‘Chained CPI’ shaves tax breaks. Will your retired pay be next?
The new Republican-passed tax law deploys a new method of tracking inflation called the “chained” Consumer Price Index, a tool that will dampen future adjustments to federal tax brackets and standard deductions, reducing over time the value of touted tax breaks for individuals and companies.
This first-ever use of Chained CPI is viewed by guardians of Social Security, federal retirement plans, veterans’ compensation and survivor benefits as a worrisome development. If the same method for measuring inflation is adopted widely, they contend, it would cut the lifetime value of most federal benefit plans.
“It’s a bad omen, in that it could have repercussions on entitlements, especially at a time when people like [House Speaker] Paul Ryan are announcing they’re going to go after earned benefits,” said Monique Morrissey, an economist with the Economic Policy Institute. EPI is nonprofit think tank that assesses how laws and policies affect the welfare of low- and middle-income workers.
By making Chained CPI part of the tax code, architects of the massive tax overhaul created a “significant revenue raiser to help offset some of the other costs in the bill,” said David Certner, legislative counsel for AARP.
The retiree advocacy group criticizes the new tax law for cutting tax rates deeply for businesses while giving only temporary tax relief to most households, raising health care costs for millions of older Americans and increasing the federal debt by $1.5 trillion over the next 10 years. AARP contends this puts at greater risk other critical programs for the elderly including Social Security.
Certner said use of the Chained CPI in the tax code will dampen inflation-based adjustments to income tax brackets, standard deductions and contributions employees can make to 401(k) plans.
That “means more and more money over time will be taxed at higher rates,” chipping away at the value of the tax breaks Republicans now tout.
“The Chained CPI has been an ongoing threat” to federal benefits “for a number of years so this continues if not heightens that concern,” Certner said.
Federal entitlements have been adjusted for inflation for decades using the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The index tracks price changes for a market basket of goods and services bought by working-age Americans. For example, changes in CPI-W during the third quarter of 2017 versus the third quarter of 2016 justified the 2 percent cost-of-living adjustment (COLA) this month for Social Security and federal retired pay.
A separate but similar CPI for All Urban Consumers (CPI-U) has been used for other purposes including to adjust federal income tax brackets until Republicans replaced it last month with the Chained CPI.
Critics of traditional indices argue they overstate inflation by failing to take into account how consumers react month to month to changing prices. For example, if beef prices rise, shoppers might purchase more chicken that month. Yet CPI-W and CPI-U market baskets assume no change in the weighting of chicken-to-beef purchases through the year.
Every several years the Bureau of Labor Statistics, which tracks consumer prices and maintains these indices, will conduct broader consumer surveys to adjust the weighting of various goods and services tracked by CPI-W and CPI-U. But that’s not frequent enough to eliminate what critics have labeled “substitution bias.”
“We essentially assume that consumers just keep buying the same quantities of goods and services regardless of what happens to prices,” said Steve Reed, an economist at the Bureau of Labor Statistics (BLS).
Starting in 2002, BLS created the Chained CPI (C-CPI-U) to better approximate inflation experienced by consumers month to month. The index tracks not only prices but changes in shopping patterns as a result of price changes.
“With Chained CPI, we are using expenditure survey data from essentially every month,” Reed said. “We are using [product] weights that are much more recent [and] based on what consumers are actually purchasing right now.”
Various deficit reduction commissions have urged adoption of the Chained CPI for adjusting federal entitlements. Former President Barack Obama even endorsed it for a short time to entice Republicans to agree in return to close some tax loopholes.
One drawback of Chained CPI is that the surveys required and extra processing data takes more time. BLS publishes a preliminary change in the index, makes two interim adjustments during the year and then publishes a final annual inflation about 10 to 12 months later than the CPI-W or CPI-U, both of report their calculations on annual inflation almost immediately.
The greater concern for guardians of federal benefits is that Chained CPI consistently shows inflation 0.2 to 0.3 percent lower than traditional indices for measuring annual inflation. That has made it politically unpopular. Still Republicans generally support the switch for adjusting entitlements. Democrats want to stick with CPI-W or move in the opposite direction, to adjust Social Security and federal pensions using an experimental BLS index, CPI-E, that captures the spending patterns of elderly Americans with their higher health care costs.
Adoption of Chained CPI for tax purposes has sensitized both camps to the billions of dollars at stake for curbing federal costs or dampening benefits if they lose the fight over how federal benefits are protected against inflation.
The stakes are particularly high for military retirees, disabled veterans and their survivors who draw retired pay or service-related compensation at relatively early ages, often years before they also qualify for Social Security. The Congressional Budget Office estimates that two-thirds of the lifetime value of military retirement flows from the full inflation protection their plans provide.
“Our position is stay with CPI-W,” said retired Air Force Col. Dan Merry, vice president of government operations for Military Officers Associations of America. “It’s stable and more accurate of the market basket of goods — before people start substituting hamburger for roast and iceberg lettuce for mixed greens. It’s the best way to provide inflation protection generally across all demographics,”
“If they are going to do Chained CPI,” Merry added, “then they need to address CPI-E for the elderly who would be disproportionately impacted. And any money [deficit hawks] make on Chained CPI they would lose on to the CPI-E.”
Morrissey at EPI estimates Chained CPI would cut lifetime benefits for military retirees roughly 5 percent on average, with the sting felt more acutely in old age. An 85-year-old enlisted retiree who left service at age 40 and received COLAs based on Chained CPI would be drawing an annuity worth about 12 percent less than if CPI-W protection is maintained, she said. That assumes Chained CPI reduces COLAs on average by 0.3 annually, she added.
Reed at BLS said Chained CPI in more recent years has shown a lag of 0.2 percent annually versus inflation recorded by CPI-W.
“We would appreciate a more accurate COLA,” said Certner for AARP. But for Social Security recipients that would not be achieved using Chained CPI but rather with an index that specifically tracks the spending patterns of America’s elderly, he said.