The rapid and unexpected onset of inflation after decades of price stability is an unwelcome development with immediate and widespread implications for the U.S. economy and politics. The effect of inflation on tax, and the effect of tax policies on inflation — issues so long absent from discussions of fiscal policy — will move to center stage. Proposals to curb inflation and its effects get priority. Like it or not, other long-standing priorities like job creation, fighting poverty, and promoting renewable energy must make way.
Pressure From All Sides
The causes of inflation can be divided into three categories, and unluckily for us, forces from all three have been let loose in the last two years. First, there is demand-side inflation, usually stemming from too much fiscal stimulus in the form of tax cuts or hikes in government spending. The waves of massive and unprecedented tax cuts and government spending that followed the onset of the pandemic in March 2020 were more than the economy could digest. Because of the federal government’s largesse, personal income increased in what otherwise would be judged an unprecedented economic catastrophe. And shortly after, the bursts of disposable personal income inflation long dormant in the U.S. economy woke up, as shown in Figure 1. COVID-19-related fiscal stimulus was greater in the United States than in other OECD countries, which probably explains why the inflation rate in the United States is greater than in those countries (Òscar Jordà et al., “Why Is U.S. Inflation Higher Than in Other Countries?,” Federal Reserve Bank of San Francisco (Mar. 28, 2022)).
Second, there is supply-side inflation, which is now at work in our economy in several ways, including through disruptions in manufacturing and transportation of goods (attributable to the pandemic) and through rising fuel and food prices (most recently connected to Russia’s invasion of Ukraine). But probably the most significant and lasting source of supply-side inflation comes from upward pressure on wages caused by a shortage of labor. One measure of the labor market conditions is the ratio of job openings (a measure of demand for labor) to the number of unemployed persons (a measure of labor supply). As shown in Figure 2, that ratio is high and growing. Based on their assessment of that statistic’s predictive power, Alex Domash and Lawrence H. Summers conclude that “that labor market tightness is likely to contribute significantly to inflationary pressure in the United States for some time to come.” (Domash and Summers, “How Tight Are U.S. Labor Markets?” National Bureau of Economic Research Working Paper No. 29739 (Feb. 2022)).
Third, there is inflation caused by the Federal Reserve increasing the supply of money and reducing interest rates. Even before the pandemic, the Federal Reserve was pursuing loose monetary policy to promote economic growth. When the pandemic hit, the Fed feared financial market collapse and supported the bond market with massive purchases, as shown in Figure 3.
Inflation Neutrality
Ideally a tax system should be inflation neutral. That means that effective tax rates shouldn’t vary with the rate of inflation. Mostly this is a potential problem with the income tax because of its progressivity and because of the taxation of capital income. But keep in mind that inflation can affect other taxes. For example, excise taxes that aren’t levied as a percentage of price, like the federal 18.4-cent-per-gallon gas tax, aren’t inflation neutral because the value of tax collected in the current year will be less than the value of tax collected in previous years.
Inflation can affect income taxation in two distinct and separate ways. Both problems can be addressed by “indexation,” but what indexation involves in each context is very different. What we will call code indexation is relatively simple and can be administered by the IRS. And it has largely been achieved by the IRS since 1985. What can be called capital income indexation is complex and, if allowed, would require burdensome calculations by tens of millions of taxpayers. When it chooses to address the adverse effect of inflation on the measurement of capital income, Congress has adopted other simpler but less precise measures.
Indexation of Inflated Code
Inflation could change the real value of all dollar figures in the code. This problem has been solved for the most part with the passage of the Economic Recovery Tax Act of 1981. That law mandated that beginning in 1985, income tax brackets, the standard deduction, and a host of other dollar amounts in the code be adjusted upward by changes in the consumer price index. This indexation eliminated “bracket creep” — the automatic tax increases that result from inflation pushing taxpayers’ inflated income into brackets with higher rates without any corresponding increase in their real economic income. If an income tax shed all features that make it progressive and was truly a flat rate tax, indexation wouldn’t be needed to prevent bracket creep. Today, the IRS adjusts 62 dollar amounts in the code annually for inflation (Rev. Proc. 2021-45, 2021-48 IRB 764).
But a handful of dollar-denominated items aren’t indexed. These include: (1) the 3.8 percent net investment income tax that applies to incomes exceeding $250,000 for married taxpayers and $200,000 for singles (section 1411(b)); (2) the $10,000 limitation on deductions for state and local taxes (section 164(b)(6)); (3) the $3,000 limit (in place since 1978) on capital losses that can offset ordinary income (section 1211(b)); (4) the amount of deductible mortgage interest limited to the interest paid on up to $750,000 of mortgage debt (section 163(h)(3)); (5) and the $500,000 exemption of gains from sale of a principal residence (section 121(b)). The lack of indexation means the real burden of these provisions increases with inflation.
