Office of Tax Analysis

U. S. Treasury Department

Washington, D.C. 20220 

Issued February, 1977 

REPORT ON U.S. EXPERIENCE ON INFLATION AND 

THE TAX STRUCTURE 

PREPARED FOR THE INTERNATIONAL FISCAL ASSOCIATION 

BY 

HARVEY GALPER 

U.S. TREASURY DEPARTMENT 

JOHN MENDENHALL 

UNION PACIFIC CORPORATION 

ASSISTED BY 

MICHAEL KAUFMAN 

U.S. TREASURY DEPARTMENT 

OTA PAPER 19 REVISED FEBRUARY 1977 
TABLE OF CONTENTS 

A. Background 

B. Measures to take account of inflation 

General 

Income tax, corporate tax, tax on 

capital gains 

C. Measures to Combat Inflation 

Page 

1 

4 

4 

6 

29 
OTA Papers are circulated so that the preliminary findings

of tax research conducted by Staff members and others associated 

with the Office of Tax Analysis may reach a wider audience. The 

views expressed are those of the authors, and do not reflect 

Treasury policy. Comments are invited, but OTA Papers should 

not be quoted without permission from the authors. 

This paper was written as a report on United States experience 

on inflation and the tax structure for the International Fiscal 

Association (IFA). The IFA is an association of government officials, lawyers, accountants, corporate executives, and members of 

the academic community who deal with tax issues having international significance. In preparing this paper, the reporters 

were responding to an IFA questionnaire, which specified both the 

particular topics to be covered and the order of coverage. This 

report will be published by the IFA in its series, Studies on 

International Fiscal Law. 
A. Background 

1. Table 1 shows the behavior of several price indexes 

since 1950 and corresponding inflation rates. These measures 

indicate that inflation has become an increasingly serious 

problem in recent years. As shown by the table, inflation 

averaged 1% to 2% percent from 1950 to 1965 and generally 

declined over the period. In contrast, the inflation rate 

averaged over 4 percent from 1965 to 1970 and has exceeded 

6 percent since 1970. Based on December to December changes 

in the consumer price index, the inflation rate was approximately 12 percent in 1974 and 7 percent in 1975. 

2. Recent U.S. inflation can be explained by the monetary 

and fiscal policies pursued by the government and other external factors. A consistent feature of the last ten years 

of U.S. experience has been the tendency for growth in the 

money supply to outpace the growth of real output. Inflation 

is an almost inevitable by-product of such a policy. Money

supply growth has in part resulted from the deficits of 

Vietnam and subsequent years as monetary policy was directed 

towards accommodating the interest rate and other credit market 

effects of these deficits. 

Furthermore, partly as a result of stimulative government 

spending, the economy was operating at high rates of capacity 

utilization during the 1968-69 period, thereby setting the 
Table 1. Statistical Measures of United States Inflation, 1950-1975 

(1967 = 100) 

Year : Consumer : Wholesale GNP Deflator : Fixed Investment ' 

: P.riceIndex. : Price Index peflator 

1950 72.1 81.8 67.9 71.8 

1955 80.2 87.8 7i.2 82.3 

1960 88.7 94.9 86.9 91.3 

1965 94.5 96.6 94.0 93.8 

1966 97.2 99.8 97.1 96.8 

1967 100.0 100.0 100.0 100.0 

1968 104.2 102.5 104.5 104.3 

1969 109.8 106.5 109.7 110.4 

1970 116.3 110.4 115.6 115.8 

1971 121.3 113.9 121.5 121.8 

1972 125.3 119.1 126.6 127.1 

1973 133.1 134.7 134.0 134.7 

1974 147.7 160.1 147.0 149.A 

1975 161.2 174.9 159.9 168.5 

Average Annual Rate of Price Change: 

1950-55 2.15 1.43 2.60 2.78 

1955-60 2.04 1.57 2.40 2.10 

1960-65 1.27 0.36 1.59 0.52 

1965-70 4.24 2.71 4.21 4.30 

1970-75 6.75 9.64 6.71 7.80 

1973-74 10.97 18.86 

1974-75 9.14 9.24 

9.71 

7.87 

10.94 

12.76 
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stage for subsequent inflation. Price controls initiated 

in 1971 suppressed inflation, but also led to supply shortages in such commodities as metals, petrochemicals, lumber, 

and raw materials generally, so that the effective removal 

of controls in 1973 (on all but oil and gas) led to rapid 

price increases. 

Other events have also had an inflationary effect. The 

widespread declines in agricultural output first in the Soviet 

Union in 1972 and then in the United States in 1974 put upward 

pressure on food prices. Similarly, the 1973 OPEC policies 

sharply raised the world price of oil. 

