Every year, the IRS adjusts more than 40 tax provisions for inflation. This is done to prevent what is called “bracket creep.” This is the phenomenon by which people are pushed into higher income tax brackets or have reduced value from credits or deductions due to inflation instead of an actual increase in real income.
The IRS uses the Consumer Price Index (CPI) to adjust the value of the parameters. It does this by taking the tax parameter’s base value and multiplying it by the current year’s CPI and dividing it by the base year’s CPI. For example, the base value for the top of the 10 percent income tax bracket is $7,000 with a base year of 2002. This is multiplied by 2014’s CPI-U of 235.69 and divided by 2002’s value of 178.68. The result is $9,225 (after rounding).
The CPI-U is not the only way to adjust tax parameters. Tax brackets could be adjusted in a number of ways including average wage growth (as Social Security brackets are currently adjusted) or the Chained CPI-U, which is another measure of inflation.
The choice of adjustment, although an obscure public policy, is meaningful for taxpayers. It could mean higher or lower tax burdens over a long period of time.
The difference can be demonstrated comparing how the income tax brackets are calculated under the CPI-U versus how they would be under the Chained CPI-U.
The Difference Between the CPI-U and the Chained CPI-U
The difference between the CPI-U and Chained CPI-U is in how each accounts for immediate changes in the behavior of consumers when they face higher prices. The CPI-U assumes that increases in price do not lead to substantial substitution effects. In other words, an increase in the price of chicken would not lead many people switching to another product—consumers would
just face the high price level. It is calculated by taking a set of consumer goods in a base year and tracking their price changes year-to-year.
The Chained CPI-U on the other hand better accounts for substitution effects. As a result, a price increase in chicken may not lead to an overall large increase in price levels because consumers may switch to lower-priced pork. Technically, this is done by varying the weights on specific goods each month to reflect shifts in consumer behavior.
Looking at the index numbers show how the Chained-CPI grows at a slower rate compared to the CPI-U. In FY2001 they are both set to 100. As time goes on and prices increase, both measures grow. However, the CPI-U grows faster. In 2007, CPI-U has grown by 16.5 percent while the Chained CPI-U has grown by 14.4 percent. By August 2014, the CPI-U is 34 percent higher than it was in 2001 and the Chained CPI-U is only 30 percent higher. The difference has grown from 2 percent in 2007 to about 4 percent in 2014. As time goes on, the gap between the two measures would widen even further.
How the Difference Affects Tax Bills
Using the Chained CPI-U vs. the CPI-U has a significant effect on the amount an individual pays in taxes over time.
Suppose an individual earns about $30,000 in 2003 and receives pay increases of $1,500 each year until 2015. At this point he earns $48,000. Also, each year the government adjusts the income tax parameters by the CPI-U (as it currently does).
As expected, his tax bill increases as his income increases. In 2003, his tax bill would be $2,980 and grow to $5,231 by 2015 (Table 1, column 3).
Table 1. Tax Bill under CPI-U and Chained CPI-U Adjustment