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The sketch of a tax plan released last week by President Trump and the congressional Republican leadership quietly includes one provision that could raise taxes on many middle-income households: It would change the way the tax code is indexed for inflation.
The adjustment is technical and obscure. But by using a less generous—though perhaps more accurate-- measure of inflation, it would result in people paying higher income taxes than under current law.
While the change would be barely noticeable for the first few years—it would raise less than $5 billion in 2018 and 2019 combined--over time it would result in a major tax increase. From 2018-2027, it would boost federal revenue by $125 billion and from 2028-2037, it would increase revenue by nearly $500 billion, making it one of the biggest revenue-raisers in the entire outline in that second ten years.
Here why: For years, the tax code had a structural problem known as “bracket creep.” In effect, as people’s incomes rose, in part due to inflation, they’d move into higher tax brackets. Even though their real incomes didn’t rise, they pay higher taxes. To avoid the problem, Congress changed the law so the IRS now adjusts the brackets each year to reflect inflation. For example, in 2016 a single person paid a 25 percent rate on taxable income between $37,650 and $91,150. In 2017, the 25 bracket doesn’t begin until taxable income reaches $37,950 and it runs up to $91,900.
With current inflation so low, the one-year change is modest. But over time, thanks to the magic of compounding, even small annual changes add up. And if inflation rises to something closer to historical levels, the effects would be even more significant.
Two big changes
The code doesn’t only index tax brackets. Some other provisions, including the standard deduction, the personal exemption, Earned Income Tax Credit, and the Alternative Minimum Tax, are also indexed for inflation.
Last week’s Republican plan would make two big changes in this inflation-adjusted world. First, it would repeal the personal exemption, which is indexed for inflation, and partially replace it with a bigger Child Tax Credit, which currently is not. While the higher CTC would help many families today, inflation would erode the additional benefit over time.
More importantly, the outline would revise the way the tax code measures inflation. Today, it uses the Consumer Price Index for urban consumers (the CPI-U), a measure the government nearly always uses to adjust for price changes. The GOP framework would shift to an index known as chained CPI (C-CPI). This initiative parallels long-standing Republican efforts to make the same change for Social Security and other government benefit programs.
Apples and oranges
Many economists believe that chained CPI more accurately reflects inflation by accounting for the way consumers respond to price changes. The classic example: If the price of oranges rises, consumers may buy more apples. Chained CPI does a better job reflecting that change, though it has some disadvantages as well. If you want to know more, here is a nice explanation by my Tax Policy Center colleague Rob McClelland, written when he was at the Congressional Budget Office.
But the bottom line is that chained CPI is consistently lower than traditional CPI-U. Using chained CPI may result in a more accurate inflation adjustment, but it would also raise taxes for many since those indexed provisions of the Tax Code would be less generous over time than under today’s methodology.
And that means people would pay higher income taxes than under current law. It would especially hit low- and moderate-income households that rely on the EITC and standard deduction, but it would affect all taxpayers in some way. And unlike proposals to repeal, say, itemized deductions, people might not notice this hidden tax increase for years to come.
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