It may be of interest to compare the inflationary experience 

of the last 10 years with that of the 1950-1965 period. The 

earlier inflation rate was much lower as were the magnitudes 

of Federal deficits and the difference between growth in the 

money supply and in real output. Two periods, 1952-52 and 

1956-58, stood out as being times of especially rapid inflation. Inflation in the former period has been attributed to 

the deficits associated with financing the Korean War and 

the dismantling of price controls. The inflationary spurt 

in 1956-58 has been explained by reduced supplies of some 

agricultural commodities and higher oil prices occasioned by 

the Suez crisis. 

In the 1970's inflation became much more of a policy 

concern. In August 1971, a price control system was implemented. 
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These price controls have been discontinued, except for domestic 

oil and gas, and have been replaced by a policy which calls 

for gradually winding down inflation by holding down aggregate 

demand, particularly through restoring budget balance and 

moderating monetary expension. However, current policy to 

reduce inflation has been constrained by the high rate of unemployment prevailing in the economy. 

B. Measures to take account of inflation 

General 

1. The general attitude of the Congress and the state 

legislatures is that tax liability is based on nominal income 

and historic cost asset valuations where such valuations are 

used in the calculation of income. Congress and the state 

legislatures have generally not dealt with the problems of 

income measurement which arise in periods of inflation. In the 

tax structures of the United States, any departures from this 

principle of nominal values are the sole jurisdiction of Congress 

and the state legislatures, Tax authorities and the courts 

have no authority to deal with inflation issues because the 

statutory structure is specific. 

2. While legislation in the U.S. has never included measures 

that were specifically designed to make the tax system inflation neutral, various tax changes have been enacted over the 
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last 15 years that have had the effect of moderating the rise 

in individual tax burdens which otherwise would have occurred. 

The changes in tax law have generally included increases in 

the standard deduction and personal exemptions and decreases 

in the structure of tax rates, The effects of these changes 

have been to maintain the real rate of taxation, particularly 

for low- and moderate-income taxpayers. At times the changes 

were explicitly made to adjust tax burdens for inflation, but 

more frequently, the changes have been adopted simply as tax 

cuts or as simplification measures, A more detailed account 

of these changes is given below in Section 3. 

Other tax changes which have been made during this same 

period, have had the effect of reducing the tax burden on 

income from capital. These, discussed more fully in Section 4 

below, include investment tax credits and general permission 

to use accelerated depreciation methods. These changes have 

not generally been advocated as direct corrections for inflation 

but rather as stabilization devices and as measures for promoting a more realistic measurement of income. But to the 

extent they were enacted during inflationary periods, they 

incidentally moderated the inflationary distortion of tax 

burdens on income from capital. 

The decline in the real value of tax provisions which are 

denominated in dollars--such as, exemptions, standard deductions, 

and tax brackets--is to be distinguished from the difficulties 
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in measuring income in an inflationary environment. -1/ Standard 

income measurement techniques tend to mismeasure income from 

capital during periods of inflation. This erroneous measurement 

of capital income results from tax law and accounting conventions 

in four separate areas--depreciation, inventories, capital gains, 

and holdings of financial assets and liabilities. In each case, 

income mismeasurement results when there are lags between the 

time an asset is acquired (at one price level) and the time 

it is sold or produces income (at a higher price level). The 

income measurement problems in each area along with features 

of U.S. tax law which may have the effect of compensating for 

inflation are discussed in Sections 4 through 6 below. Section 3 

does not deal with issues of income measurement but considers 

inflation adjustments resulting from changes in provisions of 

the tax code denominated in dollars. 

Income tax, corporate tax, tax on capital gains 

3. This section provides a brief account of the general 

structure of U.S. personal and corporate taxation and discusses 

major changes in this structure which have had the effect of 

adjusting for inflation. 

The basic structure of the personal income tax is fairly 

simple. The taxpayer adds up all his income from taxable 

sources (adjusted gross income or AGI), subtracts certain allowable deductions and exemptions for himself, his wife, and his 
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other dependents, and applies tax rates to the remainder which 

is taxable income. In taking deductions, taxpayers have the 

option of itemizing -2/ or using the standard deduction provisions. The standard deduction which can be taken is the 

greater of either a minimum dollar amount or a percentage of 

AGI subject to a maximum dollar amount. The personal exemptions 

and the tax brackets also refer to fixed dollar amounts. While 

the expenditures which a taxpayer may itemize increase automatically with inflation, the fixed dollar deductions, exemptions, 

and bracket widths can be increased only with Congressional 

approval. In 1975, Congress did, however, provide one automatic adjustment by tying to the consumer price index the 

maximum allowable contributions and the amounts of benefits 

under qualified pension and profit sharing plans which provide 

tax deferral advantages. 

