Why is Indexation Important?

Many features of personal income taxes are defined by fixed dollar amounts. For instance, income taxes have various rates starting at different dollar amounts of income. If these fixed amounts aren't adjusted periodically, taxes can go up substantially simply because of inflation. This phenomenon is known as "bracket creep." The same process tends to reduce the real value of other important features of the tax system, such as personal exemptions and standard deductions, over time as well.

In states that do not take account of the "bracket creep" problem, the existing tax structure is likely to be significantly less progressive than it was when the exemptions, deductions and rate brackets were first set at their current value. An extreme example of this effect can be seen in Alabama. The state's personal exemption has not been raised since the state income tax was adopted in 1933, and the standard deduction has not been raised since 1982. This has resulted in a significant decline in the real value of the exemption and deduction over time. For example, in 1982 the current $2,000 maximum standard deduction for single-filers was worth $3,449 in 1999 dollars.

The way the federal personal income tax code deals with this problem is by "indexing" these features of the tax code for inflation. This means that every year, the personal exemption, standard deduction and rate brackets are increased by the amount of inflation.

While several states have recently enacted legislation to index their tax structure, most have not. As the table at right shows, only 19 of the 42 states (including D.C.) with broad-based income taxes have passed legislation to index exemptions, deductions, or tax brackets for inflation--and only 7 states currently index all three of these factors.