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Repeal or delay of indexation of the individual income tax personal exemption and tax rate brackets would increase federal revenues, but would also change the distribution of tax liabilities scheduled to obtain under current law. This memorandum explains the current law, discusses some policy options with respect to indexation, and shows how this redistribution would occur and what its magnitude would be for taxpayers at various income levels.
 

CURRENT LAW

The Economic Recovery Tax Act of 1981 (ERTA) mandated the indexation of the personal exemptions and tax rate brackets (including the zero bracket amount or standard deduction) in the individual income tax effective January 1, 1985. The price index to be used is the consumer price index for all urban consumers (CPI-U). (Note that as of January 1, 1983, the home purchase component of the CPI-U was replaced by a rental equivalence measure of the cost of home ownership, making the CPI-U a better measure of actual inflation.) For every year starting in 1985, the personal exemption and rate brackets in the current law are to be increased by the ratio of the CPI-U for the immediately preceding fiscal year (for example, in the case of tax year 1985 the immediately preceding fiscal year is fiscal year 1984, which runs from October 1983 through September of 1984) to the CPI-U of fiscal year 1983 (which runs from October 1982 through September 1983).

The timing of the indexation provision means that the adjustment for inflation lags the inflation itself by more than one year. (This is necessary to allow time for the preparation of tax forms, and to avoid last-minute uncertainty on the part of taxpayers.) Thus, 1985 tax brackets will not be adjusted for the inflation that occurred in 1985, but rather for the inflation of fiscal year 1984, that is, from between 15 months and 3 months before the start of calendar 1985. Real tax liabilities on constant real incomes will therefore not be held precisely constant from one year to the next under indexation. If inflation were to be slower in 1985 than in fiscal 1984, indexation would cause a real tax cut in 1985 compared to calendar 1984; if inflation were faster, there would be a real tax increase. Thus, indexation would hold real tax liabilities constant only on average over the long run, not in each individual year. This phenomenon will be evident in the examples provided later in this memorandum.

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