Table 2 gives a summary of the changes in the standard 

deduction, exemption, and tax rate provisions since 1960. The 

more recent increases in the percentage standard deduction 

have been explained by Congress as a necessary response to 

inflation in order to maintain parity between taxpayers who 

take the standard deduction and those who itemize. Similarly, 

the minimum standard deduction increases have been supported by 

the argument that, as a result of inflation, tax-free income 

levels had failed to keep up with poverty income levels. 
-1/ 

-2/ 

-3/ 

-4/ 

-5/ 

Table 2 

Summary of Principal Individual Tax Changes, 1960-76 

Standard Deduction ProvisionsT/ 

: Percentage Standard Deduction :Personal Exemption : Bracket Rates 21 

Year Minimum : Percent of AGI : Maximum : Per Family Member : Low : High 

1960 $267 10 $1,000 $600 20 91 

1961 267 10 1,000 600 20 91 

1962 267 10 1,000 600 20 91 

1963 267 10 1,000 600 20 91 

1964 600 10 1,000 600 16 77 

1965 600 10 1,000 600 14 70 

1966 600 10 1,000 600 14 70 

1967 600 10 1,000 600 14 70 

1968 600 10 1,000 600 14 70 

1969 600 10 1,000 625 14 70 

1970 2/ 1,100 10 1,000 675 14 70 

1971 1,050 13 1,500 750 14 70 

1972 1,300 15 2,000 750 14 70 

1973 1,300 15 2,000 750 14 70 

1974 1,300 15 2,000 750 14 70 

1975 1,900 16 2,600 750 41 14 70 

1976 1,900 16 2,800 750 E/ 14 70 

Standard deduction for taxpayers who do not itemize is determined by taking the greater of the 

minimum standard deduction or the percentage standard deduction. 

The Tax Reform Act of 1969 introduced a maximum marginal tax rate of 50 percent on earned income which 

became fully effective in 1972. 

Because of special phase-out provisions in 1970, the minimum standard deduction exceeds the percentage 

standard deduction at very low income levels. 

Also eligible for a $30 tax credit per exemption. 

Also eligible for a $35 tax credit per exemption. 

1 

03 

1 
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Table 3 has been developed to assess the degree to which 

these periodic tax changes have offset the tax increases that 

would otherwise have been caused by inflation. The years shown 

in this table have been selected to indicate major changes in 

tax law. Aside from income measurement problems, if individual 

tax reductions had perfectly offset inflation, effective tax 

rates would have stayed the same over time for each real income 

level. Table 3 shows that despite persistent inflation, the 

periodic tax reductions have generally prevented effective tax 

rates from rising for low- and middle-income taxpayers although 

not for upper-income taxpayers, -3/ 

Table 3 

Effective Tax Rates on Families of Four at the Same Real 

Income Levels in Selected Years 

Real Income Level (In 1973 Dollars)

Year $5,000 $10 9 000 : $20,000 : $%OOO 

1963 0 8.4 13.1 20.6 

1965 0 6.4 10.9 17.4 

1969 1.7 8.0 13.0 20.8 

1972 0 6.8 11.8 19.9 

1974 0.9 8.2 12.9 22.1 

1975 -6.0 -1/ 7.1 13.0 23.1 

1976 -5.0 -1/ 7.3 13.2 24.0 

Note: This table assumes all income is correctly measured. Each 

family is assumed to have two dependents and file a joint

return to take either itemized deductions equal to 16 percent of AGI or the standard deduction, whichever is higher.

The effective tax rate is negative since a provision in 1975-

76 tax law provides a tax credit to persons with less than 

$8,000 of income with an actual cash payment made to the extent that the credit exceeds tax liability. 

-1/ 
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Of course, automatic tax cuts would have deprived Congress 

of the political gains to be had from these discretionary reductions. On the other hand, under a progressive tax structure, 

even one that is indexed, taxes will rise more than proportionately with increases in real incomes, thereby affording some 

opportunities for discretionary tax changes. 

Recently legislated tax changes have been particularly 

sensitive to those families at or near poverty levels of income 

as published by the U.S. Bureau of Census. It is possible to 

determine whether the periodic tax reductions of Table 2 have 

kept poverty level income from being subject to tax. Table 4 

compares poverty and tax-exempt income levels for five-year 

intervals since 1960. 

Table 4 

Comparison of Poverty and Tax-Exempt Levels of Income for 

a Family of Four, Selected Years 1960-1975 

Income Level 

Year Poverty : Tax-Exempt 1/ 

1960 $ 3,022 $ 2,667 

1965 3 ,223 3 ,000 

1970 3,968 3,600 

1975 5,504 -2/ 5,757 

1/ Neglects tax-exempt transfer payments. 

2/ - Figure calculated by adjusting the 1974 figure by 9.14 percent, the change in the consumer price index in 1975. 
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While tax-exempt income levels have tended to lag behind 

the rise in poverty levels on a year-to-pear basis, over the 

period as a whole tax-exempt levels have generally risen along 

with poverty levels, thereby keeping poor families off the 

tax rolls. Furthermore, in evaluating the tax burdens of 

lower income taxpayers, it is important to recognize that the 

amount of transfer income received by such persons has been 

increasing over the period. Since transfer income is taxexempt, this tends to reinforce the conclusion that tax adjustments for inflation have been quite good at low income 

levels. This analysis neglects social security taxes which 

are discussed in Section 8 below. 

