The IRS announced on Tuesday inflation adjustments for more than 60 tax provisions for tax year 2023, including the standard tax deduction and the designation of tax brackets, both of which affect the vast majority of taxpayers.
These tax adjustments happen every year, but since inflation is at a nearly 40-year high of 8.2 percent, next year’s adjustments will be particularly noticeable.
The standard deduction for single taxpayers will rise 6.94 percent for 2023 to $13,850. That’s an extra $900 in tax-free income, more than double the adjustment for 2022, which was a 3.19 percent increase for a total of $400.
Tax brackets will also shift upward. The 12 percent tax bracket for 2023, which is the most common and accounted for more than a third of all tax returns in 2019 at 53 million total filings, now applies to income between $11,000 and $44,725. That’s an upward shift of just over 7 percent, compared to an upward shift of about 3.2 percent the year prior.
The adjustments follow last week’s announcement of an 8.7 percent increase in Social Security payments — the biggest shift in decades set to take effect next year.
Here are five things to know about the inflation adjustments for 2023 taxes.
The changes allow taxpayers to break even
Just like the Social Security cost-of-living adjustment (COLA), which will provide an extra $140 a month to recipients on average, the extra money resulting from the tax code adjustments really isn’t extra money. It just allows taxpayers to break even, remaining where they were the year prior for the purposes of classification by the IRS.
That’s due to inflation, which makes everything more expensive, including wages paid to workers. Average hourly wages are up 5 percent since last year to $32.46 an hour from $30.92, though they’ve been rising less quickly than prices in general for a net devaluation of 3 percent.
Inflation is showing little sign of slowing down, as it’s now been above 8 percent for seven months in a row. Core inflation, which is prices minus the volatile categories of energy and food, rose 6.6 percent in September on an annual basis. That number was the same in August.
“Ideally inflation is very low and the adjustments are low,” Robert McClelland, a former employee of the Bureau of Labor Statistics, said in an interview with The Hill. “But these adjustments make sure that people can break even.”
“People are trying to say that these things are moving up a lot so you’ll keep more of your own money, but in real terms, you’re just breaking even,” he said.
Adjustments prevent “bracket creep”
If marginal tax rates were left alone each year, experts say that inflation, which the Federal Reserve tries to keep around 2 percent in normal conditions, would cause people’s taxes to increase unfairly in what the Beltway set terms “bracket creep.”
That’s because the U.S. has a progressive income tax, which ranges from 12 percent on the low end of the spectrum to 35 percent on the high end. With inflation shrinking the value of the dollar within the domestic economy, incomes would naturally slide into a higher tax bracket and receive a higher tax rate even though personal income hasn’t actually increased.
An example provided by the Tax Foundation, a Washington think tank, illustrates this point:
“Imagine Beth has an annual income of $50,000 in 2000 and that her income grows to $75,000 by 2020. One might point out that Beth’s salary grew by 50 percent in nominal terms. However, the cumulative rate of inflation between 2000 and 2020 was about 50 percent. That means Beth’s higher 2020 salary actually buys her the same amount of goods and services in today’s economy. In other words, her purchasing power has stayed the same.”
Yanking up tax brackets every year prevents both the “inherent unfairness of paying a higher rate when you’re actually just breaking even and the government essentially raising taxes without explicitly saying that’s what they’re doing,” McClelland said.
Wages in the U.S. aren’t adjusted to keep up with inflation
Though tax brackets and some deductions are indexed to inflation, wages in the U.S. are not, meaning that employers in the U.S. are not required to offer a cost-of-living adjustment commensurate with the rising price of goods and services, though some labor unions may stipulate this in contracts with managers, experts say.
That means wages and salaries do not increase at the same rate that inflation does. In fact, inflation has actually outpaced wage growth over the last year, leading to a decline of 3 percent in real wages and perhaps taking some of the momentum out of bracket creep.
However, this lag doesn’t matter for tax adjustments, which are chained to a particular calculation of the consumer price index (CPI) known as the chained CPI. The chained CPI differs from other versions by taking into account the extent to which consumers switch between comparable goods to avoid rising prices.
Experts say that offering automatic wage adjustments for inflation would have a hard time becoming a law in the current political environment.
“To mandate that across industries and businesses, I imagine that’s something that would be pretty difficult to get Congress on board with,” Alex Durante of the Tax Foundation said in an interview. “Even indexing minimum wages to inflation, there seems to be disagreement among policymakers.”
Tax credits for the rich are adjusted upward
Tax credits affecting wealthy people are also receiving upward adjustments.
The foreign earned income exclusion is increasing to $120,000, up from $112,000 for tax year 2022. Median U.S. income is about $30,000.
For people who can afford to spend thousands of dollars a year on gifts, the gift tax exclusion will go up 6.25 percent to $17,000 for 2023, up from $16,000 in 2021.
And for the super wealthy, the estate tax for people who die in 2023 will have a basic exclusion amount of $12,920,000, up from a total of $12,060,000 for estates of people who died in 2022. That means almost $13 million of intergenerational wealth will go untaxed by the government.
Only 20,876 people filed tax returns in 2019 worth more than $10 million, according to Treasury Department figures. That’s 0.0063 percent of the population.
The earned income tax credit, which helps lower-income Americans, is rising to $7,430 from $6,935.
Not every tax credit will be revised upward
While the refundable portion of the child tax credit, which has been hailed as one of the most significant poverty reducers in U.S. tax policy, is being adjusted upward for inflation by 6.67 percent, the maximum credit of $2,000 will stay the same.
Thresholds for the net investment income tax originally passed as part of the Affordable Care Act will stay the same, as they have since 2010.
The personal exemption for tax year 2023 remains at zero, the same as 2022.
The IRS still has to release some adjustments for next year, including how much money is allowed to go into pretax contributions to 401(k) plans.