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Changing Inflation Measure Sets Stage for Higher Taxes

The new tax law adjusts how provisions are, or aren't, indexed--meaning higher real rates are ahead.

As Congress put together the Tax Cuts and Jobs Act, it needed a way to keep the costs of a package full of tax cuts to $1.5 trillion over 10 years to satisfy some members of the Republican caucus and to avoid running afoul of procedural rules. One way it did this was by setting many of the provisions to expire in 2026. But Congress also built in a slow series of tax increases by changing the way many features of the tax code are adjusted for inflation--and it made this new, future tax increase permanent.

Going forward, instead of adjusting for inflation with the traditional measure--the consumer price index for all urban consumers--Congress will use "chained CPI." The bottom line on chained CPI is that government scorekeepers expect it to grow about .25% slower than traditional CPI. When applied to features of the tax code, the shift to a slower measure of inflation increases taxes more than in the past, when Congress designated the traditional measure of inflation as an adjuster.

For example, consider the effect of slowing the growth of the tax brackets. Under the new law, the cutoff between tax rates--usually called the bracket--grows more slowly, meaning more income is taxed at higher rates than it would be if the tax code still used the traditional measure of inflation.  

What Is Chained CPI?
To understand chained CPI, we need to understand how the Bureau of Labor Statistics calculates the traditional measure of inflation. In short, the agency surveys people to find out what they spend money on, and then goes out and sees how the prices of these goods have changed.

However, the things people spend money on change over time faster than the agency accounts for these changes. Further, people may respond to price increases by substituting one item for another. Both problems would tend to overstate the average rate of inflation.

The chained CPI attempts to correct for these problems by 1) using more recent expenditure surveys to determine what people buy; and 2) trying to account for how consumers respond to changes in prices. In its methodology paper, the agency provides an example: if the price of beef goes up but the price of chicken doesn't, many people will react by eating more chicken and less beef, reducing the increase in their costs of food. The chained CPI captures this shift in consumer behavior, whereas the traditional CPI measure does not account for this "substitution bias."

The Bureau of Labor Statistics has been producing the chained CPI since 2000, and economists there believe it is a better measure of inflation. They may well be right on average, but that does not change the fact that using it in the tax code amounts to a tax increase over time.

What's Covered and what's Not?
There seems to be a lot of confusion on this point, and that's understandable. I count more than 50 parts of the tax code with adjustments for inflation that are moving to chained CPI (for the truly curious or for people having trouble sleeping, see Sec. 11002). But let's cover the big changes.

The brackets are now indexed for chained CPI, and so is another big item: the standard deduction. Rates will rise faster than they would with traditional CPI, and people will shield less of it from taxes.

For investors, a big change is that the income limits for traditional and Roth IRAs are now indexed to chained CPI, gradually reducing the eligibility for tax-favored contributions to these vehicles. The contribution limits themselves will also grow at the slower chained CPI rate. 

Similarly, the contribution limits for health savings accounts will also grow at a slower rate, which surprised many tax experts because Congress has been flirting with expanding (rather than contracting) HSAs for a few years and never pulled the trigger.

Critically, 401(k) contribution limits are not changed by the bill--at least not directly. The Treasury Department still has authority to set the inflation rules and publish new limits on the amounts people can contribute. However, it appears it could adopt chained CPI on its own by changing its methodology.

Similarly, Social Security benefit calculations were not adjusted. Some have argued that this introduction of chained CPI in the tax code means it is a matter of time before Social Security benefits are reduced. However, the logic of applying chained CPI to benefits for the elderly--whose spending is tied more to healthcare costs than anything else--is dubious, particularly since healthcare costs grow faster than regular CPI. Further, since Social Security cannot be adjusted with the procedural move the Senate majority used to implement tax reform, it needs 60 votes to clear a filibuster. Since chained CPI is already law, it would appear there is no more room for the "grand bargain" the last administration floated: raising taxes and reducing benefits with one chained CPI bill.

Perhaps lost in all of this, however, is that Congress did not include an inflation adjustment for two major features of the new code, setting up real increases in taxes every year after 2018. Specifically, the expanded child tax credit (which is now $2,000 for most families) is never scheduled to increase. This means that its value will substantially erode in "real" dollars over time. Similarly, the $10,000 cap on deducting state and local taxes is also not indexed, greatly reducing the already reduced benefit of deducting state and local taxes.

Finally, although many provisions in the new tax code expire, the new inflation adjuster does not. Indeed, although current law snaps us back to the 2017 tax system in 2026, that system will have been adjusted using chained CPI, greatly reducing the tax-saving values of the standard deduction and personal exemption (which is not in the new tax code) while pushing many people into higher brackets. All of which is to say, this change is a permanent, yearly increase in taxes unless a future Congress undoes it.