As Inflation Rises, So Will Tax Bills in Many States

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Inflation is often called a hidden tax, but in many states it yields a far more literal tax increase as tax brackets fail to adjust for changes in consumer purchasing power. This phenomenon is called “bracket creep,” and it’s far creepier than the décor beginning to pop up in people’s front yards as we enter the final weeks of October.

Inflation currently stands at 5.4 percent over the past 12 months, the highest increase in decades, and is about 6.3 percent higher than when the pandemic began. A dollar doesn’t go quite as far these days, and compensating measures have been taken in a variety of sectors. Social Security recipients, for instance, will see a 5.9 percent Cost of Living Adjustment (COLA) next year, the largest increase in about four decades. Wages are up about 7.3 percent during the pandemic, offsetting higher costs—though that may be cold comfort for those who didn’t see their own wages rise, or who saw the value of their investments decline.

Often overlooked, however, is what happens to state tax burdens when inflation is high. When tax brackets, the standard deduction, or personal exemptions are not inflation-adjusted, they lose value due to inflation, raising tax burdens in real terms. Bracket creep occurs when more of a person’s income is in higher tax brackets because of inflation rather than higher real earnings.

Imagine, for instance, a Delaware resident who made $60,000 in taxable income in 2019, and who now makes $64,000. Due to inflation, she hasn’t seen an increase in real income: her $64,000 today has about the same purchasing power as her $60,000 in 2019. But if her state’s income tax brackets aren’t inflation-indexed, whereas her top marginal rate was previously 5.55 percent (on income between $25,000 and $60,000), she now has $4,000 taxed at the higher rate of 6.6 percent. Her tax bill rose by $264 even though her purchasing power remained constant.

Forty-one states and the District of Columbia tax wage income, while New Hampshire taxes just income and dividend income. Of these, 15 states and D.C. fail to adjust brackets for inflation, 10 states leave their standard deduction (if they have one) unadjusted, and 18 have an unindexed personal exemption. Taken together, 22 states and the District of Columbia have at least one major unindexed provision. Thirteen states fail to index any relevant major component. (In some cases, they may forgo a standard deduction or personal exemption, but all relevant provisions are unindexed.) They are Alabama, Connecticut, Delaware, Georgia, Hawaii, Kansas, Louisiana, Mississippi, New Jersey, New York, Oklahoma, Virginia, and West Virginia.

The absence or insufficiency of cost-of-living adjustments in many state tax codes is always an issue, as it constitutes an unlegislated tax increase every year, cutting into wage growth and reducing return on investment. During a period of higher inflation, however, the impact is particularly significant.

To see how significant inflation can be, consider capital gains. Let’s say that you purchased $10,000 worth of shares in 2001 and sold them for $20,000 at the start of 2021. Both the federal and state government would treat this as capital gains income of $10,000. The federal government provides a preferential rate on long-term capital gains, while most states do not. In real terms, however, the gain is far less than $10,000 because cumulative inflation during that period was nearly 55 percent, making the real gain $4,502. Note that inflation indexing of tax codes alone cannot solve the problem of over-taxation of capital gains income, but it is at least illustrative of the broader issue.

The following table shows which provisions in each state are indexed for inflation. For states which fall short, there is no time like the present to remedy the problem. Most states are currently flush with cash, and if policymakers fail to act, taxpayers will get a one-two punch from inflation, an explicit tax increase piled atop the implicit one.

For a full accounting of states’ approaches to inflation indexing, along with a discussion of best practices for adding cost-of-living adjustments to state tax codes, see our primer on this topic.