Corporate income is subject to separate taxation in the 

United States. After taxable corporate income has been determined, a normal tax is applied on corporate incomes up to some 

limit (called the surtax exemption) at a flat rate. For incomes 

above the surtax exemption an additional surtax is applied 

(also at a flat rate) in addition to the normal tax. From 

1950 to 1975, the surtax exemption was $25,000. Thus under the 

tax rates in effect from 1971-74, -4/ the first $25,000 of 

income was subject to the normal tax of 22 percent, and income 

over $25,000 was taxed at a combined normal and surtax rate 

of 48 percent. In 1975, the surtax exemption level was increased 

to $50,000 and the normal tax was changed to 20 percent on 

the first $25,000 and 22 percent on the second $25,000 with 
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the combined 48 percent rate applying to corporate income excee-ding$50,000. This change was supported by arguments showing 

that inflation had eroded the value of the $25,000 surtax exemption 

which had been in effect for 25 years. In this sense, it parallels the kind of personal tax changes discussed earlier. 

Despite the surtax provisions, the corporate tax is virtually 

a proportional tax with about 85 percent of U.S. corporate taxable income taxed at the 48 percent rate. Thus, the main effects 

of inflation on corporate income taxation is not to move corporate taxpayers into higher tax brackets but rather to cause 

capital income to be measured incorrectly. The features of 

business taxation which tend to adjust for mismeasurement of 

income in times of inflation are discussed below in Sections 4, 

5, and 6. 

4. After reviewing the status of inflation accounting in 

the U.S., this section will discuss the income measurement problem 

including the treatment of depreciation, inventories, and debtors' 

profits. 

(a) Thirty years ago, the American Institute of Certified 

Public Accountants (AICPA) studied the problem of financial 

accounting as to price level changes, It concludeld that there 

was no need to make price level adjustments as long as the rate 

of inflation remained moderate but it recommended such adjustments if the rate increased significantly. In 1969, the AICPA 
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recommended (but did not require) financial statements based 

on price level adjusted figures to supplement the financial 

statements based on historic costs, Generally, this suggestion 

has been ignored in practice. 

The Financial Accounting Standards Board (FASB) is an 

independent body which now largely determines how public companies 

will report to their shareholders, The FASB issued an exposure 

draft at the end of 1974 which would have required supplemental 

price level statements (i.e., cost adjusted by an index of 

general purchasing power). Profits which would be reported under 

the FASB's proposal would vary widely from current financial 

reporting. An analysis of a system similar to the FASB proposal 

indicates that after adjustments for price levels changes, profits 

of nonfinancial companies in 1970 would have been $37 billion 

rather than the $56 billion actually reported to shareholders. 

However, for 1974, a year of high inflation, price level adjustments would have yielded a profit figure of $150 billion rather 

than $110 billion because of the large income from debt which 

would become reportable. -5/ Likewise a study of 30 large

industrial companies showed that their income adjusted for 

changes in the price level would have been 87 percent of reported 

income for 1974, or 63 percent of reported 1974 income had gains 

from monetary items--principally debt--been disregarded. -6/ 

These latter results reflect the particular characteristics of 

the companies in the sample, especially their capital intensities 
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and their debt/equity ratios. Companies with substantial 

long-lived plant would have had much lower adjusted income, 

while companies which had high debt/equity ratios would have 

shown higher adjusted incomes during 1974. The aggregate 

figures seem to indicate that the effect attributable to the 

adjustment for debt in 1974 was relatively more important. 

The Security and Exchange Commission (SEC) registered its 

objections to FASB proposal. The SEC proposed a supplemental 

disclosure of certain replacement costs rather than the use 

of a general purchasing power index. Replacement cost depreciation adjusts historic costs for the change in the price of the 

specific assets employed by the firm. General purchasing power 

adjustments take into account overall price inflation only. 

Thus, gains or losses resulting from relative price changes 

do not enter into income with a replacement cost system. In 

addition, replacement costs calculations may be difficult to 

make particularly where, due to technological change, no exact 

counterpart of the depreciating equipment is available on the 

market. In general, industry opposed mandatory price level 

adjusted statements while accounting firms generally favored 

them. 7/ 

In Plarch, 1976, the SEC decided to require most large 

industrial and commercial companies to disclose the effect of 

replacement cost charges in their calendar 1976 supplemental 

financial statements or in footnotes. Although the SEC stated 
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that its position is not contradictory or competitive with the 

FASB price level proposals, the effect has been to cause the 

FASB to withdraw its general price level proposal and to delay 

its judgment pending the completion of a study on the general 

basis on which financial statements should be prepared. Thus, 

the whole financial statement issue is undecided and historic 

cost financial statements unadjusted for the effect of inflation 

continue to be the general rule. The SEC's replacement cost 

supplemental disclosure will likely fail to provide a solution 

because the standards of that pronouncement and its method 

of disclosure are incomplete and poorly thought out. 

