilities without legislative action.

Adjusting for brad<et creep
To adjust for this impact of inflation upon
personal income-tax revenues, Congress
adjusted the bracket ranges to which the marginal tax rates apply. However, it did not
change the marginal tax rates themselves. In
the 1983 tax schedule, for example, a joint
retu rn with taxable income of $23,000 wou Id
fall into a bracket with limits of $20,200 to
$24,600 and a marginal tax rate of 25 percent
wou Id be appl ied to the excess over the lower
limit. A five percent inflation rate would then
dictate an increase in the bracket limits to
$21 ,21 0to $25,830, still with a 25 percent
marginal rate. (The preceding year's inflation
rate would be used for indexation because
taxes would be settled on the basis of the
preceding year's income.) The same cost-ofliving adjustment (COLA) would be applied
to the personal exemption.

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Opinion::;

in this nevvslctter do not
refieci the vie\vs of the rnanagement
of thf' Federal
Bank of Si:ln Francisco,
en 01 the Board of Covernors of thE:' Federal

Systeili.
Under the new legislation, the Secretary of
the Treasury describes the adjustment tables
(inflation factors) to be applied to income
brackets and the personal exemption no later
than December 15 of 1 984 and each year
following. The annual costadjustmentwould
be "the percentage (if any) by which the consumer price index for the preceding calendar
year exceeds the price index for the calendar
year 1 983" -the first full year of implementation of the tax structure resulting from the
1981 tax legislation. (However, the law defines the calendar year in terms ofthe Federal
fiscal year ending September 30.) The adjustment for inflation would be calculated each
yearfrom the 1983 base figure (1 983= 100).
Incidentally, the Bureau of Labor Statistics, in
an attemptto improve the statistical reliability
of the price yardstick for this indexation purpose, has announced plans to revise the CPI
in order to reduce the importance of the volatile home-purchase and mortgage-interest
components of the index.

(unchanged) marginal tax rate became applied to the inflation-adjusted brackets. With
5.2-percent inflation, the lowest taxable
bracket would be between $3,580 and
$5,790. The difference between the two ends
of the bracket, when multiplied by 11 percent, would be $243 rather than the original
$231 before adjustment.
./

Consider the case of a family of four (four
personal exemptions) with taxable income of
$28,000 in 1984. Without indexation, that
family would fall into the bracket between
$24,600 and $29,900, and would pay a marginal tax rate of 25 percent. Its computed tax
liability, therefore, would amountto $4,315
(see table).
With indexation, the family's taxable income
would decline because of the increase in personal exemptions by the inflation factor.
Specifically, the sum of the personal exemptions would increase from $4,000 to $4,208,
leading to a reduction in taxable income to
$27,792. The top and bottom of the bracket
forthatfamilywould
also rise by 5.2 percent,
so that the adjusted brackets would cover
from $25,880 to $31 ,460, again with a marginal tax rate of 25 percent. The "basic" tax
meanwhile would increase from $3,465 to
$3,643, rising along with the changes in the
brackets. Thus, the total tax liability would
be $4,1 21 , representing a $1 94 reduction
due to indexation.

According to projections published by
the Office of Management and Budget, the
consumer price index would increase 5.2
percent between 1983 and 1 984. This 5.2percent factor thus would be applied to the
top and bottom limits of each income bracket
for 1 984, and also to the personal exemption
of $1 ,000. In addition, the increase would
apply to the "basic" tax-the cumulative tax
liabilities due on taxable income starting
from the lowest income bracket, as described
below.

The reduced tax liability would not be considered a tax cut, but rather would represent
tax increases that did not happen because
of indexation. The total tax would be lower
because a smaller portion of taxable income
under indexation would be exposed to the
marginal tax rate, reflecting the increase
in the bottom limit of the bracket. And in
some cases, of course, the taxpayer would
drop back into a lower bracket with a lower
marginal rate because of the indexation
procedure.