With the passage of the Tax Cuts and Jobs Act, Congress changed the index used to make inflation adjustments from the CPI to the chained CPI. This alternative generally grows more slowly. For example, the CPI increased 8.5 percent over the 12-month period ending this March compared with an 8.1 percent increase for the chained CPI over the same period. This modification was estimated to raise federal revenue by $124 billion over the years. The chained CPI is considered a better measure of the burden of inflation than the CPI because it takes into account that consumers will adjust their spending patterns to reduce the effect of inflation. The change was not across the board. Congress retained adjustment with the CPI for the dollar limitation of contributions to retirement accounts.
Inflated Capital Income
The second way inflation affects taxation is through distortion in the measurement of capital income. (Another way of saying this is that inflation creates a mismatch of the value of income and expense in multiyear transactions.) If, in the determination of taxable income (say, in 2022), expenses are deducted at their original cost (incurred in, say, 2019), the value of those deductions as expressed in current (2022) dollars would be understated and therefore taxable income would be overstated. The most direct method of correcting the measurement of capital income is to translate expenses (or basis) expressed in prior-year dollars into current dollars. This generalization especially applies to the measurement of depreciation expense, the cost of goods from inventory, and the measurement of basis in computation of capital gain.
Inflation inappropriately reduces the value of deductions for depreciation of capital assets valued at historical cost. The distortionary effects of inflation could be addressed by indexing when depreciation deductions are multiplied by a factor equal to the ratio of the current price level to the price level at the time of purchase of the asset.
It is important to note that when purchases of depreciable capital assets are written off in the first year (that is, they are expensed), inflation has no negative effect. With the passage of the TCJA in 2017, all capital assets with a useful life of 20 years or less can be written off in the first year. But what is referred to as 100 percent bonus depreciation is scheduled to be reduced to 80 percent bonus depreciation in 2023; 60 percent in 2024; 40 percent in 2025; 20 percent in 2026; and eliminated in 2027. If the price level continues its rapid rise throughout those years, that statutorily reduced incentive to invest in equipment would be compounded by inflation.
Inflation can inappropriately reduce the value of deductions for cost of goods sold out of inventory when that inventory was purchased in a period with a lower price level. This could occur under the first-in, first-out method of inventory accounting, which, under normal circumstances, uses older inventory that is undervalued by inflation. A business could address this problem on its own by adopting the last-in, first-out method of inventory accounting. LIFO would reduce taxable income below that with FIFO. But unlike the case of depreciation, when tax and book methods may be different, tax accounting for inventories must conform to book accounting — so the taxpayer would have to accept reporting lower book income to investors and lenders as the price of reducing taxable income.
Congress could repeal the LIFO conformity requirement. It could, as with depreciation allowances, index the cost of goods taken out of inventory by multiplying those costs by the ratio of the current price level to the price level in effect when the goods were purchased.
Inflation can inappropriately reduce the value of basis used to determine capital gain when a capital asset is sold. The original purchase price of an asset doesn’t reflect its true value expressed in current dollars. That can be corrected by increasing the basis by the change in the price level from the time of purchase to the time of sale.
There are four arguments against indexation correction for capital gains. First, it is complicated. Second, capital gains already enjoy various tax benefits: (1) a preferential tax rate (generally 20 percent plus a possible 3.8 percent NII tax); (2) deferral of tax until gain is realized; and (3) complete elimination of income tax on gain if the asset is held until death. Third, indexation of capital gains is usually proposed without inflation adjustments for the other distortions of measurement of capital income by inflation and, in this case, it is unclear why capital gains should be singled out for special treatment, especially given the advantages they already enjoy. Fourth, indexation of capital gains without a reduction in deductions in interest expenses attributable to inflation (discussed below) would provide arbitrage opportunities, the building blocks of tax shelters.
Inflation and Interest
So far we have discussed how actual past inflation inappropriately increases taxation by undervaluing cost and basis. For interest income and interest expense, the damage is the result of expected inflation. Nominal (market) interest rates have real and inflationary components. If expected inflation is 5 percent and the market rate is 7 percent, the real interest rate is 2 percent. Only 2 percent is real income. The other 5 percent is just compensation for inflation. Under today’s law (assuming section 163(j) limitations on interest deductions don’t apply), a debtor gets to deduct interest expense incurred at 7 percent and the lender must include 7 percent interest in taxable income. Over time, as the rate of inflation changes to 3 percent or to zero, the debtor gets a smaller deduction even though the real expense at 2 percent is unchanged. Similarly, the lender has taxable income even though the real income at 2 percent is unchanged.
The code isn’t inflation neutral regarding interest. Borrowers get unjustified tax relief and lenders are overburdened. Those two effects don’t offset each other in the aggregate because high-rate taxpayers are more likely to be borrowers, and low-rate taxpayers (or entities exempt from tax) tend to be lenders.
There are several methods of correcting the distortionary effects of inflation on indebtedness. Some adjust interest, some adjust principal, and all in the real world must take into account that expected inflation may not be considered measurable. For now (because this article is an overview), let’s assume expected inflation can be predicted, in which case deductions for interest expense will be reduced to reflect expected inflation and inclusion of interest income will similarly be reduced.
