Bracket Creep: Delaware’s Hidden Income Tax

The recent acceleration of inflation in the U.S. has undoubtedly caused most Delawareans to see the difference between nominal or money income and real income or what their income actually buys. The loss in purchasing power of Delaware households because of inflation is compounded by the fact that Delaware, like several other states, has a progressive income tax and doesn’t adjust its income tax brackets for inflation.

Delaware’s income tax brackets have remained the same since 1999. So, when nominal household incomes rise, those incomes are taxed at higher rates. This in turn results in lower disposable household incomes. This phenomenon is referred to as “bracket creep.” The loss in real income or purchasing power because of bracket creep is in addition to any loss in real income that results if the rate of inflation exceeds the increase in nominal income.

In this essay, I examine the extent of bracket creep in Delaware between 1999 and 2019 and then review the implications of this bracket creep. Figure 1 shows the change in the price level as measured by the U.S. Consumer Price Index (CPI), the mean Delaware Adjusted Gross Income (MEAN AGI), and the revenue generated by the Delaware income tax (Tax Revenue) for the period 1999-2019. All variables are index values expressed as percentages of their respective 1999 values.

The data in Figure 1 indicate that the mean adjusted gross income over the period 1999-2019 increased at an annual rate of 1.79 percent or by 45 percent over the entire period. This was less than the rise in the consumer price index which increased at an annual rate of 2.06 percent or by 53 percent over the entire period. Hence, the mean adjusted gross income failed to keep up with inflation, resulting in a loss in the purchasing power of Delaware taxpayers. 

This loss in purchasing power was further diminished by the increase in personal income tax rates as households were pushed into higher tax brackets by inflation. While the real average adjusted gross income of Delaware households declined over the period, the tax revenue generated by the personal income tax increased by an average annual rate of 3.31 percent and nearly doubled over the period 1999-2019. In other words, the state of Delaware was able to nearly double its revenue from the income tax without legislating any tax increases.

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Sources: Data for the mean adjusted income (Mean AGI) are from the Federal Reserve Bank of St. Louis. Data for the Consumer Price Index are annual data for all urban consumers and are from the Bureau of Labor Statistics and data for the tax revenue are from the Delaware Division of Revenue.

Table 1 shows the impact that adjusting the tax brackets annually for inflation would have had on the tax liability of households with varying levels of taxable income for the year 2019. Column 4 of the table denotes the percentage by which the tax liability for households with varying levels of taxable income would have declined in 2019 if the tax brackets had been adjusted for inflation.

The data in table 1 clearly indicate that the failure to adjust tax brackets for inflation results in lower after-tax incomes for households at all levels of income. However, the most adverse effects are felt by households which had incomes of $30,000 or less in 2019.

Bracket creep creates a number of problems. First, it results in a loss in the purchasing power of taxpayers which reduces the amount of income available for savings and capital investment in the private sector. As the Austrian economist Ludwig von Mises noted “progressive taxation of income and profits means that precisely those parts of the income which people would have saved and invested are taxed away.” This in turn leads to a decline in the rate of economic growth and a lower standard of living for future generations.

In addition, bracket creep requires taxpayers to pay a higher percentage of their incomes in taxes without requiring any action by the state. Instead of forthrightly increasing taxes, the state relies on inflation to push households into higher tax brackets in order to increase tax revenue and the size of government. As Thorndike  noted bracket creep is “a convenient way to raise more revenue—painful for the hapless taxpayers but painless for the gutless lawmakers.”

Higher income tax rates also incentivize higher income individuals and households to migrate to lower tax states. In fact, an increasing number of states are lowering or eliminating their income taxes to stem out-migration and spur in-migration and economic growth.

 Finally, since higher income households are already in the highest tax bracket, bracket creep tends to make the after-tax income distribution more unequal as lower income households are pushed into higher tax brackets over time. It also discourages less skilled lower income workers from entering the workforce, resulting in lower labor force participation rates. This negative effect is particularly important for a state like Delaware because of its relatively low labor force participation rate. Delaware’s labor force participation rate of 60.2 percent in December of 2022 was in the lowest quartile of U.S. states. Given this, It behooves Delaware to look for ways to incentivize, not disincentivize, higher labor force participation rates.

It’s time for Delaware to adjust its income tax brackets for inflation each year to prevent the negative consequences of bracket creep. If the executive and legislative branches of Delaware’s government want to take more of the taxpayers’ money, they should be required to do so by transparently raising tax rates. This is not such a novel concept. Even the U.S. Congress recognized how deceitful the use of bracket creep was as a means of raising revenue. As a result, in 1981, it voted to pass President Reagan’s Economic Recovery Tax Act  which included a provision to adjust tax brackets for inflation.