Indexing in Government Programs
Many government programs are indexed to inflation. The U.S. income tax code is designed so that as a person’s income rises above certain levels, the tax rate on the marginal income earned rises as well; this is what is meant by the expression “move into a higher tax bracket.” For example, according to the basic tax tables from the Internal Revenue Service, in 2014 a single person owed 10 percent of all taxable income from $0 to $9,075; 15 percent of all income from $9,076 to $36,900; 25 percent of all taxable income from $36,901 to $89,350; 28 percent of all taxable income from $89,351 to $186,350; 33 percent of all taxable income from $186,351 to $405,100; 35 percent of all taxable income from $405,101 to $406,750; and 39.6 percent of all income from $406,751 and above.
Because of the many complex provisions in the rest of the tax code, the taxes owed by any individual cannot be exactly determined based on these numbers, but the numbers illustrate the basic theme that tax rates rise as the marginal dollar of income rises. Until the late 1970s, if nominal wages increased along with inflation, people were moved into higher tax brackets and owed a higher proportion of their income in taxes, even though their real income had not risen. This bracket creep as it was called, was eliminated by law in 1981. Now, the income levels where higher tax rates kick in are indexed to rise automatically with inflation.
The Social Security program offers two examples of indexing. Since the passage of the Social Security Indexing Act of 1972, the level of Social Security benefits increases each year along with the CPI. Also, Social Security is funded by payroll taxes, which are imposed on the income earned up to a certain amount—$117,000 in 2014. This level of income is adjusted upward each year according to the rate of inflation, so that the indexed rise in the benefit level is accompanied by an indexed increase in the Social Security tax base.
As yet another example of a government program affected by indexing, in 1996 the U.S. government began offering indexed bonds. Bonds are means by which the U.S. government, and many private-sector companies as well, borrows money; that is, investors buy the bonds, and then the government repays the money with interest. Traditionally, government bonds have paid a fixed rate of interest. This policy gave a government that had borrowed an incentive to encourage inflation, because it could then repay its past borrowing in inflated dollars at a lower real interest rate. But indexed bonds promise to pay a certain real rate of interest above whatever inflation rate occurs. In the case of a retiree trying to plan for the long term and worried about the risk of inflation, for example, indexed bonds that guarantee a rate of return higher than inflation—no matter the level of inflation—can be a very comforting investment.