A Little History
The House version of the Tax Reduction Act of 1978 (H.R. 13511) included a provision to index capital gains for inflation. Under the bill, taxpayers would be allowed, beginning in 1979, to adjust for inflation the basis of corporate stock, real estate, and tangible personal property. Adjustments would be made only for increases in the CPI occurring after December 31, 1979. (Prior coverage: Tax Notes, Aug. 21, 1978, p. 217.) The proposal was dropped in conference.
In its 1984 efforts to overhaul the income tax system, Treasury proposed inflation adjustments for depreciation, inventory costs, capital gains, and interest income and expense. In its 1985 version of reform, Treasury retained inflation adjustments for depreciation and inventories, but it dropped the adjustments for interest and capital gains. Treasury proposed retaining a preferential rate on gains as an imperfect but much simpler way to compensate for the fact that nominal gains, unadjusted for inflation, are included in income. In the Tax Reform Act of 1986, Congress excluded all of Treasury’s proposals to use indexing to correct the inflation-induced distortions to capital income.
Tax Effects on Inflation
Having surveyed some of the effects of inflation on taxes, let’s now explore causality in the other direction and what taxes might do to stop inflation. Unfortunately, the menu of possibilities is limited — and what is available isn’t attractive.
The knee-jerk response of many lawmakers to a problem as economically pernicious as inflation is to offer deficit-financed financial relief. If inflation is eating away at the value of workers’ paychecks, wouldn’t this be the perfect time for a tax cut? Or how about a suspension of the gas tax? From a political perspective: Yes. From a macroeconomic perspective: Almost certainly not. You need not venture beyond economic fundamentals to understand why. The economy’s price level rises as aggregate demand exceeds aggregate supply. In an inflationary economy, tax cuts are tranquilizers that temporarily reduce the symptoms but ultimately only worsen the disease.
Ah, you say, what about tax cuts that stimulate aggregate supply? The economic fundamentals just outlined tell us these would reduce inflation, no? Let’s think about that. Aggregate supply is largely a function of capital, labor, and technological change. But there are problems with tax cuts that are designed to spur any of these. First, despite any positive effects tax cuts have on supply, this means their effects on aggregate demand disappear. Second, although supporters of supply-side economics take it on faith that tax cuts can significantly increase any of the underlying components of aggregate supply, that’s far from certain. Third, the inflation-provoking demand-side effect takes hold quickly, while any supply-side effects — to the extent they exist — are slow and often surface only after a considerable lag. Increasing tax incentives for research might increase business spending in the short run, but any resulting technological advances could be many years in coming. The same goes for tax incentives for education and worker training. Long-term investments are worthy causes that often get insufficient attention from the government, but they aren’t quick cures for inflation.
What we can say is that in an inflationary economy, tax cuts that have the possibility of increasing supply are less bad than those that focus on demand. And we can also say that although the one-year $185 billion extension of the expanded child tax credit in the House-passed Build Back Better Act (H.R. 5376) is a critically important anti-poverty measure, from a purely macroeconomic perspective, Republicans opposing the measure are on rock-solid ground. The hard economic truth is that inflation would be best cured not with tax cuts but with tax increases.
One long-shot approach to using tax policy to fight inflation comes to us from the 1970s. After serving as chair of President Johnson’s Council of Economic Advisers, economist Arthur Okun came up with the tax-based income policy concept. Under one such policy, employers and employees (perhaps only those of the largest businesses) would get a tax benefit for price and wages increases kept below a specific level (perhaps the rate of productivity growth) and a tax penalty for excessive increases. The proposal is viewed as sort of a compromise between President Nixon’s failed wage and price controls program and President Ford’s failed appeals-to-patriotism Whip Inflation Now program (which included issuance of the much-ridiculed W-I-N lapel buttons). The policy never received formal consideration in Congress, partly from widespread skepticism regarding its efficacy and partly because of its daunting complexity.
Ultimately, the taming of the great inflation of the 1970s had nothing to do with taxation. In a decisive and abrupt change in policy, Federal Reserve Chair Paul Volcker modified the Fed’s operating procedures to strictly control the money supply even if it resulted in higher interest and unemployment rates. Volcker was successful. As theory predicted, inflation was brought under control — but only at the cost of high interest rates and a major recession.
Inflation is difficult to bring under control without significant economic pain. Everybody hopes the Fed can orchestrate a “soft landing,” but that is wishful thinking. Through the rest of 2022 the Fed will raise interest rates, and if it is able to reduce inflation, that will almost certainly be accompanied by a considerable slowdown in economic growth. The role of fiscal policy isn’t to make things worse with larger deficits. Given the need for an increase in defense spending, tax increases would be a logical move. Given the political realities, the best that can be expected is that lawmakers resist the temptation to cut taxes.