Should Congress Cut the Deficit By Changing the Way it Indexes Taxes for Inflation?

By :: July 7th, 2011

Should Congress use a new measure of inflation to index the tax code? It sounds awfully technical—and it is—but shifting to what most economists believe is a more accurate measure of inflation would gradually raise a substantial amount of new revenue for politicians scrambling to find ways to cut the deficit.

The idea has surfaced in the high-stakes budget negotiations between President Obama and Congress. Government would adopt something called the chained consumer price index (CPI) to adjust programs to reflect changes in the price of goods and services.

The proposal isn’t new—it has been kicking around for decades and appeared last year in budget plans offered by both President Obama’s fiscal commission and the Bipartisan Policy Center.  And it would not only apply to taxes—indeed the most controversial change would affect Social Security benefits. But this is TaxVox, so let’s take a closer look at what this revision would mean for taxpayers.

The income tax is littered with provisions that are indexed for inflation, including the standard deduction and personal exemption, the earned income credit and the refundable child credit, and IRA contribution limits. In addition, the tax brackets themselves have been indexed for inflation since the Reagan era. This important feature prevents bracket-creep, where taxpayers pay higher rates just because their nominal (rather than real, inflation-adjusted) income rises.

Shifting to a chained CPI index would achieve two goals. It would fix a vexing problem with the traditional measure of inflation: The CPI does not reflect the fact that consumers respond to higher prices for one product by substituting another. For instance, if strawberries are very expensive at the farmer’s market this week, I may buy cheaper blueberries instead. And, let’s not kid ourselves, the other purpose is to scrounge some new tax revenues without seeming to raise rates or end popular subsidies.

The Congressional Budget Office figures chained CPI would grow at an average annual rate of 0.25 percent less than the traditional CPI. And the Joint Committee on Taxation projects this change would produce about $60 billion in new tax revenue from 2012 through 2021. But keep in mind that the cumulative decline in measured inflation gradually raises more and more revenue. So while the shift would boost taxes by only about $2 billion in 2014, it would generate more than $12 billion in 2021.

Who’d pay? New estimates by my Tax Policy Center colleague Rachel Johnson suggest that average after-tax incomes would fall by a small amount across the board. Those making less than $10,000 would see no change on average, while those making $500,000 or more would see their incomes fall by 0.1 percent. Everyone else, on average, would end up with 0.2 percent or 0.3 percent less, although those making $30,000 to $40,000 would be hit the hardest.  For all households, the typical tax bill would be about $150 higher in 2021 than it is today.  Her estimates all assume the 2001/2003/2010 tax cuts are extended.

Overall, shifting to the chained CPI seems to be a sensible technical change that is long overdue. But it is little more than a back-door rate increase. I’d much rather see a substantial revenue package that eliminates inefficient tax subsidies.