(b) Since business receipts rise in periods of inflation, 

business income tends to be overstated if depreciation deductions 

aye based on historic costs. Thus, tax liabilities at given tax 

rates rise, and real income is transferred from the private 

sector to the government. In the United States, fixed assets 

eligible for depreciation have not been entitled to any periodic 

revaluation to reflect rising prices of plant and equipment nor 

are special reserves of any kind allowed in calculating taxable 

income. However, during the Korean War (the early 1950's) as 

in World War 11, plants considered essential to the war effort 

were allowed a five year write-off. A five year write-off 

has also been allowed as a special tax incentive in recent years 

for housing rehabilitation expenditures, pollution control 
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facilities, railroad rolling stock, coal mining safety equipment, 

and on-the-job training facilities. Since 1954, accelerated 

depreciation (double declining balance and sum of the years' 

digits) has been permitted by statute. Such methods allow 

a much greater write-off in earlier years than in latter years 

and were introduced principally to provide a more realistic 

reflection of economic productivity patterns. In recent years, 

however, the availability of accelerated depreciation has been 

curtailed on residential and commercial real estate. 

In 1962, depreciation "guidelines" were established to 

make possible the use of shorter depreciable lives for equipment, 

if taxpayers could satisfy objective tests based on their experience, The justification for this change was primarily to 

improve procedures and secondarily to support modernization and 

offset higher replacement costs. This elective "guideline" 

system was generously modified and given statutory recognition 

in 1971 as the Asset Depreciation Range/Class Life system of 

determining useful lives. This system often permits the use 

of depreciable lives for tax purposes which are substantially 

shorter than those used for financial statement purposes. 

The investment credit which was first enacted in 1962 

allowed at that time a reduction in taxes otherwise due for 

7 percent of the cost of eligible capital equipment (utilities 

were initially allowed only a 3 percent credit), subject to 

the limitation that liabilities could be decreased by no more 
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than 50 percent. The investment tax credit was enacted as 

an incentive to stimulate investment spending. Since then, 

it has been repealed or suspended for brief periods for purposes 

of countercyclical fiscal policy. It is now in force at a 

10 percent rate including eligible utility property. The depreciable base is not reduced by the credit allowed. 

Such ad hoc changes do not directly deal with the continuing 

tendency of inflation to overstate business income. However, 

to the extent they reduce the taxability of income from capital, 

they mitigate this problem. 

(c) Since 1938, LIFO inventory valuation has been allowed 

for both book and tax purposes. For business firms using LIFO 

methods of inventory valuation, inflation can give rise to 

higher nominal incomes--and attendant higher tax liabilities-­

since income as measured includes what are essentially nominal 

gains on goods and materials purchases at lower prices. LIFO 

affords a type of automatic basis adjustment for inventories 

and thereby counteracts this effect. On the other hand, since 

the basis adjustment under LIFO is asset specific--as is the 

case with replacement cost depreciation--LIFO excludes from 

income gains and losses resulting from changes in relative 

prices as well as those caused by inflation. Many companies 

have adopted LIFO as a piecemeal solution to the inflation problem, 

In recent years, more companies have switched to LIFO inventory 

valuation and have realized substantial tax savings. In 1974, 
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such switches have been estimated to have reduced aggregate 

corporate tax liabilities by about ten percent. In that same 

year, however, corporate tax liabilities could have been reduced 

by perhaps another 35 percent had all firms been on LIFO. 

Although LIFO presents a more reasonable income statement, 

it understates the balance sheet and may later lead to inflated 

income when inventory quantities, priced at historic cost, are 

reduced. The statute requires that LIFO be used for book purposes if it is used for tax purposes. This "conformity" requirement has caused many problems in that management is forced to 

choose between lower tax liabilities and higher reported net 

incomes with potential effects on bonuses, credit ratings, 

collective bargaining, and government regulations. Furthermore, 

companies have faced a delicate problem of maintaining their 

LIFO tax benefits while making the type of disclosures required 

to shareholders under the SEC rules. 

(d) Inflation can cause erosion of the real value of outstanding debt, unless reflected in the interest rate charged 

on the loan. (See Section 5 on this.) However, Congress has 

not seriously considered requiring taxpayers to take account 

of the effects of inflation on either debtors' profits or 

creditors' losses in determining taxable income. 

5. The tax code does not permit indexing of interest income 

for tax purposes. However, in making financial transactions, 

borrowers and lenders can take expected inflation into account 
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in determining interest rates. When inflation is expected to 

increase, lenders will demand more interest and borrowers will 

be willing to pay it, since they will be repaying their loans 

with dollars of lower purchasing power. 

Of course, market adjustments cannot perfectly neutralize 

the current tax treatment of interest income. If inflation 

is not perfectly anticipated, real income in the private sector 

is transferred between creditors and debtors. Thus, when inflation is underestimated, creditors lose and debtors gain. 

