Among the big changes contained in the tax overhaul signed by President Trump last week is a little-remarked-upon provision changing the way inflation is calculated.
The new method, using the so-called “chained” consumer price index to determine when to adjust tax brackets and eligibility for deductions, is expected to push more Americans into higher tax brackets more quickly. In the past, the tax code used the traditional CPI measure issued by the Labor Department each month.
By switching to this new method, the government will bring an additional $134 billion into federal coffers over the next decade, according to the Joint Committee on Taxation.
How will that happen?
It comes down to this: The chained CPI makes inflation appear lower, and that means tax brackets will be adjusted upward more slowly — but lots of workers will continue to get raises based upon the faster-rising traditional CPI. In other words, your income may rise faster than the inflation adjustments, forcing you to pay taxes at a higher rate — even though you may not feel any richer.
“Compared to where taxpayers would be under present law, by 2027 most individuals will actually pay more taxes,” said Steve Rosenthal, senior fellow at the Urban-Brookings Tax Policy Center.
The difference will be slight, perhaps just a few tenths of a percentage points a year, he says — “but over time, these fractions of a percentage point add up and can amount to a fair amount of money.”
Since 2000, the traditional CPI has increased by 45.7 percent, while the chained CPI has risen only 39.7 percent, a difference of 6 percentage points, according to the Tax Policy Center.
And unlike other parts of the bill that expire over time, such as the tax cuts for individuals, this new inflation measure will last indefinitely.
Since the 1980s, the government has been indexing tax rates to inflation, to prevent “bracket creep” — the steady movement of more and more taxpayers into higher tax brackets. For example, the income threshold for the top marginal tax rate of 39.6 percent rose from $415,050 in 2016 to $418,400 in 2017.
“These adjustments prevent taxpayers from being pushed into higher tax brackets when their incomes rise just enough to keep up with inflation,” according to a report from the Brookings Institution.
To calculate inflation, government officials use the Labor Department’s long-running CPI rate, which measures fluctuations of prices of specific products over time.
“The usual way to do an index for inflation is to look at a basket of goods, see how much it costs you in, say, 2016, go back, get the next basket of goods and see what it costs you in 2017, and compare the same basket over two years,” says Douglas Holtz-Eakin, former director of the Congressional Budget Office. “Unfortunately, when prices for goods go up, people tend to purchase less of them.”
Translation: When beef gets expensive, shoppers buy fewer steaks and more chicken breasts.
Chained CPI is calculated by the Labor Department to account for these real-world purchasing decisions, by factoring in the kinds of product substitutions consumers make in the real world.
This alternative inflation measure is seen by many economists as more accurate. The administrations of George W. Bush and Barack Obama proposed switching to chained CPI as part of a broader tax reform.
“What the tax-reform bill does is actually just substitute what everyone agrees is a more accurate measure of inflation for the old measure,” says Holtz-Eakin, president of the American Action Forum.
David Kamin, former special economic adviser to Obama, says the use of chained CPI may make some economic sense but needs to be put in context.
“It’s one thing to put in chained CPI if you think that it’s going to go toward actually helping working families in the long run,” says Kamin. “It’s another thing if you’re doing chained CPI in order to pay for a permanent corporate tax reduction.”