The tax law that became effective Jan. 1 makes many changes to federal personal and corporate taxes including one that has received little attention but could have a major and widespread impact long term. It has to do with how tax provisions are indexed for inflation.
Under the new legislation marginal personal tax rates, tax credits and the standard deduction, which was doubled are indexed to inflation using the Chained Consumer Price Index for All Urban Consumers, or C-CPI-U, instead of the more traditional CPI-U.
The chained CPI, like traditional CPI measures, tracks the prices of a basket of goods and services but adjusts for changes in purchases as consumers substitute cheaper products and services for more expensive ones. As a result, the chained CPI usually rises more slowly than the traditional CPI measure.
Linking tax brackets to the chained CPI means taxpayers will move more quickly into higher brackets as their incomes rise, but the tax credits they receive and standard deduction they take will rise more slowly. And many more taxpayers are expected to take the standard deduction due to the elimination of many itemized deductions and limits on others such as the state and local tax deduction.
Tax experts David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution, and Howard Gleckman, a senior fellow at the Tax Policy Center, say the inclusion of the chained CPI as an inflation index in the new tax legislation is the first federal government use of the index that they know of. Both expect its usage will likely grow over time.
“Someday, Congress will move to restrain spending on federal retirement and health programs,” says Wessel. “When that happens, using the chained CPI to adjust benefits for inflation surely will be an option high on the list; using it for tax brackets makes that a bit more likely.”
Mary Johnson, Social Security and Medicare policy analyst at The Senior Citizens League, is concerned that the chained CPI could become the index used to set the Social Security cost of living adjustment (COLA), which is currently linked to the CPI-W, for Urban Wage Earners and Clerical Workers, a subset of the CPI-U that tracks retail prices as they affect urban hourly wage earners and clerical workers.
Rep. Sam Johnson (R-Texas), a member of the House Ways & Means Committee and chairman of its Social Security Subcommittee, proposed just that in his Social Security Reform Act of 2016.
So did President Barack Obama in his 2014 federal budget proposal, but he dropped it the following year, and Gleckman suspects there will be another effort to index the Social Security COLA to the chained CPI. The result would be a decline in Social Security benefits.
Gleckman “suspects” that since the chained CPI is included in the latest tax legislation there will be another effort to index the Social Security COLA to the index.
Johnson calculated the impact of using the chained CPI as the basis for the Social Security COLA, starting with a benefit of roughly $1,300 in 2017, indexed to a chained CPI that is 0.2 percentage point lower than the CPI-W, which is often the case but not always. Over a period of 30 years, the retiree would collect $20,000 less in benefits than she would have if the CPI-W was used, according to Johnson’s calculations.
“The difference looks small, but over time the impact compounds,” says Johnson.
She and others would prefer that Social Security COLAs be tied to the CPI-E, an index focused on the expenses of those 62 years and older, which more heavily weights expenses for health insurance and health care services and prescriptions. The BLS has been calculating the CPI-E for many years but still calls it “experimental.” Its data shows that a Social Security COLA indexed to the CPI-E rather than the current CPI-W index would increase the COLA by 0.2 percentage points.
Johnson would also like to see the income thresholds for taxing Social Security benefits indexed to inflation. Since 1984, single recipients with a modified adjusted gross income of $25,000 or more and couples filing jointly with an AGI of at least $32,000 must pay income taxes on a sizable portion of their Social Security benefits — 50% or 85%, depending on income. Those thresholds haven’t changed in over 30 years. The Social Security Administration projects that an average 56% of recipient families will owe federal income tax on part of their benefit income from 2015 through 2050.
— Related on ThinkAdvisor:
- How Tax Bill Impacts 4 Key Areas for Advisors & Clients
- 4 Year-End Tax Tips as Overhaul Looms
- 4 Last-Minute Tax Strategies for Clients in High-Tax States