Steve Bain

Bracket Creep Definition, Example & Reforms

The term 'bracket creep' is used by economists to describe a situation where a worker's income increases in nominal terms such that it is subject to being taxed in a higher tax bracket. Specifically, the concept relates to circumstances when the purchasing power of the higher nominal income did not increase.

Tax bracket creep occurs during times of inflation, because nominal incomes will rise at these times in order to maintain the purchasing power of any given salary.

When that happens, and when the government does not adjust its tax brackets to compensate for the effects of inflation on purchasing power, workers end up paying a disproportionately higher rate of tax.

This sort of thing can happen even in circumstances whereby nominal incomes only rise enough to partially offset the cost of higher inflation, meaning that real income fell, and still the bracket creep effect leads to a disproportionately higher tax burden.

Bracket Creep Example

Mary is a single lady in the US who files her tax returns for the previous financial year every April. Her income will be $60,000 in 2023, and her applicable tax brackets on her income are:

  • First $11,000 at 10% ($1,100)
  • $11,000 to $44,725 at ($4,047)
  • Remaining $15,275 at 22% ($3,360.50)
  • TOTAL TAX = $8,507.50

As a proportion of her income, she pays a 14.2% ($8,507.50 divided by $60,000) rate of tax.

The cost of living for the financial year ending March 2021 to March 2022 rose by 8.5% (according to the consumer price index CPI), but the payment thresholds for the tax brackets in that year only increased by just over 7% to compensate for the higher cost of living. As a result, bracket creep occurred, and people's rate of tax increased.

At the time of writing we do not yet know what the overall cost of living increase will be in the year 2022 to 2023, but with recession looking increasingly likely it will be difficult for workers to negotiate pay rises that equal the rate of inflation, and if bracket creep happens again then the standard of living for many Americans will fall significantly.

Keep in mind that the cost of living is very difficult to assess accurately, and there are many accusations that the CPI is being manipulated to understate the true cost of living increases. I won't get into that here, but you can check out my article about substitution bias for more details on that.

Bracket Creep Tax Reform - Indexation

In view of the injustices suffered by workers who are hit by the bracket creep effect, governments have introduced policies of indexation. Indexation has become popular since the 1970s when many people at that time suffered declining real incomes and declining real returns on their savings.

Indexation works by linking the tax threshold to a cost-of-living index so that, when inflation increases, tax bracket thresholds also rise proportionately. In some cases this raising of tax thresholds may be done automatically, but it is more typical that they are adjusted during an annual budget announcement.

The 1980s tax reforms in the US reflected the latter case of periodical adjustments for inflation rather than automatic adjustments as soon as inflation occurs. To the extent that delays in adjustments have real effects on workers' disposable incomes, the tax reforms have failed to fully offset the effects of bracket creep.

Politicians, of course, much prefer to stick with periodic adjustments to the tax thresholds because it allows them to present such maneuvers as tax cuts thereby gaining some political favor.

Indexation of tax brackets, while an obvious improvement, can be criticized for the reasons given in the example above. There are many additional reasons why it is an imperfect solution, and the PDF article linked to below examines some of these.

In summary, indexation is a very blunt tool at best, and fails to address each person's particular situation. Inflation affects different people in different ways, and some people can even gain from it, but regardless of impact the adjustment is the same for everyone.

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