AMALIO HUMBERTO PETREI *
A progressive personal income tax combined with inflation can produce both increased revenue for government and significant changes in the distribution of the tax burden among individuals.1 As money income rises, even if real income is unchanged, taxpayers are moved upward in the tax schedule and are thus subject to higher tax rates. In addition, persons who were not taxed previously because their incomes were below the limits fixed by law may become liable to taxation as a result of a general rise in money incomes. Other exemptions and deductions defined in nominal fixed amounts may similarly lose their importance in relation to income, so that taxpayers with the same real incomes may end up paying very different amounts in income tax. If government took no action and inflation proceeded at high rates, a substantial number of people would eventually become subject to the highest marginal rate of income tax. This kind of interaction between inflation and progressivity affects not only the distribution of income and the level of tax revenue but also the built-in stabilizing power of the tax structure and various economic incentives.
The increased tax burdens faced by individuals as a result of inflation have led in many countries to corrective action by governments, either on their own initiative or in response to greater pressure from taxpayers. The most common method adopted has been to adjust, from time to time, the principal items legally defined in money terms—for example, lowering tax rates or raising exemption levels. A few countries have gone one step further and have introduced legal provisions to ensure more automatic adjustment of these items in response to price level changes. In addition, there have been academic discussions and proposals for the implementation of automatic adjustment schemes. This paper examines existing and proposed inflation adjustment schemes and discusses the effects of introducing them for the personal income tax.
Section I describes the various schemes and proposals incorporating automatic provisions to cope with the problem of unintended tax burden changes as a result of inflation. Section II then compares the technical aspects of the different schemes. Finally, Section III discusses advantages and disadvantages of adopting an adjustment scheme for the personal income tax, with major emphasis on the distributional effects of inflation on the progressive tax, since this concern has given rise to most adjustment schemes.
I. A Technical Note on a System of Lowering Tax Rates in Proportion to a Rise in Prices
A system of lowering tax rates in proportion to the rate of inflation can have different results, depending on the tax schedules and the rate of inflation, but generally the average tax rates will decrease.
This procedure of inflation adjustment has two effects: (1) The tax liability on the preinflation income is reduced by the application of lower tax rates across the board. (This reduction is represented by the shaded area A in Chart 1.) (2) A tax on the increase in money income due to inflation is levied at a rate equal to the marginal rate faced by the taxpayer (represented by shaded area B in Chart 1). Normally the second effect will be greater than the first. However, unless the tax schedule is steeply progressive, the decrease in real terms in tax liabilities due to inflation will more than offset the increase in nominal revenues.
For tax liability to increase in real terms, it is generally required that the marginal tax rate be at least twice the average tax rate. More precisely, the average tax rate can increase only if the marginal rate in the original tax schedule is greater than the average rate in the preinflation period multiplied by two and plus the rate of inflation.
II. Income Tax Rates and Inflation: A Simulation Study
This appendix describes a simulation study of the average tax rates for different categories of taxpayers in several countries.
The study analyzed how the combined forces of inflation and progressivity have altered tax liabilities for taxpayers at various income levels; considered how much legislative changes compensated for augmented tax burdens; and indicated how average tax rates would have moved if legislation had remained unchanged. The study was essentially one of formal incidence—that is, tax liabilities of the taxpayers were estimated according to the legal provisions on the assumption that there was no shifting or evasion.
Similar studies have been carried out for individual countries. One study by Goetz and Weber is based on U. S. data for the period 1954–70.42 The authors showed that a considerable change in effective income tax rates occurs automatically when prices increase. One of their principal conclusions was that, in spite of two major downward revisions in statutory tax rates, large categories of taxpayers in the United States were liable to higher income tax rates in 1970 than in 1954 on the same real incomes. Changes in the real value of exemptions as a result of inflation had an important influence on these changes in effective tax rates, so that the increase in tax burdens was felt relatively more by taxpayers in the lower income brackets and by those having a large number of exemptions.
Goetz and Weber attempted further to show the distribution of changes in tax burdens among the total number of taxpayers through an exploratory analysis of the distribution of exemptions among income levels, but they could not draw very definite conclusions because of the limited availability of information. The report of their study includes tables and graphs showing variations in average and marginal tax rates and absolute changes in real disposable income.
A similar study was carried out by Vukelich for Canada, also for the period 1954–70.43 His paper concluded that low income, multichild families were, as in the United States, the most adversely affected by the combined forces of inflation and progressivity. In comparison with the United States, however, Canada has had a greater increase in tax rates because, while inflation rates have not differed significantly between the two countries, Canada took less corrective action during the period.
