Bracket creep

Bracket creep describes the process by which inflation pushes wages and salaries into higher tax brackets, leading to a fiscal drag situation.

Most progressive tax systems are not adjusted for inflation. As wages and salaries rise in nominal terms under the influence of inflation they become more highly taxed, even though in real terms the value of the wages and salaries has not increased at all. The net effect is that in real terms taxes rise unless the tax rates or brackets are adjusted to compensate.

Suppose a person earns $20,000 per year and is liable to 20% tax on earnings above a threshold of $5,000 per year. Then they pay ($20,000–$5,000)*0.2 = $3,000 in taxes, or 15% of their income. Now suppose that due to inflation, their wage goes up by 5%, but the government only increases the tax threshold by 2%. They must now pay ($21,000–$5,100)*0.2 = $3,180 or 15.14% of their income as tax. Thus the proportion of the person's income that is paid as tax has increased.

The Alternative Minimum Tax originally (1971) targeted 155 high-income households; based on 2004 law, it would affect 20% of households by 2010.

Nominal bracket creep can easily be countered by a system of index-linked tax brackets, but this may be politically undesirable. Many voters do not perceive the effects of bracket creep, and so the government may prefer to adjust tax brackets manually once every few years: in effect, restoring the real tax rates to their approximate pre-inflation levels but in a way that gives the government the appearance that they are cutting taxes. Not surprisingly, such changes are usually made right before a general election is to be held.

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