EXPLAINER | What is bracket creep?
- Bracket creep occurs when marginal tax rates are not adjusted for inflation.
- If your income increases with inflation and tax brackets are not adjusted, more of your income is taxed at a higher rate.
- Bracket creep causes your effective or average tax rate to increase.
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Bracket creep is a term that is used to describe an increase in taxes that occurs when the marginal tax brackets are not adjusted annually for inflation.
Each year, your salary or income needs to increase to keep up with inflation or else you will be able to buy less with what you earn. If your income does not increase by at least inflation, your real or after-inflation income decreases and you have less buying power.
When it comes to income tax, you pay based on your marginal tax rate. This means that you pay tax at a rate that depends on which income bands or tax brackets your income falls into.
The lowest tax rate applies to the first band. You start paying tax at that rate, but the income that falls below the tax threshold is not taxed.
If your income increases with inflation, but there is no increase in either the tax threshold or the tax brackets or income bands for the different tax rates, a higher proportion of your income will creep up the brackets, with a greater proportion of it being taxed at a higher marginal tax rate. This will slowly increase your average tax rate or effective tax rate.
To avoid bracket creep, the tax threshold, and tax brackets all need to be adjusted each year for inflation.
Policymakers often decide not to adjust for inflation or not to adjust fully for inflation in order to raise more income tax.
How it works
Sam’s tax rate is 0 percent on the first R120 000 he earns and 10% on the next R120 000 he earns. Sam will pay R12 000 in tax for the year. If SAM is employed, this tax will be deducted as R1 000 a month.
Sam’s average tax rate is R12 000/ R240 000 x 100 = five percent even though Sam’s marginal tax rate is 10 percent.
But if Sam’s income increases by five percent to R252 000 and the tax brackets stay the same, Sam’s tax will be:
R0 on the first R120 000
R12 000 on the next R120 000
R1 800 on the remaining R12 000.
In total Sam will pay R13 800 in tax for the year or R1 150 a month.
Sam’s average tax rate is now calculated as follows: R13 800 / R252 000 x 100 = 5.47 percent
Sam is paying more tax even though Sam’s income has increased only by inflation – in other word’s Sam’s real income or buying power remains the same.
The increase to compensate Sam for inflation resulted in Sam’s income creeping up into another tax bracket and pushed Sam’s tax liability or the proportion of income paid in tax, higher.
Tax by stealth
Bracket creep and the failure to increase other monetary tax thresholds and exemptions is also sometimes referred to as increasing tax by stealth.
In addition to the tax brackets, there are a number of ways in which the failure to increase thresholds and exemptions increases taxes.
For example, a failure to increase the estate duty exemption will slowly increase the number of estates that exceed the limit and become liable for estate duty.
A failure to regularly increase monetary limits on deductions, such as the maximum amount you can deduct for contributions to a retirement fund, also increases taxes.
This article was written with the help of Keitumetse Sesane, Strategic Lead for Stakeholder Engagement and Legislation at the South African Institute of Taxation
This article was first published on SmartAboutMoney.co.za, an initiative by the Association for Savings and Investment South Africa (ASISA).
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