Amid Highest Inflation In Four Decades, State Lawmakers Seek To Alleviate Harm

The Bureau of Labor Statistics Consumer Price Index report released on June 10 showed an inflation rate of 8.6% from May 2021 to May 2022. That means the U.S. is experiencing the highest annual inflation rate since December 1981.

The Biden White House now acknowledges inflation is its top challenge but is proposing legislation and advancing regulations that critics contend will exacerbate rising prices. Congressional Democrats have introduced a plan that includes some inflation-quelling reforms that Republicans could also get behind, such as repealing tariffs and reducing non-tariff regulatory barriers to trade and commerce. Governors and state legislators, meanwhile, have taken action this year to help offset the adverse effects inflation is having on their constituents.

In two states — Georgia and Mississippi — lawmakers recently enacted legislation that, in addition to allowing workers to keep a larger percentage of their paychecks through income tax rate reduction, will also put an end to unlegislated tax hikes that result from not indexing state income tax brackets for inflation. Most states with graduated income tax rates index their income tax brackets for inflation. That prevents what’s called bracket creep, in which households get pushed into a new income tax bracket with a higher rate due to inflationary rather than real wage gains.

“At the federal level, the IRS adjusts more than 40 tax provisions for inflation, including rates (by way of bracket widths) and bases (deductions, exemptions, and other provisions), such as the federal income tax brackets, the standard deduction, or the Earned Income Tax Credit (EITC),” explains the Tax Foundation. “Many states build a cost-of-living adjustment into their individual income tax brackets, standard deductions, personal exemptions, and other features of their tax codes. A movement that began with three states—Arizona, California, and Colorado—in 1978 has now expanded to half of all states.”

While most states with a progressive income tax system index brackets for inflation in order to prevent bracket creep, 13 of them do not. The states that do not index tax brackets for inflation are Alabama, Connecticut, Delaware, Georgia, Hawaii, Kansas, Louisiana, Mississippi, New Jersey, New York, Oklahoma, Virginia, and West Virginia. Lawmakers in some of these 13 states have taken action this year to protect their constituents against bracket creep.

“In just two of the 13 states that don’t index tax brackets for inflation—New Jersey and Connecticut—Republican lawmakers have recently introduced legislation to change that,” Bloomberg Tax reported in March. “Maryland’s Legislature is considering a narrower bill for seniors only. New York is weighing a cost-of-living adjustment for former government employees’ pensions, and West Virginia is looking to wipe out its personal income tax entirely.”

Unfortunately for Garden State taxpayers struggling with inflation, the indexing legislation in New Jersey has not moved since March. “Governor Phil Murphy’s (D) recent budget address emphasized the importance of tax relief for New Jerseyans,” the Tax Foundation’s Janelle Fritts wrote in March. “Protecting residents from unlegislated tax increases due to inflation would be a great tool to do just that.”

There is good news, however, for taxpayers in Mississippi and Georgia, two of the 13 states with graduated income tax brackets not indexed to inflation, which is that bracket creep will soon cease to be an issue for them. That’s because legislation enacted by Governors Tate Reeves (R-Miss.) and Brian Kemp (R-Ga.) this spring will move their states to a flat income tax, rendering moot the issue of bracket creep.

Lawmakers in nine states thus far have enacted income tax relief in 2022 that will help households deal with inflation by letting them keep a larger percentage of their paycheck. Most recently, South Carolina lawmakers passed a compromise tax relief package on June 15 that will cut South Carolina’s top income tax rate below 7% for the first time since that rate was set in 1959. The tax package sent to Governor Henry McMaster’s (R) desk will reduce South Carolina’s top income tax rate from 7% to 6% over the next five years, while consolidating the bottom three brackets into a single one taxed at 3%.

South Carolina is one of the graduated income tax states that indexes tax brackets for inflation, but that annual inflation adjustment is capped at 4%. That means, in a world with 8.6% inflation, South Carolina’s indexing is not keeping up with inflation, resulting in some bracket creep. South Carolina lawmakers can rectify this by passing legislation to lift their inflation indexing cap.

