Inflation triggers an invisible rise in personal income tax that affects all taxpayers

The sudden return of inflation has brought with it old debates that seemed forgotten. One of them is updating and adapting the tax system to price changes. If taxes do not adapt to the new inflationary environment, taxpayers will pay higher and higher absolute and relative amounts (average effective rate) to the Treasury, despite the fact that their real purchasing power is maintained or even decreased. The ‘positive’ part is that tax collection has increased as revealed by the latest data.

Although Spain has by no means closed the GDP gap opened up by the covid crisis, tax collection has reached an all-time high in 2021. Although it is true that a good part of this increase in collection is due to the emergence of many activities that have sought the umbrella of public aid (Ertes, credits…), another part is probably due to the sharp increase in prices, which has allowed an annual nominal GDP growth of 7.2% (compared to the 5% true). A price boom Other things being equaldirectly implies a higher VAT collection, for example.

“In VAT, the increase in collection is produced directly by the increase in prices on which the tax is applied, although given its proportional nature, the effective tax is not increased (another thing is that if consumers do not see their income in inflation, real purchasing power decreases),” explains Jorge Onrubia, Associate Professor of Public Finance at the Complutense University of Madrid and FEDEA researcher, in statements to the Economist.

However, Onrubia highlights that “in general, all tax figures are affected by inflationary phenomena, but especially taxes with progressive tax structures, such as personal income taxthe Tax on Inheritance and Donations and the Tax on Wealth, due to the phenomenon of the so-called ‘cold creep'”.

The ‘surcharge’ for personal income tax

Precisely, this inflationary phenomenon is causing Spaniards to pay an ‘extra cost’ in personal income tax that José Félix Sanz, professor of Applied Economics at the Complutense University, puts at more than 4,000 million euros. On average, Spaniards will pay about 199 euros more for this figure in the settlement that will take place in the spring of this year, according to a new work published by the Disenso Foundation.

Onrubia agrees with the calculations, although he offers a somewhat wider range: “According to my estimate, the increase in collection that inflation would provide for the settlement of personal income tax for the 2021 financial year would be in a range between 3,700 and 4,400 million euros. This wide spread would be justified for two reasons that introduce uncertainty in the estimate: a) the different income structure of the 2018 financial year, compared to the 2021 financial year, in the midst of the covid pandemic; b) the lack of differentiation of the impact of inflation in the generation of the different income categories”.

The economist Javier Santacruz goes further back with his calculations and explains to the Economist that “since 2008, the last date on which the IRPF rate was deflated, accumulated inflation was 18.54%. With which, with an average full fee (a worker who earns the median salary in Spain generates a liquidable base of 18,326 euros) of 3,775.92 euros, inflation generates an extra cost of 700.05 euros (since then). The jump between the latest estimate (2019, with data from 2018) and 2022 is enormous because inflation is well above the average after the 2008 crisis, the last year in which the rate was deflated,” says this expert. .

José Félix Sanz emphasizes in his work that this tax overload in personal income tax associated with inflation is a phenomenon that is well known by economists: “This ‘cold progressivity’ has the peculiarity of going relatively unnoticed since is a hidden tax increase that does not require discretionary action on the part of the government”.

This is how the income tax rate rises

In personal income tax, nominal income above a certain threshold is taxed by a growing sequence of marginal rates. A salary linked to inflation and that is revalued from time to time can amount to a higher income tax bracket despite the fact that the real salary (discounted inflation) remains exactly the same. Even without going to a higher step, a nominal salary increase implies that a greater part of the salary is taxed at the highest rate that supports that income, so the effective rate paid is higher despite the fact that the purchasing power is lower, points out the researcher from Fedea.

For example, a worker who earns 20,000 euros pays a marginal rate of 24%. If his salary rises, for example, by 6% to compensate for an identical rise in inflation, he would earn 21,200 euros and, in principle, cushion the impact of that inflation. However, this is not the case because from 20,200 euros the section of Personal income tax jumps from 24% to 30% so the taxpayer would have to pay 37% for 1,000 of the 1,200 euros that his salary has increased. If, on the other hand, the sections were adjusted for inflation, that next section would not start until 21,412 euros, so the worker will continue to suffer the same effective rate and the same marginal rate of 24%, conserving their purchasing power.

In turn, the deductions, exemptions, bonuses and reductions are usually set in nominal terms, so that higher inflation reduces these figures in real terms, reducing the taxpayer’s tax savings, which also tends to benefit the taxpayer to a greater extent (in relative terms). lower income taxpayers. “So, on the one hand, it reduces in real terms the exempt minimums and reductions applied in the quantification of the taxable base. On the other hand, it distorts the magnitude of the real income subject to taxation”, highlights José Félix Sanz.

Beyond wages, Professor Onrubia points out that in the case of income from movable capital, the main problem occurs in the calculation of changes in equity. When it is taxed, for example, for the sale of shares that have doubled their price from the moment of purchase, a part (even the totality, if applicable) of the increase in equity will be taxed, which will only be a nominal increase and not real. Although inflation has doubled in that period and, therefore, the shares have only served to maintain the purchasing power of that capital, the investor must pay taxes on the difference between the purchase and sale price.

In other words, inflation increases the tax bill of taxpayers without explicitly having to raise tax rates or other structural elements of the tax. It is, therefore, an inconspicuous tax increase and, precisely for this reason, it is usually to the liking of governments as it does not impose political costs on them, says the professor at the Complutense University.

Collection evolution in 2021

The average inflation of 2021 has exceeded 3% in Spain, while in December the general CPI presented a variation rate of 6.5%, the highest figure since 1992. This increase has been led by energy, but has been been moving to the rest of the basket little by little. This rise in prices in turn implies a higher payment of taxes, although the effective rate is maintained in some of them, such as VAT. The Government has managed to collect 72,493 million euros through VAT, almost 1,000 million more than in 2019 (before the pandemic).

As far as personal income tax is concerned, the collection has been 94,546 million in 2021, compared to 86,892 million in 2019. Well, “the results confirm that the extraordinary tax bill for personal income tax due to tax burden in 2021 will amount to a total of 4,110 million euros, of which 1,693 million are due to not having indexed the tax rates and 2,417 million to the absence of adjustments in the elements that limit the definition of the taxable and liquidable bases”.

Restructure personal income tax

“The need to adjust the structure of personal income tax to inflation, in all its elements, it is desirable for the tax to distribute its burden equitably,” Onrubia asserts.

This economist and Fedea researcher explains that if, when these elements were approved, the distribution of the burden was what was considered fair (both in terms of vertical and horizontal equity), all these displacements of the effective tax will give rise to a new load sharing, which will not take into account the real payment capacity, but the nominalwith the consequent loss of vertical equity (how the effective average rate increases as income increases) and horizontal (similar treatment to taxpayers with similar real payment capacities, since not all income categories will have the same impact of inflation) .

José Félix Sanz concludes his work by pointing out that “unfortunately, no country has developed a tax that meets these characteristics to date. For this reason, the reality is that inflation induces distortions of different magnitude and intensity in the personal income tax “. In the case of Spain, Ciudadanos has presented a non-law project in which it urges the Government to deflate the IRPF rate in order to adjust the sections of the scale of said tax to the evolution of inflation and the real economic capacity of taxpayers.