988 June 3,1994 BEWARERETURNOFBRACKETCREEP INHEALTHREMlRM By Daniel J. Mitchell McKenna Senior Fellow in Political Economy INTRODUCTION As the true cost of the Clinton health care proposal becomes clearer to Congress, key lawmakers supporting the central themes of the plan have felt impelled to call for new ways to fund the plans mandated health package. House Ways,and Means Committee chairman Dan Rostenkowski (D-IL) has proposed unspecified broad taxes. More specifi cally, Representative Pete Stark (D-CA), who chairs the health subcommittee of Ways and Means, proposes to fi nance part of the plan by eliminating the indexation of federal income tax rates-which would mean costly new taxes for millions of middle-class Americans.

Indexing was one of the most important tax reforms of the 1980s. With indexing, the levels of taxable income at which higher tax rates take effect are adjusted each year to keep pace with inflation. As a result of this reform, taxpayers are no longer subjected to bracket creep, being forced into higher tax brackets simply because their income keeps pace w ith inflation. Indexing also protects the value of the personal exemption and stand ard deduction, a particularly important feature for families and low-income workers. It also increases, in line with inflation, the amount of income subject to the lower r a tes of taxation for taxpayers in higher brackets. Since going into effect in 1985, indexing has saved taxpayers more than $100 billion. It has also forced pro-tax increase politicians to be more honest about their efforts to bring more money to Washington eral coffers by $132.2 billion over the next five years through the return of the inflation tax. But this estimate is based on the assumption that inflation will average only 3.0 per According to the Congressional Budget Office, eliminating indexing would enrich fed 1 Stark Floats Repeal of Indexing Tax Brackets to Fund Health Bill, BNA Daily Report for Executives, May 3,1994. cent. Since many experts believe that prices will increase at a faster rate, the actual tax in crease imposed by a return to bracke t creep could be considerably higher.

Repealing indexing would have serious adverse consequences for the American econ omy. Even by itself, the restoration of bracket creep would result in one of the largest tax increases in American history. Combined with the other taxes being considered as part of the health care debate-such as employer payroll taxes, taxation of employee fringe benefits, and tobacco taxes-the economic damage and job losses would be immense TKs is particularly true since bracket creep su b jects taxpayers to higher marginal rates thus reducing the after-tax reward for working, saving, and investing THE IMPACT ON HOUSEHOLD FINANCES While bracket creep would undermine the economys long-term performance by sub jecting increasing amounts of per sonal income to higher tax rates, the effect on house hold finances would be immediate and more dramatic. Even if inflation stays low, restor ing the inflation tax would have a major impact on lower and middle-income taxpayers.

As the accompanying tables illustrate, a middle-income family whose income rises at the rate of inflation could see its taxes climb by as much as $4,444 over the next five years.

Single taxpayers with middle-class incomes could see their tax bills climb by as much as 2,214 in the same time period?

Lower-income taxpayers would be hit almost as hard. A married couple with two chil dren and earning $16,150 does not pay any income taxes and would not pay any taxes un der current law assuming their income rose at the rate of inflation. B ut if bracket creep is restored, as Representative Stark desires, their tax liability will go from zero to more than $1,138 over five years? A single taxpayer with an income of only $6,250 in 1994 pays no income taxes. But if indexing is repealed and his i ncome rises at the rate of infla tion, he will be subjected to a five-year tax hike of more than $440 compared with cur rent law HIGHER INFLATION MEANS EVEN HIGHER TAXES What happens if inflation rises faster than government forecasters believe? Consider t he impact on taxpayers if indexing is repealed and the rate of inflation increases by ust one-half of one percentage point more each year than assumed in the CBO forecast. The middle-class family cited earlier would see its tax bill climb by almost $6,290 , or a 42 B 2 3 These 1994 figures are calculated based on a personal exemption of $2,450 and standard deduction of $3,800 for individual returns and $6.350 for joint returns.

Assuming their income came from wages. this couple would be eligible for the Earned IncomeTax Credit. Depending on how one counts the check received from this program, it could be argued that this couple would not pay any net taxes.

Nonetheless, they would still be worse off because their check from the government would be reduced by the amount of taxes they would have paid.

This example assumes inflation would gradually rise, up to 5.6 percent in 19

99. Given the monetary policy views of President Clintons fmt two appointees to the Federal Reserve Board, many financial experts worr y inflation will rise even faster 4 2 percent jump from the 4,444 tax hike under CBOs more sanguine inflation estimate. And as the accompanying tables indicate, lower-income fami lies would see their tax burden rise to more than $1,610 using more realisti c inflation numbers.

The tax penalty on single taxpayers also would climb dramatically with more reasonable in flation assumptions.

