A change in how we measure inflation and how we implement it through federal policy is reportedly on the table to avert the upcoming “fiscal cliff.” Specifically, the idea is to use the “chain-weighted” Consumer Price Index (C-CPI) to calculate Cost of Living Adjustments (COLAs) for Social Security and other federal benefits and to index the income tax brackets. Currently, the standard CPI is used for these purposes, but it frequently overestimates the actual increase in the cost of living by not accounting for customer substitution. The Bureau of Labor Statistics states, and most economists seem to agree, that the C-CPI is “designed to be a closer approximation to a cost-of-living index than other CPI measures.”
The application of the C-CPI to Social Security has received a great deal of attention, but less has been paid to the tax code. Because incomes grow faster than inflation, an ever-greater share of incomes is subject to higher tax rates due to the so-called “real bracket creep.” The CBO projects that this effect will boost income tax revenues by around 2.6 percentage points relative to GDP over the next 25 years, a nearly one-third increase versus the 8.2% of GDP historical share collected through personal income taxes. A lower CPI in the form of a chained CPI would only exacerbate this autopilot trend toward higher taxes. A better approach would be to index the tax brackets to the growth of incomes; this would stabilize average tax rates over time and force Congress to make tax increases explicit.
Moreover, while the Obama administration surely would prefer to apply the C-CPI to taxes as well as Social Security benefits, doing so would violate their pledge not to raise taxes on households earning less than $250,000 per year. They might argue that the chained CPI is merely a technical fix to better measure inflation, but it’s unclear whether Americans will accept it.