California State Income Taxes Rise Because Of Deflation; Federal Status In Question

California state income taxes are indexed to the CPI. As a result of the the recent unprecedented drop in the CPI, taxes are going up.

Please consider State taxes going up because of deflation.

California taxpayers just got hit with another increase in state income taxes, and it didn't require a vote from a single legislator.

The culprit: deflation.

In 1982, California voters approved a proposition that indexed state income tax rates to inflation. So each year, the California Franchise Tax Board adjusts tax brackets and certain deductions and credits for inflation. The annual adjustment is tied to the California Consumer Price Index, and it usually goes up. Indexing is designed to prevent people from paying higher taxes as their incomes rise proportionately with inflation. But when inflation turns negative, indexing works in reverse. Tax brackets and credits are adjusted downward. If your income remains the same, the result is a tax increase.

The Franchise Tax Board has just released adjustments for 2009, and for the first time since 1983 they are down, reflecting a 1.5 percent drop in the California Consumer Price Index between June 2008 and June 2009.

Proposition 13 limited the annual increase to 2 percent but didn't say exactly what would happen if there was deflation. The California Board of Equalization expects to announce next week whether property taxes will go down next year if the CPI is negative.

Some seniors are complaining because they probably won't get an increase in Social Security benefits next year because of deflation. Benefits are indexed each year to inflation, but by law can never go down.

Federal taxes also are indexed to inflation. Adjustments for 2009 were announced in October and were based on the change in U.S. CPI for the 12 months that ended Aug. 31, 2008. Inflation during that period was positive, so adjustments were up. It's not clear what will happen in 2010 if inflation for the 12 months ending in August is negative.

"It's likely it would be down about 1.7 percent," says Mark Luscombe, principal tax analyst with publishing company CCH. Technically, the IRS could adjust brackets down, "but there is speculation the IRS might have enough wiggle room to leave it the same," thus preventing a tax increase.

"The IRS is aware of the issue, but we are not speculating at this time," says IRS spokesman Jesse Weller.

I have the CPI at negative 6.2%, but the official CPI is -2.1%. Please see What's the Real CPI? for details.

Given that -2.1% is the largest drop since the 1950's, I do no see what "wiggle room" Mark Luscombe is talking about. Nonetheless, the IRS "refuses to speculate".

Technically there is nothing to speculate about. With a month to go, it is a certainty the CPI will be negative year over year.

Politically is another matter. Obama will not want to raise taxes on the lower and middle classes, even by a slight amount. It will be interesting to see what magic the Administration comes up with.

Mish

GlobalEconomicAnalysis.blogspot.com