Tax Refund

The Internal Revenue Service announced its inflation adjustment for tax year 2023: It will be a bit more than 7 percent, the largest increase in many years. But this change is widely misunderstood:  It isn’t a cause for joy, and it isn’t a tax cut.

The adjustment is intended to reflect today’s higher cost of living. But in terms of inflation-adjusted after-tax income, which measures our spending power, many people are worse off than they were a year ago.

The IRS inflation adjustment serves two related purposes. First, it prevents bracket creep. Without correcting for inflation, people with incomes that just keep pace with inflation could be pushed into higher tax brackets and end up paying more individual income tax.

That’s less of an issue now that the revenue code has seven tax brackets, even with 8 percent annual inflation. But this was a very big concern in the late 1970s, when there were as many as 26 brackets and annual inflation was as high as 13 percent.

The second reason for the adjustment is to limit the amount of revenue the federal government can bring in purely as a result of inflation. Pushing people into higher tax brackets meant that revenue increased without Congress explicitly raising taxes.

The Economic Recovery and Tax Act of 1981 and the Tax Reform Act of 1986 fixed both problems by indexing much of the tax code for inflation. Additional provisions have been indexed since then. Some provisions that are adjusted: the tax brackets, the size of the standard deduction, the Earned Income Tax Credit, and the exclusions for estate and gift taxes.

Not all provisions will see an inflation adjustment, however. For example, the phase-out of Lifetime Learning Credits is unaffected. And the income levels where Social Security benefits are taxed haven’t changed in years.

Bottom line: The inflation adjustment isn’t putting extra money in people’s pockets. It’s just keeping them from facing higher taxes if their inflation-adjusted incomes (also known as real incomes) rise by 7 percent. But average real incomes aren’t rising, they’re falling.

The Bureau of Labor Statistics estimates that real average earnings were about 3 percent lower in September 2022 than a year ago. That’s the average, meaning that many people saw even sharper declines in their incomes. While some enjoyed higher earnings this year, many saw them rise by less than 7 percent.

A much lower inflation rate would benefit the economy in many ways. If inflation falls in the coming months, future inflation adjustments will be smaller. And that would be a good thing, not a bad thing.

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