High rates of inflation are causing major changes in the Virginia personal income tax. There has been no legislated tax increase since 1972. But, inflation, by eroding the real value of exemptions and deductions and lowering real bracket boundaries, has caused an increase in effective tax rates. Inflation thus results in automatic, unlegislated tax increases.

Inflation also distorts income from capital gains and business enterprise. Capital gains are overstated because the original price of an asset is not adjusted to its value in current dollars. Depreciation based on historical cost understates replacement cost. When costs are understated, income is exaggerated, and taxes are higher.

"Indexation" is the term for a procedure used to neutralize the effect of inflation on an income tax structure. Six states and Canada now have some form of indexation and several more states are considering it.

This paper covers the following topics on indexation:

l. How indexation distorts the personal income tax structure.

2. The mechanics of indexation of the personal income tax.

3. The effect of indexation of the personal tax on tax burdens by income class.

4. How inflation reduces the progressivity of the personal income tax.

5. The revenue impact of indexing the personal income tax.

6. How inflation distorts the taxation of capital gains and business income.

7. A description of indexation in other states and Canada.

8. Pros and cons of indexation.

The major findings of the paper are summarized below:

• Indexing will not prevent dollar taxes from rising with inflation; it will merely remove-the increase in effective tax rates due solely to inflationary pressures on income.

• Indexing lowers tax liabilities for all income classes but has the greatest relative impact for lower income classes.

• The progressivity of the Virginia personal income tax has been greatly reduced because of inflation. Indexation would eliminate future reduction due to this cause.

• Indexation would slow the growth in state personal income tax revenues.

• With indexation, growth would exceed the rate of inflation only if real personal income grew. Indexation would not keep state income tax revenue from growing with inflation, but from growing much faster than the price level as it currently does. Indexation would not remove the progressivity of the income tax; as real personal income increased, an indexed income tax system would take a larger and larger share of that income.

• If indexing were instituted beginning in the next fiscal year, the cost in terms of foregone revenue would be large because of present and forecast high rates of inflation. Crude estimates of the reduction are $46.8-106.2 million in 1980-81 and $91.8-198.7 million in 1981-82.

• Although it is easy to demonstrate how indexation would correct distortions in the taxation of capital gains and business income, the necessary information to compute the revenue impact is not available.

• The major arguments for indexation are: (1) it eliminates unlegislated tax increases due to inflation; (2) it promotes tax equity by removing inflation as a factor in reducing progressivity; and (3) it serves as a brake on government expansion by causing a slowdown in the growth of revenues.

• The major arguments against indexation are: (1) "we can't afford it;" (2) indexation would be expensive and complicated to implement; (3) the rapid growth of government costs requires the revenue stimulus provided by an unindexed system; and (4) the consumer price index (the most likely index that would be used to measure price changes) overstates inflation. Each of these arguments is rebutted.