Inflation and the Individual Income Tax

Abstract

It has been noted that, because of the progressive nature of the federal income tax, substantial amounts of revenue accrue to the federal government as a result of the purely nominal increases in income which occur during inflationary periods. Amid the discussions about indexation and its desirability, it has been estimated that inflation alone would have increased average tax rates by 40 percent between 1967 and 19751 and also that revenues are likely to increase 1.6 percent for each one percent increase in prices [15]. We find these estimates and other examinations of the impact of inflation on federal individual income tax liabilities to be limited in several important respects. The purpose of this paper is, therefore, to discuss these shortcomings and to present alternative estimates of the aggregate impact of inflation on income tax revenues and on the tax burdens of different types of taxpayers. First, it is important to note that the need to estimate inflation elasticities arises out of the fact that real and inflation-induced growth have different effects on the distribution of income, and therefore on tax liabilities. Consequently, estimates of the elasticity of federal income tax with respect to total or real growth in total income are distinct from the elasticities with respect of inflation-induced growth. A serious problem confronting all elasticity estimations, and one that has all but precluded direct estimation through time series analysis, is that the actual performance of the system has been greatly influenced by structural changes affecting the levels and types of deductions, exemptions, and the rate structure. To isolate the effects of price changes on federal income tax liabilities and