What Adjusting the Price Index Would Mean for Taxpayers
President Obama and House Speaker John Boehner may be close to agreeing on a plan that, among other things, would revise the way government programs are adjusted for inflation. Most attention is focused on what this means for Social Security recipients. But the Tax Policy Center estimates that changing the cost-of-living measure would also result in a gradual tax increase for many households that would average about $140 a decade from now.
Before delving into the substance, I can’t help but note one delicious irony. Three decades ago, Ronald Reagan fundamentally changed the nature of the income tax by mostly ending what was called bracket creep—the phenomenon where people would slip into higher tax brackets as their incomes rose with inflation. Reagan convinced Congress to stop this by indexing tax brackets by the Consumer Price Index (CPI). Now, at the insistance of Republicans, Obama seems to have agreed to open the door to a bit more bracket creep.
So what’s this all about? At its heart is a technical argument about what measure of inflation best captures the fact that people respond to price changes. The model that Congress may adopt assumes that people adjust their behavior when prices rise (or fall). So, if beef gets more expensive, they buy chicken.
By buying the less expensive fowl, a shopper’s cost of food does not go up as much as it would if he stuck with beef. As a result, the rate of food inflation is a bit less than otherwise. While the traditional CPI reflects some of this, another version, called chained CPI, may do a better job.
At first, this is one of those arguments only economists could love, except for the real world consequences: Taxes and government benefits are adjusted each year to account for cost-of-living changes, and the way those are measured directly affects taxes and benefits.
Adjusting Social Security this way would reduce projected benefits by about $100 billion over a decade, according to a 2010 Congressional Budget Office analysis. CBO estimates that shifting to chained CPI would increase revenues by about another $100 billion over 10 years. And keep in in mind that, because inflation compounds, those cost savings and revenues will gradually but inexorably grow.
What would chained CPI mean for taxpayers? The Tax Policy Center, in a 2011 analysis, projected such a shift would boost taxes by an average of about $140 in 2021 under a current policy baseline (where today’s tax rules remain in place). Compared to current law, (that is, where all the 2001-2010 tax cuts expire), it would raise taxes by about $75.
About three-quarters of households would see their taxes rise relative to current policy. Those making $30,000-$40,000 would face the biggest percentage cut in after-tax income—about 0.3 percent on average.
While nearly all those at the top would pay higher taxes, they’d see only a very small change in after-tax income on average—only about 0.1 percent.
Stepping away from the highly-charged deficit debate, chained CPI seems to be a better measure of inflation. Shifting to that model makes some sense. But it would result in higher taxes for tens of millions of households, all else equal.