Leonall C. Andersen

English

Research Papers in Economics

recent years there has been an apparent willing-
ness on the part of many individuals to accept the
present five percent rate of inflation as a more or less
permanent feature of our economy. This vie\v may be
exemplified by the expression “So what, it’s only a
five percent inflation.”
Some individuals argue that a five percent rate of
inflation is relatively satisfactory when compared with
the recent double-digit rate or with the higher rates of
inflation in most other countries. Others argue that, it
inflation is stabilized at this rate, individuals would
take actions in the market place such that their
money income would also rise at a five percent annual
rate. Consequently, a permanent five percent rate of
inflation would have little effect over time on the
ability of individuals to buy goods and services.
But such is not the case. Even if an individual’s
money income rises as fast as the rate of inflation and
his real income received (actual purchasing power)
thus remains unchanged, his after tax real income
decreases. The reason for this result is the progressive
nature of the existing personal income tax structure
which causes an individual’s tax payments to rise
faster than money income.
Indexation of the Federal personal income tax struc-
ture — altering the strncture each year according to
the rate of inflation that has been experienced — is
a prominently mentioned method for preventing such
a decrease in after tax real income. lndexation for
inflation would maintain the degree of progression
provided in the existing personal income tax structure,
but progression would be based on real income re-
ceived instead of money income. With such a pro-
gram, tax payments as percent of income would
increase only when a worker receives a real wage rate
increase (purchasing power of money wage rate) for
a given job, or moves into a job paying a higher real
wage rate. Effective tax rates would not rise as in the
ease \vhere wages were rising because of the per-
nicious effects of inflation.
This article illustrates the impact of the 1976 per-
sonal income tax structure on after tax real income dur-
ing a prolonged period of five percent inflation. The
example used is that of a worker currently holding a
job paying $3.00 an hour and a worker holding the
same job at a later date. Income taxes are calculated
for a married couple who have two dependent chil-
dren, take the standard deduction, and file a joint
return. The article also presents the changes in the
parts of the 1976 personal income tax structure appli-
cable to this worker if there were indexation for the
rate of inflation,1
IMPACT OF THE 1976 PERSONAL
INCOME TAX STRUCTIJRE
The effect of inflation on after tax real income can
he illustrated by three simple examples — a 5 percent
rate of inflation and no growth in real income, a 3.5
percent rate of growth in real income and no inflation,
and both a 5 percent inflation and a 3.5 percent rate
of growth in real income, The time period considered
is the next 45 years, the expected number of remaining
years of work for a twenty year old worker.
I-’rvc I’ercent Inflation
In this ease, it is assumed that the money ivage rate
for this job increases over the next 45 years at the
same rate as inflation; thus, there is no increase in the
real wage rate. Table I presents the implications for
lother provisions would also be indexed, but they are not eon-
sidered in this article.
Page 21
So What, It’s Only a Five Percent Inflation
LEONALL C. ANDERSENFEDERAL RESERVE BANK OF ST. LOUIS MAY 1977
Table I
Influence of 1976 Federal Personal Income Tax
on Earnings From a Job Currently Paying $3 Per Hour
Level A
4
tr’ £5 Y’:a’s
35Pr’~,.r’ lif’atior’ &
Beninning 5 P,,rccnt Sresti: :~ Growth in
-. Level i-i?cit on Rc& ‘ncnr: Rt.ai Income
Ho~rlyMoneyWage $ 3.00 $ 26.96 S 1411 $ i1789
Annual Incon& 6,240 56,fl?’7 29,~~9 245,211
Tax tiS5Y ‘7,C19 5,336 lii 586
frfter tax income.
cu’ier,t Year Doliari 6.395 38.058 24,01 3 133.625
Cor~!a’itDollars
1977j 6.395 4.346 24,013 1 4,869
Tax as a Percent
a’ Income t-—-2 31 30’’ 18~‘a
ni—.,,., ‘l~ ‘i ‘nn.i’.,’. i.’,.’:.s,, I: ‘.:.i,i’
‘-‘inn mu.’ reil ‘‘,,:, i.
‘It,,,,,: a—: ‘-i. .. ‘.:rt’,i n.’’u,s.’.hl
would be considerably less. This result
is accounted for by the rise in taxes as
a percent of income shown in the table,
but this is the normal result of the pro-
gression provided in the existing per-
sonal income tax structure.
.lnfla.ti.on and Crowth in
I..aai .hcoine
‘o:,s’ II
Inde,cation of 1976 Federal Personal Income Tax
StructL’re for a Five Percent Rate of Inflation
Over the Nexl Foity-Five Years
After 43 Years
Exemption Per Dependent 5 150 $ 6,739
Standaid Dedcctor,
16% of Ao
1
, n’ed Groc. Income:
Minimum 7,100 18.869
Maximum 2.8C0 25 158
Tax credt’
Per Dependent 35 315
or
2% of Taxable ircome
Web a Maxims.m of 180 1.617
Ec’ned Income c~cd,t
Starting Incam, 4,000 33,940
cut-off Incam,, 8,000 71,880
Pr,:,’:rt Tn,aa’,. Taxob.o Income
Ma’ginal Tax Rate income After 45 Years
Mo’e iou, Marc Less
thcn; Than Th~r’ - Ihon
4 $ ‘3 LOGO $ 0 8,985
is 1 .‘JCO 2,000 8,983 17,9/0
I6 2,030 3,000 17,970 26,955
I? 3.003 4,000 2&955 35,940
19 4,000 8,000 35,9.10 71,880
A more realistic assumption is that the
money wage rate for this job rises at a
rate reflecting both the rate of inflation
and the increase in productivity (the