The tax increase on a single middle-in come taxpayer would be nearly 3,132, up from the 2,214 using CBOs inflation es timate. For a lower income single tax payer, repeal of in dexing would push their tax bill up by 623, compared with the 440 tax hike usin g (30s numbers 300 250 $200 150 100 50 Single Taxpayer, No Dependents, I994 Income of $29.000 Removlng Indexlng from Federal Taxes Expected Tax Increases by Income Level Tax Increase with CBO Inflation Estimate Tax Increase with Realistic Inflation Estimat e Nore: Totals may not add up due to mundii Source: Heritaae calculations, based on Cohonal Budeet office finuRs AVERAGE TAX INCREASE HIGH These examples show how badly bracket creep could affect selected taxpayers. To be sure, some taxpayers, particularly those with incomes just above the thresholds where higher tax rates take effect, would face smaller tax increases. It is possible, though, to measure the expected impact on the average taxpayer. CBO projects that restoration of bracket creep would result i n a tax hike of $132.2 billion. Dividing that amount by 115 million personal income tax returns shows that the average tax increase over the five year period would be $1,150: This figure, of course, is based on CBOs low inflation es timate. Using more rea l istic assumptions about future inflation, showing the inflation rate 3 climbing to 5.6 percent by 1999, the average new tax burden would be more than $1,600 per taxpayer The middle 'lass and DISPARATE IMPACT Source: Heritage dadabions based on Wod Budget O thce tigums It is important to note that bracket creep af fectsdl taxpayers, not just those forced into higher tax brackets. A taxpayer in the 15 per cent bracket may not be pushed into the 28 per cent bracket for many years, but he will still be harmed s i nce infla tion erodes the value of the personal exemption and standard deduction As a result, even though his marginal tax rate re mains temporarily sta ble, some income which was in the zero percent tax bracket will now be taxed at 15 percent. This is al s o why bracket creep hurts even those already in the highest tax bracket. Well-to-do taxpayers would see their average tax rate in crease as greater por tions of their incomes were subjected to higher tax rates, even though their marginal tax rate was unch a nged Removlng lndexlng from Federal Taxes Expected Tax Increases by Income Level 1994 1995 1996 1997 1998 1999 Married Couple. 2 children, Combined I994 Income of 54. I50 3000 2500 $2000 $1500 1000 500 I CBO Inflation titimate $4.444 Realiic Inflation Est b Mte 4290 1994 1995 1996 1997 1998 1999 Tax Increase with CBO Inflation Estimate Tax Increase with Realistic Inflation &timate 4 There is also a moral aspect to the indexing debate, quite separate from the financial impact on individual households. Bracket creep is a hidden tax which allows politicians to effectively impose higher taxes year after year without casting recorded votes. Indeed some suspect this is one reason why Congress is considering the proposal. As Repre sentative Stark, who first floated t he bracket creep proposal, freely admits, [Repealing indexing] might be an easy tax for members of Congress to vote for. Nobody quite knows what it is and their constituents would have a hard time ginning up doubts.5 But bracket creep violates elementary n otions of fairness and justice. When govern ment fails to protect and maintain the value of the currency, taxpayers should not be the ones who are punished. Furthermore, politicians who want to subject the economy to more taxes should be prepared to make a public case for new revenues and then cast a re corded vote-not rely on inflation surreptitiously to do the job of raising taxes for them.

Perhaps most troubling of all is that Representative Stark and others have referred to the indexing provision as a loophole In the minds of most Americans, tax experts and laymen alike, a loophole is a provision of law which grants a special privilege or favor to certain taxpayers. Indexing, by contrast, protects the entire population from losing a greater portion of t heir incomes to government as a result of inflation. 6 CONCLUSION Indexing was added to the tax code in 1985 as a result of the 1981 Economic Recovery Tax Act and may be the most important surviving legacy of the Reagan years. Since it went into effect, i t has saved taxpayers more than $100 billion. Perhaps even more criti cal, however, it has restored a level of honesty to fiscal policy. Repealing this provision and allowing politicians to return to the days of stealth tax increases would damage not only the economy, but contribute to a further decline in the publics confidence in politi cal institutions 5 6 Stark Floats Repeal of Indexing Tax Brackets to Fund Health Bill, ENA Daily Reportfor Executives, May 3,1994.

Indeed, much of the tax code remains vul nerable to bracket creep. While personal income tax rates, the personal exemption, and the standard deduction are indexed, the capital gains tax is not. As a result, many Americans are forced to send money to Washington following the sale of an asset even though the taxpayer may have lost money after adjusting for inflation. To make matters worse, the corporate tax code is completely unprotected against inflation, thus hindering the ability of American companies to compete 5