What are the consequences of the tax inflation adjustments?
Recently, the Internal Revenue Service announced several changes to the tax code for tax year 2023. The changes, including an increase in the standard deduction, are intended to adjust for the unexpected surge in inflation since mid-2021. Although it is tempting to think of inflation as one problem to solve, identifying the particular cause of inflation is vital to finding the right solution. Moreover, measuring the benefits of the IRS policy change across personal income levels is easier than along regional lines due to differences in local circumstances. That is, while the policies seem to broadly benefit Americans with lower incomes, where Americans live may have a large impact on the level of their expected benefit.
Identifying the root causes of inflation
Before discussing what exactly the IRS did, it may be useful to think carefully about why they would need to adjust for inflation in the first place. Some claim that this is a result of "the rapidly rising cost of food, energy and other daily staples." To some extent that is true, but such comments miss the larger point.
Economists distinguish between the “real” value of a good and its “nominal” value. The simplest distinction between the two is that the real value of a good is its value in terms of other goods and the nominal value is in terms of money. For example, the real value of a chicken thigh is how much of other products it could fetch at a competitive market, whereas its nominal value is how many dollars it takes to buy a chicken thigh. Those dollars could also be used to buy gasoline or pay electric bills and so, implicitly, when the exchange rate between goods and dollars and other goods is constant, real value and nominal value coincide. Inflation, properly defined, is what happens when the price of the basket of goods we call “consumption” increases relative to dollars.
Basically, inflation can happen for one of two reasons. One potential cause is a sudden decline in efficiency that leads to fewer goods being produced. The other cause could be a sudden increase in the quantity of dollars chasing the same amount of goods. In either case, the consequence is that the ratio of goods to dollars declines, with the end result that the money prices of many individual types of goods rise.
The ideal government response to inflation
With that in mind, the issue with the “rapidly rising cost” observation is that it ignores the origin of inflation. This is important to tax policy because the response of the government should differ depending on the underlying cause. If inflation is caused by production suddenly falling–in a pandemic, for example—and people become poorer in real terms as a result, then the government would ideally cut taxes. Otherwise, the pre-inflation level of taxes would unnecessarily depress the economy further because people would be forfeiting more income when they need it more than usual.
When inflation is driven by a rise in costs, the government may want to raise taxes to slow the pace of nominal growth. This is the logic of "automatic stabilizers," policies that automatically adjust with economic conditions. On the individual level, unemployment insurance is an automatic stabilizer because it kicks in to ease the burden of job loss.
In the current environment, it is difficult to discern whether inflation has been caused more by one factor versus the other. The tax inflation adjustment essentially straddles the line between the two potential causes. As the Tax Policy Center points out, the adjustment—which is roughly seven percent—is not a tax cut. Based on national average inflation, the adjustment is intended to keep the tax burden constant in real terms so that the revenues collected by the government are the same after adjusting for inflation.
The adjustment is also supposed to avoid tax bracket creep, which is what happens when a household is pushed into a higher tax bracket solely because its nominal income rises as a result of inflation. Although the IRS’s main job is to collect revenue, it has behaved as if it were actually conducting fiscal policy. The IRS responded ideally given they uncertainty about the causes of inflation.
Who benefits most from the tax inflation adjustment?
With that framework in mind, it is possible to observe how both underlying variation in experienced inflation and wage growth around the nation may change the net effect on different people. The IRS can justifiably claim the adjustment is not a tax cut on average, but it can be one depending on how different a particular individual’s real income is from the national average change in real income. For example, suppose wage growth was the same across income levels but inflation varied between households because the basket of goods consumed by households differs along the income distribution. Because rich households may consume high-end goods like yachts and low-income households may mostly consume low-end necessities like single-ply toilet paper, each may experience different price inflation. The seven percent change made by the IRS would more likely benefit those experiencing lower inflation. Likewise, if inflation was fixed but wage growth is higher for high-income households, then high-income households will be better off as a result.
Taking a closer look, consider variation based on income level. As Jon Hartley and I documented in this space a few months ago, inflation is usually disproportionately higher for low-income households. According to the Congressional Budget Office, that continues to be true and the gap has widened in recent months. On the other hand, there are positive signs that wage growth has been substantially higher at the bottom of the income distribution compared to the middle and the top. That is a sensible result: the low-income labor market is substantially less rigid because the share of long-term labor contracts is much lower, allowing for more wage flexibility. Put another way, real income fell more for high-income households than for low-income households, with the net result that the seven percent change made by the IRS compensates low-income households for the fall in real income. It does not benefit high-income households to the same degree.
On the other hand, consider variation based on region. Given the high migration out of states like New York and California, those states should have lower inflation and wage growth, making the net effect unclear ex ante. Analysis from the Joint Economic Committee shows that the Mountain West, the Midwest, and the South have experienced higher inflation than the rest of the country, and the difference is not particularly small. Whereas inflation in the Mid-Atlantic—which includes New York, New Jersey, and Pennsylvania—ran about three percentage points lower than in the Mountain West.
The differences can be even larger at a metropolitan level: inflation in Phoenix is around 12 percent compared to seven percent in New York City. Wage growth data is less up-to-date than inflation data, but data from the Bureau of Labor Statistics data indicate that wage growth is substantially stronger in the high-inflation regions. For a particularly striking example of that difference, consider that California experienced one percent wage growth between March 2021 and March 2022 compared to the 8.7 percent and 10.2 percent wage growth rates over the same period in Texas and Florida, respectively. Hence, wage growth has tracked inflation better in the high-inflation regions, which also tend to have lower taxes. The net effect is unclear because of the extent of the regional variation in both inflation and wage growth.
Tentatively, the biggest winner from the IRS changes is low-income households. Even though their inflation is somewhat higher, their wage growth dwarfs those with higher incomes, which means that higher-income households are taking a bigger hit. The regional variation is less clear and time will tell who will benefit most and by how much.