real wage rate). In this case it is as-
sumed that the money wage rate in-
creases at an 8.5 percent annual rate —
the sum of the assumed 5 percent rate
of inflation and a 3.5 percent rate of
after tax real income and for taxes as a percent of growth in productivity (that is, the real wage rate).
income.
According to Table I, the level of after tax real in-
The money wage rate would increase from $3 to $27 come of a worker holding this job would be $14,869
per hour (Table I), and annual money income re- compared with $24,013 in the previous case, even
ceived would increase from $6,240 to $56,077.2 Never- though the real wage rate rose the same in each ease.
theless, as a result of inflation the higher money in- Also, taxes as a percent of income are 46 percent corn-
come received 45 years from now would purchase
only the same amount of goods and services as in
1977. On average, the prices of most items purchased
would rise as much as money income. Exhibit I pre-
sents the prices of selected itemus at the end of the
period, assuming that all prices increase at the same
rate as inflation.
Although real income received by a person holding
this job remains unchanged, after tax real income de-
creases from $6,395 to $4,346. The reason for this re-
sult is the progressive nature of the existing personal
income tax structure in which taxes as a percent of
income received rises from —2.5 percentto 30 percent.tm
•Thm..e and One-Ito.!I Fovea:nt Growth
iR ItC&• hzoonie
This case assumes that the money wage rate of a
worker holding this job and, hence, the real wage rate,
increases at a 3.5 percent annual rate. Table I indi-
cates that, while money income would increase from
$6,240 to $29,349, the increase in after tax real income
m
l3ased on pay for 2080 hours of work, paid vacation, and
holidays.
~The —2.5 percent figure results from the 1976 provision for
an earned income credit for low income families with de-
pendent children,
Page 22FEDERAL RESERVE BANK OF ST. LOUIS MAY 1977
pared with 18 percent. The increase in tax burden
reflects the effect of inflation transferring resources
from the taxpayer to the government under the exist-
ing personal income tax structure.
1NDEXAT10~I REQUJREI) POE FIVE
PERCENT INFI.~AT.I0N
Table II presents the provisions of the 1976 per-
sonal income tax structure applicable to the worker at
the beginning of the period and these same provisions
at the end of 45 years if they were indexed for a 5
percent rate of inflation. Such indexation would main-
tain the tax payment of a worker holding the assumed
job as a percent of income received at the same level
as in 1977 in the case of inflation and no growth in
real income, and at the level implied at the end of 45
years in the case of growth in real income without
inflation.
The table indicates that substantial changes in the
tax provisions would be required to accomplish these
results. For example, the exemption per dependent
would be $6,739 and the minimum standard deduc-
tion $18,869. The lowest marginal tax rate would
apply to taxable income up to $8,985.
CONCLUSIONS
The simple examples considered here give results
that may appear to be extreme. But that is the point.
Acceptance of the view — “So what, its only a five
percent rate of inflation “ — because it is believed
that individuals can take actions in the market place
to protect their real income fails to take into consid-
eration the existing personal income tax structure.
Even if increases in an individual’s money income re-
flect fully the rate of inflation, the gap between real
income and after tax real income tends to widen. The
reason for this result is that taxes as a percent of in-
come increases as money income incorporates the rate
of inflation.
Ext: bit I
Influence of Pesnianent Five Percent Rate
of Inflation on Selected Prices
1
Boginnng After
- Level , 4,~5Years
G’orery Items
Bread I’ lb loot) $ .25 S 2.25
2% milk (I gallon) 1.39 12.49
A-Lorae eggs (1 dazenl .85 76~
C’o,,nc, b”ef (1 lb.) .99 8.90
~t,c’ck roost (I ib.) 69 6.20
W1,ole t, yer II lb.) .49 44 0
Rand steak (I b) 1.49 13.39
cabbage (1 lb.) 33 2.97
Potatoec (1 lb.) 13 1.17
conned tomotoes (16 or.) .35 3.14
Pconu’ butter ç25 cz.) 1.35 12.13
Butter II lb.) 1.25 11.23
ToUr., Poper 14 ‘olk) .79 7.10
Clothing
Work pant, $ 8.98 $ 80.69
Wo’k ,liirt 7.98 71.70
Work shout 26.00 233.61
Work ,rket V gut) 9.98 89.67
V/ark o”kel (htovyl 1398 12561
Mon’s suit 85 00 763.73
Mon 5 coot ~oi v.ootreri 6C 00 539.1 C
Mon’u ores, shoes 25.00 224.63
Woman’s sock, 14.00 123./9
Woman: dren, 30.00 26955
Wonon’s coot (all wcothe,) 3900 350.42
Woman s co c ,Fo”c 16.99 157.66
Housirg
New Ho,,,’ $ 34,980 ‘~34,296
1 Bedroom Apartment 135/ 1,213/
month month
AL ‘0n,ohie
Pinto S 37 5 5 28.52/
Mo’bu coupt 4,588 41,223
R2
0
u’o 005 (I 0° oni .i9r 5 3f
ening of the gap between real income received and
after tax real income. There is also another method
available for accomplishing the same objective. That
ludexation of the existing personal income tax struc- method is the elimination of inflation by reducing the
tare for the rate of inflation would eliminate the wid- present excessive rate of monetary expansion.
Page 23

So what, it's only a five percent inflation

http://research.stlouisfed.org/publications/review/77/05/Inflation_May1977.pdf

So what, it's only a five percent inflation

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