How Inflation in economy results in hidden income tax hikes

Tax brackets represent the currency amount that stratifies taxable income of a person. Personal income taxes usually have various tax rates starting at different income levels. If these fixed income levels aren’t adjusted periodically, taxes can go up substantially simply because of inflation. This is kind of a hidden tax hike. This problem of hidden tax hike is not limited to tax brackets only.

Any feature of an income tax that is based on a fixed amount will have inflationary effects i.e. it also extends to tax breaks designed to provide low-income tax relief—including exemptions and deductions — which are worth a little bit less to taxpayers every year.

Consider the following example:

Mr. A is having a gross total income of Rs. 6,50,000 in Year 1 before availing any deductions. He also has incurred the following amounts – Rs. 50,000 in respect of LIC premium paid, Rs. 109,000 in PPF contributions, Rs. 30,000 for medical insurance premium paid for self and spouse.

Suppose, he had received a salary hike of 5% in the following year, hence his gross income in Year 2 would be Rs. 6,82,500 and had incurred the same amount of expenses as he did in Year 1. Let us also assume that the overall inflation rate in Year 2 was 5%. Let’s see how his income tax liability computation looks:

In Year 2, we are able to see that, by performing normal income computation as we do, Mr. A is liable to pay tax amounting to Rs. 14,560 as he is now falling into the tax net on account of salary increase which is entirely due to inflation, not increasing in real terms. But, if the deduction limits that are available through Sec 80C and 80D are adjusted for inflation in Year 2, so that the amount of limits under 80C and 80D become Rs. 157,500 (Rs. 150,000*105%) and Rs. 26,250 (Rs. 25,000*105%) respectively, then Mr. A would not be liable to pay any income tax.

This was just a small example of a person who is becoming taxable due to breaching of the limit level of Rs. 5 lakh for availing rebate. Consider cases of tax payers who become taxable at higher tax slabs entirely due to inflationary increases in income and are taxed at higher income tax percentages. Every year we do see that there is increasing amount of direct tax collections and number of income tax filers going up, but we fail to factor in that calculation that how much of the increases are due to inflation.

Each year, the U.S. Internal Revenue Service (IRS) adjusts tax brackets for changes in the cost of living to calculate federal tax liability.

Adjustments are made to exemptions, standard deductions, tax brackets, and other tax credits to account for changes in the cost of living. This is done because if the above elements weren’t periodically adjusted for inflation, more of our income would move into a higher bracket, increasing our tax bill — even if our real income hadn’t kept pace with the cost of living.