South Carolina’s income tax brackets were initially indexed for inflation in the 1980s. Indexing was subsequently repealed, only to be reinstated more recently. According to the Tax Foundation, had South Carolina indexed its brackets for inflation since the adoption of the 7% rate in 1959, that top rate would kick in above $85,000 today, instead of hitting those making less than $17,000 annually.

South Carolina legislators could also protect their constituents from inflation by passing legislation to move to a flat tax like lawmakers have done in North Carolina, Georgia, Iowa, Mississippi, Arizona, and Kentucky. In fact, moving to a flat tax is less of a leap in South Carolina than in most states. That’s because South Carolina is one of only 10 states with a graduated income tax whose top rate hits income below $20,000. Right now South Carolina’s top income tax rate of 7% kicks in at $16,040 in annual income for single and joint filers, meaning that most workers are already paying the top income tax rate on most of their earnings.

South Carolina will still have the highest income tax rate in the southeastern U.S. even after the tax cut passed this year takes effect. That’s why some South Carolina lawmakers have already said the tax cut passed this year should be considered a first step and that more work needs to be done to address the flaws in the state tax code. Getting the personal income tax rate down to a flat 3%, the same rate at which passthrough business income is taxed in South Carolina, will be seen by many as a logical goal for Palmetto State lawmakers in subsequent legislative sessions. Moving to a 3% flat income tax would also absolve lawmakers of their need to lift their 4% cap on tax bracket inflation indexing.

Another reason why South Carolina legislators will be inclined to build upon the tax cut recently sent to Governor McMaster’s desk is that lawmakers in other states have made clear they’re not resting on their laurels. Legislation has been filed in North Carolina, for example, to cut the state income tax rate again, taking it down to 2.5%, which will match the income tax rate that Arizona is heading toward. Recent polling indicates that such proposals, policy arguments aside, make for smart politics.

The South Carolina Policy Council released a poll on June 4 finding 77% of respondents think it is important to cut the state income tax, with 54% saying state income tax rate relief is very important. The Center for American Ideas and the GOPAC Education Fund, meanwhile, released polling on June 8 finding vast support for the proposal to again reduce North Carolina’s income tax rate, cutting it to 2.5% by 2030. This new polling found support for cutting the state income tax ranging from 74% to 77% in the four competitive state legislative districts surveyed. Based on this polling, it’s not surprising the income tax cuts recently approved in North Carolina and South Carolina both passed with bipartisan support. Expect to see lawmakers in more states look to reduce and flatten personal income taxes in the coming months and years. Though the midterm elections come first, planning is already underway in many states for 2023 legislative sessions, during which inflation is likely to remain a top challenge.

“Governor Glenn Youngkin (R) has a great opportunity to build on the $4 billion in tax relief approved this year with a follow up tax reform package that addresses the top issue facing households, inflation, by indexing state tax brackets to CPI,” said Ryan Ellis, president of the Center for a Free Economy and a Virginia-based IRS-enrolled agent. “Even better, Governor Youngkin should look to follow up on his first term successes with a 2023 tax reform package that gets Virginia’s personal income tax rate down to a flat 5%. Phasing in a flat income tax rate of 5% or lower over multiple years and based on revenue triggers being met would put Virginia on a much more competitive footing relative to the likes of North Carolina, Tennessee, Florida, Texas, and Arizona. Furthermore, in order to protect households from being taxed on inflationary gains, the next Republican White House needs to index capital gains for inflation. Indexing capital gains for inflation would also provide state level tax relief, since states conform to the federal definition of income. Failing to do this was the Trump administration’s biggest missed opportunity, at least when it comes to tax policy.”

A Pew Foundation poll released in May found Americans list inflation as the top challenge facing the nation. The highest inflation in more than four decades has imposed what is effectively a large, unlegislated tax hike hitting all families. Worse, it’s an effective tax hike that is regressive, doing the greatest harm to low-income households who can least afford the added costs. President Ronald Reagan once remarked that “inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” This is why state lawmakers, even though they cannot address the root causes of inflation, are seeking and will continue to look for ways to limit the harm and offset the pain that high inflation is inflicting on their economies and constituents.