In this chapter, we assume that the only inflation-induced distortion in the personal income tax system is caused by the progressivity. In particular, we assume that (1) either there is no capital income problem, or (2) that capital incomes have already been adjusted. We also ignore the issue of collection lags. In this way we can focus on one basic aspect of the problem: the fact that inflation pushes taxpayers into brackets levied with higher tax rates even when their real income has not changed.

Effects of inflation on personal income tax liability

In most countries, personal incomes above certain exempted levels are taxed with progressive statutory rates. These rates apply to income brackets specified in money terms in the tax legislation. Personal exemptions, as well as some of the deductions or tax credits, are also fixed in current values. Such a legal structure for the personal income tax guarantees that, in the absence of evasion, higher taxable incomes will be subjected to higher average tax rates. This feature has generally been considered desirable from both an equity and a stabilization point of view: because it promotes the objective of income redistribution and conforms to the principle of ability to pay; and because the progressivity of the income tax generally increases its built-in-flexibility and this increase is supposed to moderate cyclical fluctuations.