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How will tax reform affect you?

February 8, 2018

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CPI and Chained CPI: What's the difference?

March 21, 2018

 This week we will take a break from lists of deductions to break down a specific concept: chained CPI.  Many readers and taxpayers will be familiar with the Consumer Price Index, or CPI. The CPI is a measure of inflation that watches price changes in a set “basket of goods” over time. As a gallon of milk rises in price from a dollar in the 1970s to over three dollars today, the CPI reacts appropriately and gives legislators a statistic to measure how much cost of living rises or falls.

Chained CPI seems at first like a slightly different statistic. The basics remain: changes in the same basket of goods and services as CPI, reported every month by the US Department of Labor. However, chained CPI also accounts for “substitution bias,” or the idea that as a product rises in price consumers switch to similar substitutes; if apple juice increases in price by a dollar, consumers will turn to grape juice. In this way, the full effect of the inflation of apple juice is not felt by consumers, even if the standard CPI would suggest so. This likely makes chained CPI a more accurate measure of cost of living and does not overestimate inflation as some other measures might.

Why is this important in a series on the tax reform bill? Because Congress previously used the CPI as the basis for adjustments to income tax brackets. As people’s income increased with standard inflation, the tax bracket increased as well based on the CPI to match that rise and keep taxpayers in the same brackets. However, as the new chained CPI is a lower measure of inflation those brackets will now rise more slowly. Bracket increases will not match standard inflation, and more taxpayer income will slowly get pushed into higher tax brackets.  Over the course of decades, the effect will become more pronounced, but for now, Congress views this as a sound way to reduce the deficit.
 

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