by Joseph Johns, ACRE Policy Analyst
Consumer price inflation hit 40-year highs in 2022. The rapid increase in prices has already hit households hard in their wallets as they buy everyday goods and services. But for taxpayers in Arkansas, there could be another hidden cost of inflation: your taxes could be going up in real terms, even if your income barely kept up with inflation. How does the complicated relationship between taxes and inflation work?
Arkansas is one of seventeen states that adjusts their individual income tax brackets to inflation as of 2022, according to the Tax Foundation. That’s good for taxpayers. The federal tax code is also adjusted for inflation. For both states and the federal tax code, this means that each year the income levels in tax brackets (as well as other parts of the tax code) are adjusted upward to avoid what is known as bracket creep. The Tax Foundation summarizes the issue:
Bracket creep occurs when inflation pushes taxpayers into higher income tax brackets or reduces the value of credits, deductions, and exemptions [that would otherwise help reduce income tax burdens.] Bracket creep results in an increase in income taxes without an increase in real income. Many tax provisions—both at the federal and state level—are adjusted for inflation.
Think of it this way: if your income increased 6.5 percent in 2022, just barely enough to keep up with inflation, you wouldn’t want your taxes to go up by more than 6.5 percent either. Inflation-adjusting tax brackets prevent you from being bumped up into a higher tax bracket, when your real income hasn’t increased.
Given all this, it’s a good idea that Arkansas already indexes its tax brackets to inflation, and that the Arkansas legislature also recently indexed the standard deduction to inflation during the Second Extraordinary Session of the Arkansas General Assembly in 2021. So what’s the problem for Arkansans?
Under current tax law, Arkansas places a hard cap of 3 percent on inflation adjustments each year. Very few states have a cap on inflation adjustments, with almost all using the full inflation rate. This cap limits the effectiveness of adjusting brackets to inflation since inflation exceeded 3 percent since April 2021. Because of this cap, many Arkansas taxpayers could see higher taxes as they are pushed into tax brackets with higher rates.
A bill before the Arkansas legislature, known as the “Inflation Reduction Act of 2023” (not to be confused with the federal law from last year), would remove this 3 percent limit on annual inflation adjustments. Instead, individual income tax brackets and the standard deduction would be indexed to the full rate of inflation under this bill. Additionally, the bill utilizes a newer measure of inflation from the Bureau of Labor Statistics (BLS), a version of the well-known Consumer Price Index that applies to the “West South Central” division, a four-state area that includes Arkansas. This index should more accurately reflect the inflation situation in Arkansas, rather than the index that uses all 50 states.
The Department of Finance and Administration (DF&A) estimates that this bill would have a revenue impact of $32.6 million in 2023 and $65 million in 2024. In other words, by lifting the cap on inflation adjustments (currently 3 percent), Arkansans will avoid close to $100 million in inflation-induced taxes over the next 2 years. After that, DFA assumes that inflation levels will fall back below 3 percent, thus there would be no additional fiscal impact. But if high inflation returns in the future, this safeguard will protect future taxpayers as well.
Beyond just the impact on tax brackets, the costs of inflation to Arkansans are already large. The Congressional Joint Economic Committee (JEC) began tracking inflation beginning in January 2021 since inflation “was within recent historical norms at 1.4 percent.” It had not yet started to increase at the interval it did from February 2021 through December 2022.
Utilizing data from the BLS Consumer Price Index (CPI), the JEC staff calculated each state’s monthly household inflation costs. They found that inflation peaked in Arkansas in October 2022. During that month, households needed $579 more per month to maintain the same standard of living as they enjoyed in January 2021. Figure I below shows the inflation costs for Arkansas households between January 2021 and December 2022 (for this calculation we used the West South Central division CPI).
Figure I: Inflation Costs in Arkansas Peaked in October 2022
The Arkansas Joint Budget Committee could also consider further consolidating the two tax brackets to a unitary table. This type of reform would reduce, but not wholly eliminate concerns about bracket creep by eliminating the differences between tax rates when income levels change. Only a flat tax with a single rate avoids bracket creep since there is no possibility of moving to a different rate in the same table.
Regardless of how the Arkansas legislature chooses to respond to the uptick in inflation, such trends persist as a toll first on the earnings of Arkansas citizens and should be controlled for by fully indexing all elements of the Arkansas tax code to inflation. This will allow current households to avoid paying more in taxes than is absolutely necessary and guard against any future spikes in inflation as a result of federal monetary policy.