Index State Tax Brackets Now
The US government and many state governments have progressive income taxes. The word “progressive” doesn’t mean “good.” All it means is that as you progress up the income ladder, your marginal tax rate, which is your tax rate on additional income, increases. When the rates were set for the United States, there was a link between gold and the dollar. The US government’s commitment to keeping the price of gold at $35 per ounce limited its ability to print money and, thus, limited its ability to create inflation. But on August 15, 1971, President Nixon cut the last remaining link between the dollar and gold. Up until then, the US government stood ready to redeem foreign governments’ dollars for gold at $35 an ounce. But on August 15, Nixon closed the “gold window.” That meant that one remaining legal constraint on the Federal Reserve’s ability to print money was gone. The result, not surprisingly, was a decade of high inflation. From 1971 to 1981, the annual inflation rate averaged 8.4 percent.
This meant that tax brackets that had been designed for relatively high-income people were increasingly applicable to middle-income people and tax brackets designed for middle-income people were increasingly applicable to lower-income people. A table in the 1982 Economic Report of the President tells the tale. In 1970, a four-person family with one half the median income was in a 15 percent tax bracket. By 1980, that family was in an 18 percent tax bracket. A four-person family with the median income paid a marginal tax rate of 20 percent in 1970 and 24 percent in 1980. A four-person family with twice the median income paid a marginal tax rate of 26 percent in 1970 and a whopping 43 percent in 1980. And remember that this is just the family’s personal income tax rate and did not include either the Medicare (HI) or the Social Security (FICA) tax.
This is from David R. Henderson, “Index State Tax Brackets Now,” Defining Ideas, May 19, 2022.
Not surprisingly, Milton Friedman was ahead of the curve in advocating, in 1974, that tax brackets be indexed for inflation. And Ronald Reagan, upon becoming president, wanted to do something about the problem. Although I’ve never seen this discussed, I would bet that Reagan badly regretted increasing the top tax brackets in California shortly after he became governor in 1967. He was facing a substantial state budget deficit, but he chose higher marginal tax rates on higher-income people to deal with it. For example, California’s marginal tax rate on people with taxable income of $30,000 or more was 7 percent in 1966. An income of $30,000 in 1966, adjusted for inflation, would be $268,694 today. In 1967, Reagan and the legislature raised the marginal tax rates for people making $25,000 to $28,000 to 9 percent and for people making $28,000 or more to 10 percent. His tax rates remained, inflation took off, and by 1980, middle-income Californians were paying tax rates that Reagan, his advisers, and the California legislature had intended only for high-income Californians. Things bad begun make strong themselves by ill, as Shakespeare put it.
Reagan seems to have learned the lesson. In the 1981 Economic Recovery Tax Act, he and Congress cut marginal tax rates at all income levels annually from 1982 through 1984, and indexed tax brackets for inflation from 1985 on. The result is that inflation by itself cannot put you in a higher tax bracket. Well, almost. The income levels above which Social Security recipients pay taxes on their Social Security benefits, introduced in 1984, have never been adjusted for inflation. But those not getting Social Security benefits cannot be put in higher tax brackets by inflation alone.
Read the whole thing.