If inflation were perfectly anticipated, these redistributional 

effects would tend to vanish as interest rates would rise to 

compensate lenders. 

However, usury laws or other restrictions may prevent 

interest rates in various markets from adjusting to inflation. 

For example, the monetary authorities establish the maximum 

rate that banks can pay on savings accounts and prohibit the 

payment of interest on demand deposits. Furthermore, the laws 

of many states do not deal adequately with the question of 

whether interest or principal payments can vary with changes 

in the price level. If people did enter into contracts where 

principal repayments were indexed, there would be questions 

about the enforceability of such contracts in addition to the 

fact that present tax rules do not seem clear on how such 

transactions would be reportable. For these reasons, securities 

with such provisions are difficult to market. The tax and 
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legal situation should be clarified to allow individuals to 

negotiate loans with price level adjustments if they desire. 

Even if interest rates could freely adjust, inflation will 

push borrowers and lenders into higher tax brackets. Furthermore, because taxes are based on nominal interest income, 

market interest rates would have to rise by more than the rate 

of inflation to keep borrowers and lenders in their same real 

after-tax positions. This is because the rise in interest rates 

must compensate for the taxes to be paid on the higher interest 

income as well as the inflation itself. If lenders and borrowers 

are in different tax brackets, market interest rates cannot 

adjust so as to leave both groups in the same positions as before 

the increase in prices. Thus, the real costs of borrowing and 

returns to lending may be altered with attendant effects on 

the use of debt financing. 

6. No special tax measures for other income have been 

introduced to take direct account of inflation. However, certain 

categories of income now receive preferential tax treatment, 

and this has the effect of offsetting the tendency of inflation 

to raise taxes, For example, many employee fringe benefits are 

tax exempt. Individuals owning and occupying houses do not 

have to report their implicit rental income. Interest income

from state and local bonds is exempt from Federal income taxes. 

One-half of capital gains is excluded from income taxation and 

capital gains tax payments can be deferred--without interest 
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penalty--until these gains are realized. Until the Tax Reform 

Act of 1976, unrealized capital gains at death escaped tax 

entirely. Effective 1977, this Act allows the deferral advantage to be continued indefinitely, but requires a carryover 

of the decedent's basis in the property to the heir. Also, 

special DISC (Domestic International Sales Corporation) provisions allow taxes on export income of corporations to be 

deferred--without interest penalty--on up to 50 percent of such 

income, although the Tax Reform Act of 1976 reduced these benefits 

by about one-third. Transfer income such as from social security 

and unemployment compensation programs is tax exempt as well. 

Percentage depletion partially exempts from taxation income 

from many minerals despite recent restrictions on oil a.nd gas 

depletion benefits. All these special features of tax law that 

exclude income from the tax base reduce the tendency of inflation 

to raise taxes on these preferred investments. 

It should be noted that many forms of income are now indexed. 

Congress recently placed social security benefits on an indexed 

basis. Millions of pension arrangements and wage contracts are 

indexed. However, because of the tendency of inflation to push 

people into higher tax brackets, the indexing of these forms 

of income is not sufficient to prevent effective tax rates from 

rising on constant real incomes. 
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Taxes on capital 

7. (a) Since 1942, the Federal estate and gift tax 

structure has consisted of a progressive tax on taxable estates 

exceeding $60,000and on lifetime gifts exceeding $30,000.In 

testimony before the Congress in 1976 on estate and gift taxation, 

various witnesses, including the Secretary of the Treasury, 

pointed out that 30 years of inflation had seriously eroded the 

value of these exemptions. In current dollars, comparable 

exemption levels would be about $200,000 for estates and $100,000 

for gifts. The Tax Reform Act of 1976 unifies estate and gift 

taxation and increases the value of estates and gifts not subject to tax by means of a tax credit which is to be phased-in 

over a five year period. By 1981, the level of estate and gift 

transfers which can be made without tax will be $175,625, much 

closer to the current dollar equivalent of the 1942 exemptions. 

The Tax Reform Act of 1976 also allows property used for 

farming or other closely held businesses, to be valued in terms 

of its current use rather than at its highest market value. 

While this step was taken mainly to benefit farmers and owners 

of closely held businesses, it has the side effect of reducing 

estate taxes on inflationary gains on their property. 

Property taxes in the United States are the main revenue 

source of local governments, although they are also imposed 

at the state level. These taxes are essentially proportional 
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taxes levied on the assessed value of real property and in many 

instances personal property. Localities vary greatly in assessment practices, but the tax base tends to increase generally 

with inflation. The main problem which an inflationary environment raises for property taxation is the possibility of serious 

inequities among taxpayers as a result of time lags and inaccuracies in assessment procedures and practices. 

(b) Taxes on capital make no allowances for inflation even 

when the tax base includes financial assets. 

