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Tuesday’s Consumer Price Index report had some important implications for taxpayers. To offset recent increases in the CPI, the incomes that taxpayers can earn before moving into higher tax brackets will be roughly 1.7 percent higher next year. For married couples, for example, the first $18,150, rather than $17,850, of income will be taxed at the bottom 10 percent rate, before moving into the 15 percent bracket. Numerous tax breaks will also be marked up by about 1.7 percent. Next month’s CPI report will pin down the cost-of-living adjustment for Social Security and certain other entitlement programs. That adjustment, computed using different months and a slight variant of the CPI, is expected to come in at or around 1.5 percent.
These annual adjustments are intended to prevent inflation from pushing taxpayers into higher brackets and to maintain the buying power of benefit checks. But, there’s a problem – the adjustments are based on a price index that overstates the true inflation rate. The excessive adjustments lower tax revenue and increase entitlement spending, adding to the deficit. Switching to an alternative price index known as the chained CPI would make the inflation adjustments more accurate and, more important, would help narrow our nation’s long-run fiscal imbalance.
Economists have long known that the traditional CPI exaggerates the true increase in consumers’ cost of living because it doesn’t fully reflect consumers’ ability to change their buying patterns when prices rise. For example, consumers can partially avoid the impact of rising beef prices by substituting chicken for beef. The Bureau of Labor Statistics began publishing the chained CPI in 2002 as an alternative measure that better accounts for consumers’ responses to rising prices. Yet, Congress continues to base the annual tax and benefit adjustments on the traditional CPI.
If we were to adopt the chained CPI now, the upcoming tax adjustment would be lowered by 0.17 percentage points and the upcoming Social Security adjustment might be trimmed by 0.2 percentage points. Of course, that would be just the beginning, as similar trims in future years would cumulate to yield big differences over time.
Using a more accurate inflation measure would better align the tax and benefit adjustments with their stated goal of offsetting the increase in the cost of living. But, the chained CPI’s technical accuracy is not the best argument for moving to it. The strongest argument is that the chained CPI would offer a bipartisan way to reduce entitlement benefits and raise taxes, steps that are needed to address our nation’s unsustainable long-run fiscal outlook.
If we were on a sustainable fiscal path, there’d be little reason to change the price index. In that environment, we might even welcome adjustments that overstate inflation. Letting retirees’ benefits rise faster than inflation as they age might be a useful way to focus benefits on older retirees, who tend to be poorer and have higher medical costs. And, larger tax adjustments would protect taxpayers from being pushed into higher brackets when their incomes rose faster than inflation due to normal economic growth.
Unfortunately, we’re nowhere close to a sustainable fiscal path, as the Congressional Budget Office reminded us on Tuesday, soon after the inflation numbers came out. Despite recent short-run budget improvements, CBO warns that the federal debt will explode from 73 percent of annual GDP today to 190 percent in 2038 under its extended alternative fiscal scenario. While we work toward the fundamental reforms that will ultimately be needed to put our fiscal house in order, we should be on the look-out for modest steps that combine benefit cuts and tax increases in ways that can win bipartisan support.
Enter the chained CPI, which has won support across the political spectrum, including from some who normally reject benefit cuts and some who normally reject tax increases. The Bipartisan Policy Center, the Committee for a Responsible Federal Budget, the Center on Budget and Policy Priorities, the Wall Street Journal editors, and the Washington Post editors have endorsed a switch to the chained CPI under various conditions. Also, President Obama embraced the idea in his most recent budget plan.
Moving to the chained CPI would show up on both the spending and tax sides of the ledger. Even after adding sensible protections for the poor and the oldest retirees, the president’s proposal would cut benefits by $130 billion over the next decade, while also pulling in $100 billion of extra revenue. The budgetary impact in the following decade would likely be three times larger, as the annual reductions continued to cumulate.
Moving to the chained CPI is not the perfect textbook way to change the annual tax and benefit adjustments – a different approach would probably be chosen in the ivory tower. But, if we’re looking for practical steps to chip away at the long-run fiscal gap, the chained CPI is a good place to start.
Alan D. Viard is a resident scholar at the American Enterprise Institute. He is the co-author of the just published Progressive Consumption Taxation: The X-Tax Revisited.
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