Let’s index Indiana’s income tax


With April 15 at hand, it’s a good time to review income taxes. On the surface, the federal government has kept income taxes the same since President Donald Trump and Congress decreased marginal tax rates a bit (and simplified the tax code a lot) in 2017.

Unfortunately, federal payroll (FICA) taxes on income are unchanged. At 15.3 percent of every dollar earned by those in the lower through upper-middle income classes, these taxes are far greater for most taxpayers, even though politicians rarely discuss their onerous burdens. For example, if you earn $40,000, you lose about $6,000 to payroll taxes; if you earn $80,000, you lose about $12,000 to payroll taxes.

President Trump, President Joe Biden and Congress have significantly increased taxes in notable ways. Trump and Biden have been equally aggressive with higher tariffs — taxes on imported goods that increase prices and reduce consumer purchasing power. Trump and Biden (and Congress) have both pursued profligate spending and economy-threatening debt. These must be re-paid through higher future taxes. Under Trump, the national debt increased by $8 trillion; under Biden, it has increased by $6 trillion so far. That’s $42,000 per individual in the U.S. over the last seven years. With all of the rhetoric about defending democracy these days, it’s odd (and hypocritical) to see so much debt being foisted on people who don’t have a vote in the matter.

Inflation is another sort of tax, by reducing the purchasing power of dollars. Under Trump, inflation was 7 percent; under Biden, it’s been 20 percent so far. Inflation can also have the insidious effect of increasing taxes if they are not “indexed” for the impact of inflation. Fortunately, at the federal level, most of this has been fixed. For example, Social Security payments were indexed in the 1970s. And income tax rates were (dramatically reduced and) indexed in the 1980’s by President Ronald Reagan with a Republican Senate and a strongly-Democrat House.

The harm of inflation to fixed payments is obvious; the same amount of money will not go as far. But the impact on taxes is more subtle. Without indexing, as incomes typically increase with inflation, more income ends up in higher tax brackets. This is called “bracket creep”: people and their incomes “creep” into higher tax brackets — even if they’re not better off, given what inflation is doing to their purchasing power.

At the state level, indexing is a mixed bag. Arizona, California and Colorado indexed their tax codes in 1978, but many states have not followed their lead. (Nine states don’t have a state income tax, so the concern is irrelevant in those cases.) The issue is especially bothersome in states with multiple marginal tax rates. Some states (including Indiana) have a single marginal tax rate. But many states (including Indiana) do not index their deductions and exemptions, resulting in more income exposed to that tax — and thus, greater tax burdens. The most prominent examples are the cap on the property tax deduction and the size of the exemptions for family structures.

Let’s use some numbers to see how this works. Assume you earned $60,000 in 2021. For 2024, your income has risen by 20 percent (along with 20 percent inflation). So, you earn $72,000 in 2024, but still have the same purchasing power (or “real income”). With a spouse and four children, each year you would have $12,000 in exempted income. Thus, your taxable income would be $48,000 in 2021 and $60,000 in 2024 (25 percent higher). Assume a 3 percent state tax rate and a 2 percent county tax rate, your tax bill would be $2,400 in 2021 and $3,000 in 2024 (again, 25 percent higher). Even though your standard of living is no higher, the state and county governments are taking a higher percentage of your income.

How to fix this? Index the exemptions for inflation. In my example, the exemptions would also rise 20 percent (to $14,400) because of inflation. The new taxable income would be only $57,600, resulting in a tax bill of $2,880 (now 20 percent higher than in 2021). Without indexing, the taxpayers in my example would have an extra $120 taken from them by state and county governments.

It was encouraging to see Indiana pass a slightly lower marginal tax rate in 2023, reducing it from 3.23 percent to 3.15 percent. Going forward, the next tax reform should be to index deductions and exemptions for inflation, limiting the impact of federal inflation on state income taxes.

Eric Schansberg, Ph.D., an adjunct scholar of the Indiana Policy Review Foundation, is Professor of Economics at Indiana University Southeast and the author of “Poor Policy: How Government Harms the Poor.” Send comments to [email protected].

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