8. Other major taxes in the United States are sales taxes 

which are imposed primarily at the state and local level and 

payroll taxes at the Federal level which finance social security 

payments and unemployment compensation. Sales taxes are proportional taxes imposed on consumer purchases, although items such 

as food, medicine, or rent are often exempted. The tax base 

tends to increase generally with inflation, but there are neither 

problems of income measurement nor of taxpayers moving into 

higher marginal brackets such as occurs with income taxation. 

Federal payroll taxes for old age and survivors insurance, 

disability insurance, and medical care are assessed on wage 

earnings subject to a ceiling and paid by both employers and 

employees. E/ As a result of changes first effective in 1974, 

there has been some form of indexing of payroll taxes in that 

the wage ceiling itself tends to rise in periods of inflation. 

Nonetheless, since not all wage income is subject to payroll 
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taxation, the effective tax rate is always lower on high-wage 

earners than on wage earners at or below the ceiling. Since 

1960, real effective payroll tax rates have been increasing 

for all wage groups. However, the distributional effects of 

the payroll tax cannot be evaluated without taking into consideration the structure of social security benefits, which generally replace a larger fraction of the earnings of a low-wage 

worker than of a high-wage worker. 

9. The ability to delay the payment of taxes otherwise 

due is fairly limited because there is a rather efficient system 

of requiring withholding and current estimated tax payments for 

both individuals and corporations. Interest is charged on 

delayed payments, and the interest rate is set at approximately 

the prime interest rate. To the extent that expected inflation 

is adequately built into the prime rate, there is little opportunity for reducing the real value of taxes by delaying payment. 

The only exception to the rule that market interest rates 

are charged for late payment arises in connection with the 

deferral of estate taxes for estates with closely held farms 

and small businesses. Prior to 1975, a 4 percent borrowing 

rate was allowed on such deferrals. Market rates were temporarily established in 1975, but under the Tax Reform Act of 1976 

the deferral privilege has been extended and a below market 

borrowing rate of 4 percent has again been made available. Such 

a below market borrowing rate reduces real tax liabilities for 
-25-

people who choose to defer payment of estate taxes, and thereby 

acts to offset the higher taxes that inflation would otherwise cause. 

10. In evaluating the effectiveness of the tax measures 

tending to offset inflation, it is important to distinguish 

between the impact of inflation on the tax structure and its 

effect on the measurement of income. Concerning the first 

problem, it seems clear that the measures which have adjusted 

the personal tax structure have been reasonably effective in 

preventing an inflation-induced rise of real tax burdens at 

low and moderate income levels, although some increases have 

occurred in the case of high-income taxpayers. 

On the other hand, while the measures which one can be 

viewed as helping to compensate for the problems of income 

measurement have provided some relief, they have often done 

so in a haphazard and unpredictable manner. Changes in these 

provisions have even increased taxes on capital income at times 

of accelerating inflation. For instance, the investment tax 

credit was suspended when inflation was increasing during 1969-

1971. In other cases, the special provisions were designed 

for purposes unrelated to inflation. That the timing of the 

enactment of these features of tax law helped to compensate 

to a degree for inflation, appears to be more an accidental 

result rather than a deliberate policy aim. 
-26-

To the extent that inflation generally causes income to 

be erroneously measured, it aggravates horizontal tax inequities. 

As noted earlier, such income mismeasurement occurs with unanticipated inflation when lenders are repaid in dollars of 

reduced purchasing power. Similarly, fixed income recipients 

generally--such as those unindexed pensions--suffer losses as 

do people holding cash balances or bank deposits. The failure 

to index depreciation deductions and nominal capital gains also 

results in the overstatement of capital income. As a consequence, recipients of such overstated capital income pay higher 

taxes than others who may be in the same real income class. 

11. Given the apparent ability of Congress to make reasoTzably good changes in the income tax structure to correct for 

inflation, it seems clear that the most needed adjustments relate 

to income measurement. Since the LIFO method of inventory valuation is presently available, depreciation, capital gains, and 

the measurement of income from financial assets remain serious 

problems. 

In the absence of impediments to interest rate increases, 

there appears to be an important distinction between capital 

income in the form of interest and that generated by depreciating 

assets and capital gains. One problem with interest income is 

that of equity since inflation tends to transfer real income 

from creditors to debtors. If inflation is not correctly 
-27-

anticipated and no indexing adjustments are made, the reisulting gains and losses will not: be taken into taxable income. 

In the longerrun, equity may be less of a problem 

$rovided interest rates can rise upwards to provide lenders 

with protection against erosion of their principal. Tn addition 

to the equity problem, if market interest rates are not responsive, incentives for continued lending will be diminished. 

More reasonable rules for measuring the income for financial 

assets may be appropriate. 

The failure to index depreciation and capital gains is 

potentially more serious. Since current tax laws link depreciation and capital gains to historic costs, there is no avenue 

of escape from higher taxes on these assets and the associated 

transfer of resources from the private sector to the government. As a consequence, in addition to considerations of equity, 

there is the further concern that higher real effective tax rates 

on income from capital may adversely affect capital formation. 

