The new Tax Cuts and Jobs Act changed both personal and corporate income taxes. Much of the discussion has focused on the changes in the tax rates, but there’s another change in this law that has an effect on personal income tax. A household’s tax obligation depends on the income bracket for their earned income. For example, a married couple earning $77,000 faces a tax rate of 12% on all income over $19,050. The next bracket starts at $77,400. While the new tax code decreased the tax rate, another change that has received less attention deals with how the tax brackets are adjusted over time. Economists argue that the income brackets should be adjusted when prices change. If the household in this example received a 3 percent cost-of-living increase, their new income level would be $79,310. Despite their inflation-adjusted income level not changing, this household would now fall in the next income bracket and face a 22% tax rate on income over $77,400. If the tax brackets were adjusted for the increased inflation, the marginal rate would not change. This is referred to as indexing the tax brackets.
The Act continues to adjust the tax brackets for price changes, as did the prior personal income tax legislation. The difference is the price index used to adjust those tax brackets. The previous tax code used the CPI-U measure to adjust the brackets, while the new code uses the C-CPI-U measure. The first measure, the consumer price index for urban consumers, assumes you purchase the same quantity of each good in the CPI basket over time. In contrast, the C-CPI-U, or chained consumer price index for urban consumers, recognizes that individuals can shift their expenditure patterns toward cheaper goods in the same expenditure category. For example, suppose chicken prices increase while turkey prices remain unchanged. The CPI-U implicitly assumes individuals continue to buy the same quantity of chicken. In contrast, the C-CPI-U recognizes that consumers will see the price change and substitute turkey for chicken. As a result of this expenditure shift, the price change is less. In the graph, these two price indexes are shown for the period 2000 to 2017 and indexed so that both equal 100 in 2000. The prices in the C-CPI-U index increase at a slower rate because individuals can shift their purchases toward cheaper substitute goods.
The choice of CPI measure has consequences. As shown in the graph, C-CPI-U implies smaller price increases than the CPI-U. This means the tax brackets will have smaller adjustments and more individuals will fall into the higher tax brackets and pay more taxes. If social security payments are linked to the C-CPI-U, then social security payments will increase at a slower rate. In the popular press, some have pointed out that this change in the price index has resulted in an implicit increase in tax revenue, which is true. But from an economic perspective, the primary concern is which index more accurately measures the change in the prices of goods that individuals purchase.
How this graph was created: Search for “cpi” and select “Consumer Price Index for All Urban Consumers: All Items.” From the “Edit Graph” menu, click “Add Line” and enter “chained cpi” in the search box. Select “Chained Consumer Price Index for all Urban Consumers: All items” and click “Add Data Series.” Change the units to “Index (Scale value to 100 for chosen date),” change the date to 2000-01-01, and click “Copy to all.” Finally, adjust the date range to start at 2000-01-01.
Suggested by Daniel Eubanks and Don Schlagenhauf.