I refer to inflation as a hidden tax because it can dramatically increase a person's taxes without that person ever realizing just how much more in taxes they are paying because of inflation.
Inflation is the increase in price of goods and services over time. I was reminded of this at the car wash when I saw one of my favorite childhood treats – a Chick-0-Stick. When I was a kid, I could buy a big Chick-0-Stick for $.05. Today the price is $.25 and the size of the candy is about a tenth of the size. Five times the price for a tenth of the candy!
The Impact Inflation Has on Your Taxes
If your income keeps pace with inflation, then you should pay the same amount of tax every year. Right? In theory it should work this way, but this is why I refer to inflation as a hidden tax.
I'll use the U.S. tax system as an example, but these same principles apply to other countries.
The U.S. tax system, like many countries, uses a progressive tax system. This means the more income you make, the higher the tax rate on your income (this is why I always try to get the benefit of as many low tax brackets as possible when I create a tax strategy with a client).
The U.S. tax code requires that the federal income tax brackets be adjusted for inflation. Given this, it is easy to fall into thinking that this protects taxpayers from paying more taxes simply due to inflation.
The reason this is not true is because tax brackets are just one component of many when it comes to calculating your tax liability. Many of the other components are not indexed to inflation.
The combination of inflation and a lack of indexing for inflation for all components of the tax system creates bracket creep – being pushed into a higher tax bracket due to inflation. Bracket creep increases government revenue without having to enact new tax increases.
If you are in the U.S., you have probably heard of AMT (Alternative Minimum Tax). AMT is a prime example of how inflation is a hidden tax. While AMT was first introduced in 1969, it has only been in recent years that it has received increased attention.
AMT operates as a parallel tax system to the regular tax system. All taxpayers are required to calculate their tax under both the AMT system and the regular tax system and pay the greater of the two.
AMT was originally enacted to target only the “very wealthy” who were receiving “too much” benefit from legal tax deductions. In order to target the very wealthy, AMT is only triggered if certain income limits are exceeded. When AMT was enacted, these income limits were set very high and few taxpayers worried about AMT because the income limits didn't apply to them.
The problem though is that these income limits were not indexed to inflation. While there have been some periodic adjustments, the limits have not kept pace with inflation and as a result, AMT now impacts an increasing number of middle-income taxpayers.
Just like with my piece of candy, inflation has not only increased the cost, it has left less. In my case, I was left with a much smaller piece of candy, even after paying more. In the case of taxes, we are left with less cash in our pockets, even after making more.
Many states in the U.S. are even bigger violators of bracket creep because the majority of states do not index for inflation at all.
It Doesn't Apply to You…YET!
Today you may be in a position where the taxes assessed on only the “very wealthy” do not apply to you. But, you could be subject to these taxes sooner than you think simply because of inflation.
This is why it is so important to plan your taxes years in advance. A long-term tax strategy can help avoid this hidden tax and create long-term permanent tax savings.