Example adjllJstment
of
For the lowest taxable bracket, $3,400 to
$5,500, a tax rate of 11 percent on the excess
over the $3,400 figure would yield a tax of
$231 for a taxpayer at the top of the bracket.
For the next bracket, $5,500 to $7,600, the
tax would be $231 plus 12 percent of the
excess over $5,500. The increment of $252
for a taxpayer at the top of that bracket wou Id
be added to $231 to serve as the baseline tax
liability for the next income brackets. With
the appl ication of the index to the bracket
ranges, the basic tax would increase as the

Futurefor indexation
The indexation approach recently has come
under attack because of its contribution to the
2

massive Federal budget deficits projected for.
the next several years. According to the Congressional Budget Office, the cumulative
deficit for the 1 983-87 period could exceed
$1 trillion under current tax and spending
legislation. Some Congressional leaders,
therefore, have suggested eliminating the indexation provision-which
would increase
revenues by $12 billion in fiscal year 1985
and $51 billion in 1 987 on the basis of CB O
inflation assumptions. Supporters of indexation, however, argue that bracket creep
would reoccur if indexation procedures were

not put into plac;e following the final stage of
the 1 981 -83 tax cuts.
The importance of indexation cannot be
overestimated in a period of high inflation.
After the severe inflation of the 1970's, the
average tax paid has risen to a degree not
foreseen by the drafters of the original tax
legislation. In effect, inflation setthe tax rate
during that period, and notatall to the advantage of the average taxpayer.

HerbertRunyon

EXAMPLE INDEXATION
OF
Family of four
Taxable income of $28,500
Inflation rate of 5.2% (1983-84)

Taxes indexed
not

Taxes
indexed

Income bracket: $24,600 to $29,900
Tax:
$28,000
24,600
3,400
x .25
850
+ 3,465
4,31 5

Income bracket: $25,880to $31 ,460
Tax:
$27,792*
25,880
1,912
x .25
478
+ 3,643
4,121

*Taxable income adjusted for indexation of personal exemptions

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BANKING DATA-lWElFTH FEDERAL
RESERVE
DISTRICT
(Dollar amounts millions)
in
Selected
AssetsandLiabilities
large CommercialBanks
Loans
(gross,
adjusted) investments*
and
Loans
(gross,
adjusted)
-total #
Commercial industrial
and
Realestate
Loans individuals
to
Securities
loans
U.s. Treasury
securities*
Othersecurities*
Demanddeposits total#
Demanddeposits adjusted
Savings
deposits total
Time deposits total#
Individuals,
part.& corp.
(Large
negotiable
CD's)
WeeklyAverages
of Daily Figures
MemberBankReservePosition
Excess
ReserVes )/Deficiency
(+
(-)
Borrowings
,
Net freereserves )/Netborrowed(
(+
-)

Jr

Amount
Outstanding
4/14/82
158,151
137,060
42,587
56,659
23,322
2,026
6,332
14,759
40,999
28,379
31,672
90,285
80,850
33,188
Weekended
4/14/82
81
31
50

Change
from
Cliange
yearago
from
Dollar
Percent
4/7/82
7.5
11,063
124
12,314
9.9
108
5,939
16.2
259
9.4
85
4,859
2.2
506
61
681
50.6
34
I287
4.3
53
I943
6.0
37
I- 10.4
4,749
503
I10.4
- 654
3,278
160
0.5
152
19.6
14,785
265
21.2
57
14,133
4,302
14.9
88
Comparable
Weekended
year-ago
period
4/7/82
40
95
56

57
39
18

* Excludes
tradingaccount
securities.
# IncludesitemsnotshownsePilrately.
Editorialcomments
maybeaddressed the editor (William Burke) r to theauthor...• Free
to
o
copies this
of
and other Federal eserve
R
publications beobtained callingor writing thePublicInfonnation
can
by
Section,
FederalReserveBankof SanFrancisco, Box7702,SanFrancisco
P.O.
94120.Phone
(415)544-2184.