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New Tax Law Takes Aim at a Different Measure of Inflation

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As we make an auspicious start to the year with a new tax law, let’s look at one bit of information from that law relating to the consumer price index — basically what the tax implications would be from the change in utilizing measures of inflation. Here is that passage:

For tax years beginning after Dec. 31, 2017 (Dec. 31, 2018 for figures that are newly provided under the Act for 2018 and thus won't be reset until after that year, e.g., the tax brackets set out above), dollar amounts that were previously indexed using CPI-U will instead be indexed using chained CPI-U (C-CPI-U). (Code Sec. 1(f), as amended by Act Sec. 11002(a)) This change, unlike many provisions in the Act, is permanent

Was I the only one who saw this in the codification of the new tax law and smiled? It’s time for all the macroeconomics geeks to have their moment. I am one of them, having minored in economics. This seems so small, but it really isn’t.

Let’s take a moment and give you the definition of inflation:

In economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy.

So, what is CPI-U and C-CPI-U anyway? CPI-U is an acronym for Consumer Price Index for All Urban Customers, and C-CPI-U is Chained Consumer Price Index. What does this mean and why should you care?

The CPI-U only considers the prices paid for goods and services by those who live in urban areas. Rising CPI-U figures means that the prices of goods/services within the urban population are becoming more expensive and can be a sign of rising inflation. To understand that, you have to understand Consumer Price Index (CPI), and how it is calculated.

CPI measures the change in price levels of certain consumer goods and services that are paid by a household. (In economics the price of goods is a measurement of supply.) CPI is a statistical estimate using the prices of a sample of representative items whose prices are measured periodically. The calculation of which (here comes the math geek in me) is:

I apologize for that equation, but I never in a million years thought that I would ever get to use that out of college. When you saw in the tax code the term “indexed for inflation”, that meant it was being measured by CPI-U. The problem with CPI-U is that it only measures the CPI of urban areas, so if prices are up in the cities, then inflation is up. (A recent government report says that the all urban consumer group represents about 89 percent of the U.S. population.)

C-CPI-U is more a true measurement of inflation. It’s an alternative measurement of CPI created by the Bureau of Labor Statistics. In layman’s terms, because the definition gets complicated, it takes into account that if inflation goes up, consumers will choose less expensive substitutes for the normal products they use. This reduces the cost of living increases through the reduction of the quality of consumed goods. Basically, inflation grows at a slower rate than it previously did.

What does all this mean? In general, chained CPI-U grows at a slower pace than CPI-U because it considers a consumer's ability to substitute between goods in response to changes in relative prices. Proponents for the use of chained CPI say that CPI-U overstates increases in the cost of living because it doesn't take into account the fact that consumers generally adjust their buying patterns when prices go up, rather than simply buying an item at a higher price.

What this really means in the tax world is even if inflation grows at a rate of 3.5 percent (which is roughly close to the average annual inflation rate of the U.S.), your taxes aren’t going up because of that normal increase. I’ve always been self-employed, so I have never really gotten a pay raise, but if you are one of those lucky ones who gets a 3.5 percent inflationary rate raise, your taxes aren’t going to go up with the raise, all things being equal.

The best part of this change is that it is permanent.

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