Tables similar to those in the U. S. study are found in Vukelich’s paper. In addition, he calculated changes in tax liabilities in which the effects of inflation were isolated from the results of statutory changes. The study also forecast changes in tax liabilities for the period 1970–76, based on the new income tax provisions that came into effect in Canada in January 1972 and on an assumed annual rate of inflation of 3 per cent. It did not, of course, allow for the effects of the system of inflation adjustments that came into operation in January 1974.
Mr. Petrei was an economist in the Tax Policy Division of the Fiscal Affairs Department at the time this article was written. He is now Director of Training in Project Formulation and Evaluation at the Organization of American States (OAS). Mr. Petrei has doctoral degrees in economics from the National University of Córdoba (Argentina) and from the University of Chicago. He was a member of the faculty at the National University of Córdoba, and served as OAS Advisor on Investment Planning to the Mexican Government before joining the Fund. Mr. Petrei is the author of numerous professional articles.
Studies by Goetz and Weber for the United States and Vukelich for Canada have shown that low income, multichild families are those which are most affected by this aspect of inflation. See Charles J. Goetz and Warren E. Weber, “Intertemporal Changes in Real Federal Income Tax Rates, 1954–70,” National Tax Journal, Vol. 24 (March 1971), pp. 51–63; and George Vukelich, “The Effects of Inflation on Real Tax Rates,” Canadian Tax Journal, Vol. 20 (July-August 1972), pp. 327–42. A more extensive study of a number of other countries, made at the Fund, suggests similar patterns on the whole (see Appendix II).
Amotz Morag, On Taxes and Inflation (New York, 1965), especially Chapter 7.
European Taxation, Switzerland—9, Section B. Tax Tables for Individuals, Canton of Basel-Land, No. 5 (May 1973).
Joint Tax Program of the Organization of American States and the Inter-American Development Bank, Sistemas Tributarios de América Latina—Chile (Washington, 1964), pp. 16–17.
Chile, Public Law No. 15564, Article 43, Diario Oficial (February 14, 1964).
Chile, Public Law No. 14688, Diario Oficial (October 21, 1961).
Roberto Poblete M., editor, Impuestos a la Renta Vigentes en 1970, Divulgación Tributaria, No. 20 (Santiago, February 1970), p. 7.
Brazil, Law No. 3898 (May 19, 1961); see also Carl S. Shoup, The Tax System of Brazil, report to the Getúlio Vargas Foundation (Rio de Janeiro, 1965).
Brazil, Law No. 4140 (September 17, 1962).
Brazil, Law No. 4506 (November 30, 1964).
Vito Tanzi, “A Proposal for a Dynamically Self-Adjusting Personal Income Tax,” Public Finance, Vol. 21, No. 4 (1966), pp. 507–20.
The Netherlands, Public Law No. 259 (April 23, 1971), Staatsblad (1971). pp. 640–41.
The Netherlands, Minister of Finance, Order B71/19821 (October 20. 1971).
The Netherlands, Department von Financiën, Miljoenennota 1972 (September 19, 1972), p. 43.
Canada, House of Commons Debates, Vol. 117, No. 33; 1st Session, 29th Parliament (February 19, 1973), especially pp. 1434–45.
Canada, Ministry of Treasury, The Ontario 1973 Budget, (Toronto, April 1973), Budget Paper B, pp. 13–21.
Canada, Ministry of Treasury, Economics and Intergovernmental Affairs, Taxation and Fiscal Policy Branch, “The Dynamic Impact of Indexing the Personal Income Tax,” Ontario Tax Studies, No. 9 (Toronto, 1973).
Christian Seidl, Edgar Topritzhofer, and Walter Grafendorfer, “An Outline of a Theory of Progressive Individual Income Tax Functions,” Zeitschrift für Nationalökonomie, Vol. 30, Nos. 3 and 4 (1970), pp. 407–29.
Argentina, Law 20046, December 28, 1972.
Argentina, Law 20544, October 27, 1973.
Argentina, Dirección General Impositiva, Resolución-General No. 1572, October 31, 1973.
Argentina, Law 20568, December 29, 1973.
Denmark, Law No. 330, June 18, 1969.
United Kingdom, Board of Inland Revenue, Income Taxes Outside the United Kingdom, 1971 (Her Majesty’s Stationery Office, London, 1973), Vol. 2, p. 238.
Aargau (Switzerland), Cantonal Law of November 10, 1970.
Aargau (Switzerland), Cantonal Law of May 17, 1966, Article 34.
