You Decide: Will the New Tax Law’s Inflation Measure Cost You?

By Dr. Mike Walden

The new federal income tax law is chock full of changes, alterations and adjustments that are keeping taxpayers, accountants and economists spending hours trying to understand it. It appears almost nothing has remained the same.

A good example is the inflation measure used to make annual adjustments to tax brackets, standard deductions and some other tax elements. “Whoa”, you say, “back up, start over and speak English, not in bureaucratic lingo!” You’re right, so let me go to the beginning.

Decades ago, a big issue in the tax code was something dubbed “taxflation.” Taxflation arose from the fact that the income a person pays tax on – called “taxable income” – is broken into several ranges – called “tax brackets” – with each range taxed at a different tax rate. Tax brackets with higher incomes are taxed at higher rates.

For example, in the new tax plan, there are seven tax brackets. Using married couples as an example, the lowest tax bracket is for taxable income from zero to $19,050. This taxable income is taxed at a 10 percent rate. The second bracket is for taxable income from $19,051 to $77,400.   This taxable income is taxed at a 12 percent rate. There are four more tax brackets until the top bracket is reached of taxable income above $600,000, which is taxed at a rate of 37 percent.

Taxflation was a term coined to indicate how inflation could push a taxpayer into higher tax brackets, therefore causing them to pay more in taxes, even though the taxpayer was not effectively earning more in purchasing power. For example, say the inflation rate is 10 percent, meaning, – on average – prices rise by 10 percent. Also assume the taxable income of Jane and Joe Smith increases by 10 percent. Jane and Joe Smith aren’t better-off. Their income is 10 percent higher, but so are the prices of what they buy.

However, prior to the early 1980s, the income tax system only recognized Jane and Joe Smith’s higher taxable income. The tax system didn’t factor in the fact that, once accounting for inflation, Jane and Joe Smith’s purchasing power hadn’t changed. Public dissatisfaction with this situation reached a boiling point in the late 1970s and early 1980s when the annual inflation rate was over 10 percent for three consecutive years.  

Relief came in 1985 when tax brackets were first adjusted for inflation. How was this done?  Very simply – the endpoints for each tax bracket were increased by the inflation rate. Take the first two tax brackets mentioned above – the zero to $19,050 bracket taxed at a 10 percent rate, and the $19,051 to $77,400 bracket taxed at a 12 percent rate. If 10 percent inflation occurs, then the first bracket becomes zero to $20,955 ($19,050 x 1.10), and the second bracket becomes $20,956 ($19,051 x 1.10) to $85,140 ($77,400 x 1.10). Taxflation was ended!

That’s the background. Today’s issue is not over keeping the annual adjustment of tax brackets for inflation – that is staying. Rather the issue now is about the measure of inflation to use in adjusting the tax brackets.  

Since the adjustment to tax brackets was begun over 30 years ago, a measure of inflation based on what consumers buy has been used. It’s called the Consumer Price Index, or CPI. This measure is drawn from monthly surveys of 85,000 items in 22,000 stores. Changes in prices of each item are weighted by the relative importance of that item in the typical consumer’s budget.  So, for example, changes in the price of a gallon of gas receive a larger weight than changes in the price of a can of peas.  

In the CPI calculation the government also tries to adjust for quality changes in products. For example, when power brakes were added as standard equipment to most vehicles, this increased average vehicle prices. Since this was an additional cost for an improved product, the government did not include the cost of the power brakes in the inflation rate for the year the brakes were introduced.

Some economists have long argued the CPI still overstates inflation. How? By not adjusting for the fact consumers will respond to a price increase in one product by shifting some purchases to substitute products with smaller price increases. If the price of beef rises more than the price of pork, consumers will begin buying less beef and more pork. If the CPI assumes consumers continue buying the same quantity of the more expensive beef, the actual inflation rate experienced by consumers would be overstated.

The government has developed a version of the CPI – called the “chained CPI”, or C-CPI for short – that incorporates the expected changes in purchasing habits when prices change at different rates. Importantly, the new tax law mandates the C-CPI as the inflation rate to be used for adjusting tax brackets. It’s estimated the C-CPI averages about one-quarter percent less than the regular CPI. This means tax brackets won’t be adjusted quite as much, which also means people will pay slightly more federal income taxes in future years using the C-CPI than the CPI.

The change in the inflation measure was made in the name of accuracy.  But when accuracy costs each of us a little more in taxes, is that a good thing? You decide!

Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook, and public policy.