For these reasons, basis adjustments for inflation should 

be made for both depreciable assets and capital gains. However, 

in order to keep real tax burdens constant, smaller adjustments 

would be required where the tax advantages are greater under 

current law, in the absence of inflation. A matter for separate 

review is whether the existing tax advantages are appropriate. 

Of course, the case for these inflation adjustments becomes 

stronger the higher the rate of inflation. 
-28-

Although indexing is likely to involve additional costs 

of compliance, the mechanics of general price level accounting 

for correcting the measurement of business income for inflation 

have been fairly broadly tested -9/ and are capable of practical 

implementation. Neither the initial costs nor the continuing 

operational costs are likely to significantly inhibit the installation of such a system. However, further work is needed 

to develop reasonable adjustments for smaller enterprises as 

well as to investigate appropriate procedures for dealing with 

financial assets and liabilities. 

Several bills have been introduced that would adjust major 

features of the tax system as the standard deduction, personal 

exemptions, bracket widths, and withholding schedules automatically depending on movements in the consumer price index. 

Other bills have gone further and would allow automatic capital 

gains and depreciation adjustments tied directly to price index 

movements. The Treasury Department recently proposed a sliding 

capital gains tax rate such that the rate would decline with 

the length of time an asset is held, although a basis adjustment is a more appropriate way of dealing with the effect of 

inflation on capital gains income. 

yone of these measures has been adopted by the Congress. 
-29-

C. Measures to combat inflation 

Since income taxes are based on nominal incomes, and in 

the case of individual taxes, rates are quite progressive as 

well, such taxes tend to be highly elastic with respect to the 

price level. The elasticity of the individual income tax has 

been estimated to be about 1.5. 7lo/ However, there appears 

to have been no conscious effort to counter inflation by redesigning the tax system to make it more elastic. Instead, 

aggregate economic policies, on the tax as well as the spending 

side of the budget, have been used to attempt to control inflation. Particularly good examples of such a use of tax policy 

are the Revenue and Expenditure Control Act of 1968, which 

imposed a 10 percent surcharge on personal and corporate income 

taxes in 1968 and 1969, and the Tax Reform Act of 1969, which 

suspended the investment tax credit although it was reinstated 

by the Revenue Act of 1971. Recent evaluations of these measures 

have found them to be not particularly successful in combating 

inflation. -11/ 
FOOTNOTES 

-

1/ For a detailed discussion of these issues see, Henry J. 

Aaron, ed., Inflation and the Income Tax, (Brookings Institution, forthcoming); Eileen Shanahan, ed. Indexing and 

Inflation (American Enterprise Institute, 1974); William J. 

Fellner, Kenneth W. Clarkson, and John H. Moore, Correcting 

Taxes for Inflation (American Enterprise Institute, 1975). 

2/ Itemized deductions include such expenditures as charitable -

contributions, interest paid, state and local taxes, medical 

and dental expenses above 3 percent of AGI, and casualty 

and theft losses above $100, among others, 

-31 Using an analysis similar to that demonstrated in Table 3, 

Sunley and Pechman have reached essentially the same conclusion. See Emil M. Sunley, Jr. and Joseph A. Pechman, 

"Inflation Adjustment for the Individual Income," in Henry J. 

Aaron, ed., Inflation and the Income Tax, 2. -

cit.

4/ Since 1950, the combined normal and surtax rate, including - a temporary surcharge for the years 1968-1970, ranged from 

42 to 52.8 percent. 

-5/ John B. Shoven and Jeremy I. Bulow, "Inflation Accounting 

and Nonfinancial Corporate Profits: Financial Assets and 

Liabilities," Brookings Papers on Economic Activities, 1:1976, 

p. 40. 
-6/ Sidney Davidson, Clyde P. Stickney, and Roman L. Weil,

Inflation Accounting, (McGraw-Hill, 1976), p. 151. 

-7/ Adding to this controversy is the fact that many observers 

believe the whole concept of cost as the basis for financial statements should be abandoned in favor of market 

values. 

-8/ Unemployment compensation is also financed by a payroll 

tax, although with a much lower base and rate, and is 

assessed only on employers. 

-9/ See Davidson, et. al. Inflation Accounting, op. cit. 

-10/ See Joseph A. Pechman, "Responsiveness of the Federal 

Individual Income Tax to Changes in Income," Brookings 

Papers on Economic Activity, 2:1973. Elasticity, which 

is defined as the percentage change of tax receipts divided 

by the percentage change in the price level, measures the 

responsiveness of the tax yield to inflation. Thus, an 

elasticity of 1.5 means that personal tax revenues increase 

by 1.5 percent for every one percent rise in the price 

level. 

-11/ For example, see the evaluation of Alan S. Blinder and

Robert Solow, Analytical Foundations of Fiscal Policy, 

pp. 102-3, in the Economics of Public Finance, Kermit Gordon, 

ed., (Brookings Institution, 1974).