Tax Blog/Blawg

We previously discussed how the Wyden-Gregg bill proposes reducing interest deductions to the extent the interest simply compensates for inflation.  Inflation affects tax calculations in two ways.  First, it affects the dollar figures in the Code so that, for example, when your wages keep up with inflation, but you are pushed into a higher tax bracket, the resulting “bracket creep” is caused by inflation.  Second, when the value of your investment simply keeps pace with inflation and does no better, you still recognize a “gain” when you sell it.  Here, the measurement of real income has been distorted by inflation.

Many “bracket creep” issues are taken care of through section 1(f) of the Code, which adjusts dollar amounts in the Code to account for inflation.  But the Code has not generally corrected for the effects of inflation on the measurement of income.  A proposal made by the Treasury after the 1984 election would have broadly attacked the effects of inflation on income measurement.

To see an example illustrating the two ways inflation affects tax calculations as well as further discussion of the 1984 Treasury proposals, keep reading.

[1] How Inflation Affects Tax Calculations

Suppose the tax law in Year 1 taxes income up to $20,000 at 10% and income above $20,000 at 20%.  At the end of Year 1, Taxpayer buys an asset for $1,000,000.  At the end of Year 2, Taxpayer sells the asset for $1,140,000 a nominal gain of $140,000.  During Year 2, there is 10% inflation.

Since there was 10% inflation during the year, the increase in value of the asset from $1,000,000 to $1,100,000 did not result in any real gain in value for Taxpayer.  Thus, the only real income Taxpayer had, adjusted for inflation, was $40,000 ($140,000 nominal gain minus $100,000 inflationary gain.)  To calculate the base of the tax correctly, we should reduce the $140,000 nominal gain to the $40,000 real gain.

Secondly, the $40,000 should not be taxed as if it were earned in Year 1.  If it had been earned in Year 1, $20,000 would be taxed at 10% ($2,000 of taxes) and $20,000 at 20% ($4,000 in taxes), for a total of $6,000 in taxes, 15% of a $40,000 gain.  However, in real terms, $40,000 in Year 2 is less valuable than $40,000 in Year 1, and so it should be taxed at a lower average rate.  A tax system that accounts for inflation in the rates (as section 1(f) does) would increase the $20,000 figure that separates the 10% bracket from the 20% bracket by 10% (10% of $20,000 is $2,000), so that the break point for Year 2 should be $22,000.  This will reduce the tax below the $6,000 we calculated above, reducing the average rate below 15%.

[2] The 1984 Treasury Proposals

Trying to adjust the base of our tax code for inflation is a very complicated affair.  One of the most comprehensive attempts made in this area was described in the Treasury Department’s tax reform proposals that were sent to President Reagan right after the 1984 elections.  The proposals covered three major areas: capital assets, inventories, and interest payments.  The basis of a capital asset was indexed along the lines described above.  The proposal for inventories was to allow taxpayer’s to use an indexed FIFO method of accounting.  The proposal for interest was to disregard a percentage of interest payments (for both the borrower and the lender), with the percentage a function of the amount of inflation.  (However unrealistic this seemed as a political matter, rest assured that the mortgage interest deduction was not included in this proposal.)

When we compare this broad proposal to what is included in the Wyden-Gregg bill—an inflation adjustment for interest paid only—we may question whether there is a serious possibility of such a proposal becoming law.  It is very hard to justify such a  limited attach on the effects of inflation on the tax base unless the proposal is viewed as a more or less arbitrary attack on the use of borrowed funds.  If that is the purpose of the proposal, we question whether there is a need for such a complicated provision rather than a simpler rule that would just disallow some fixed percentage of interest payments.

Drafting note:  The bill as published contains a paragraph that indicates that the IRS is to take account of “a constant real before tax rate of return of 6 percent” in determining what portion of a corporation’s interest payment is to be disallowed.  No indication has been given as to how this figure is to be taken into account, and it appears to us that this paragraph may have remained in the draft from some earlier version of the interest disallowance.