United Kingdom, Board of Inland Revenue, op. cit., several issues; and Sweden, Decree No. 576, January 21, 1947 (amended up to date).
See Lars Matthiessen, “Index-Tied Income Taxes and Economic Policy,” Swedish Journal of Economics, Vol. 75 (March 1973), pp. 49–66, where useful references for the Swedish case can be found, although Matthiessen did not mention the provisions referred to in this paragraph.
European Taxation, Switzerland, No. 9, Section B, Master page (May 1973).
However, indexes for different income groups have been calculated in the United States and Japan at least. See Eleanor M. Snyder, “Cost of Living Indexes for Special Classes of Consumers,” in The Price Statistics of the Federal Government, National Bureau of Economic Research, No. 73, General Series 1961 (Washington, 1961), pp. 337–72; and Ryōtarō Iochi, Measurement of Consumer Price Changes by Income Classes (Tokyo, 1964).
Further consideration of some of these issues may be found in, for example, Robert M. Clark, “Inflation, Taxation and the White Paper,” Report of Proceedings of the Twenty-Second Tax Conference (Canadian Tax Foundation, Toronto, 1970), pp. 213–29; Richard A. Musgrave, “Tax Structure, Inflation and Growth,” paper presented at a meeting of the International Institute of Public Finance, Barcelona, Spain, Sept. 1973; and A. R. Prest, “Inflation and the Public Finances,” Three Banks Review, No. 97 (March 1973), pp. 3–29.
John Bossons and Thomas A. Wilson, “Adjusting Tax Rates for Inflation,” Canadian Tax Journal, Vol. 21 (May-June 1973), pp. 185–99.
John F. Helliwell, “The Taxation of Capital Gains,” Canadian Journal of Economics, Vol. 2 (May 1969) pp. 314–18; Hirofumi Shibata, “The Taxation of Capital Gains: A Comment,” Canadian Journal of Economics, Vol. 3 (February 1970), pp. 151–53; and John F. Helliwell, “The Taxation of Capital Gains: Reply,” Canadian Journal of Economics, Vol. 3 (February 1970), pp. 154–58.
John F. Helliwell, “Towards an Inflation-Proof Income Tax,” in Report of Proceedings of the Twenty-Fourth Tax Conference (Canadian Tax Foundation, Toronto, 1973), p. 166.
An appropriate measure of flexibility has been suggested by E. Cary Brown, “The Static Theory of Automatic Fiscal Stabilization,” Journal of Political Economy, Vol. 63 (October 1955), pp. 427–40. He measures flexibility as
If prices are rising, a good stabilizing performance presumably requires real taxes to rise. For a tax to be a price stabilizer, the elasticity of money taxes with respect to prices must exceed unity; unitary elasticity (that of proportional taxation) would be neutral. See E. Cary Brown, ibid., pp. 435–36.
A useful reference for the dynamic approach is John F. Helliwell and F. Gorbet, “Assessing the Dynamic Efficiency of Automatic Stabilizers,” Journal of Political Economy, Vol. 79 (July-August 1971), pp. 826–45. Another useful reference covering both the static and the dynamic approaches is D. A. Auld. “Automatic Fiscal Stabilizers: Problems of Identification and Measurement,” Public Finance, Vol. 26, No. 4 (1971) pp. 513–30.
Bossons and Wilson, op. cit.
On the problems of determining lag structures, see Evi Griliches, “Distributed Lags: A Survey,” Econometrica, Vol. 35 (January 1967), pp. 16–49.
Richard M. Bird, “The Tax Kaleidoscope: Perspectives on Tax Reform in Canada,” Canadian Tax Journal, Vol. 18 (September-October 1970), pp. 444–73.
C. J. Goetz and W. E. Weber, “Intertemporal Changes in Real Federal Income Tax Rates, 1954–70,” National Tax Journal, Vol. 24 (March 1971), pp. 51–63.
George Vukelich, “The Effect of Inflation on Real Tax Rates,” Canadian Tax Journal, Vol. 20 (July-August 1972), pp. 327–42.
Average tax rates were computed for ten levels of income. The multiples used were: 0.5, 1, 1.5, 2, 3, 4, 6, 10, 20, and 30. The source for an average industrial worker’s income was: International Labor Organization, Yearbook of Labour Statistics (Geneva), various issues.
The basic source of information for legal provisions was the United Kingdom, Board of Inland Revenue, Income Taxes Outside the United Kingdom (cited in footnote 25), various issues, 1965–70.
The source for the consumer price index was the International Monetary Fund, International Financial Statistics (Washington), various issues.