The Facts on the Chained CPI

Coverage of the so-called "chained CPI" has been heating up recently, due to rumors that it might be included in the latest round of debt negotiations. The Wall Street Journal reported that it could be a potential "link to a budget deal", as the idea of switching to the chained CPI has won support from both the left and the right. The Hill and Bloomberg covered the story as well, with the latter quoting CRFB’s own Marc Goldwein who stated that "It’s a no-brainer. We’re measuring inflation wrong now and it’s obvious we should measure it right--especially if it’s going to reduce the deficit."

For a little background, a number of federal programs and provisions of the tax code are indexed to inflation -- but they are indexed to a measure which overstates cost of living increases. Switching to the more accurate inflation measure known as the Chained CPI is not only good policy, but would reduce the deficit by over $250 billion over the next decade. 

Yet a recent distributional analysis from the Joint Committee of Taxation pours some cold water on this policy by suggesting that, according to a press release from Congressman Sander Levin, switching to chained CPI "would hit middle- and low-income Americans hardest."

Looking at JCT's tables without any context does indeed suggest that low-income individuals (particularly those making between $10,000 and $20,000 per year) are hit hard by this policy. However, a more complete analysis of the distributional affect from the Tax Policy Center shows the change to be close to distributionally neutral. 

JCT's estimates are limited in a few ways, including that they look at percent of taxes paid (so if someone pays $10 a year and this policy increases it to $12 that is a 20 percent tax increase) rather than percent of income and that they do not account for the many low income individuals who do not file tax returns. In addition, they assume the continuation of current law where a very large number of taxpayers are hit by the Alternative Minimum Tax (AMT) rather than the regular income tax -- even though Congress enacts AMT  "patches" every year. Taxpayers subject to the AMT are not affected by the changes in indexation of tax brackets or deductions from chained CPI, and the chained CPI would not affect a significant number of higher income earners because they are pushed into the AMT. Under a baseline which assumes continuation of an AMT patch, which prevents a dramatic increase in the number of taxpayers subject to the AMT, chained CPI would have a much greater impact on the top two quintiles. Looking at the above graph, taxpayers earning between $100,000 and $200,000 would be affected the most by a change to the chained CPI compared to a baseline that patches the AMT.

The Tax Policy Center analysis looks at the impact of chained CPI relative to current policy, and finds that pretty much everyone (except the very rich and very poor) would see their taxes go up by about 0.2 percent of income by 2021 -- compared to current projections.

Indeed, those making over $100,000 a year, according to TPC's analysis, will bear nearly 60 percent of the burden from switching to chained CPI (compared to 30 percent using JCT's current law numbers). The top quintile alone will pay more than 40 percent of the additional taxes.

More to the point, though, chained CPI is a more accurate measure of inflation and even if the distributional impacts were less favorable it would not change that. But if policymakers are concerned about the distributional impact of the chained CPI on certain taxpayers, any number of changes can be made to the tax code to achieve a desired distributional outcome in a far more targeted and efficient manner, just as the impact of chained CPI on certain Social Security beneficiaries could be offset by targeted policies such as an old-age benefit bump-up. Take the Fiscal Commission's tax plan which not only enacts the chained CPI but also raises an additional $1 trillion in revenue -- and yet actually reduces taxes for the bottom quintile.

Bottom line: there is no reason to maintain a $450 tax windfall for those in the top quintile just to protect a $25 windfall for those in the bottom quintile -- something like a $25 increase in the EITC or even child tax credit would be far cheaper and better targeted.

We have a tremendous debt problem ahead which will require at least $4 trillion in deficit reduction over the next decade alone. As we wrote recently, "addressing our fiscal challenges will require many tough choices and policy changes – but switching to the chained CPI represents neither."

Chained CPI Misses a Key Point

 The idea of using the Chained Consumer Price Index, C-CPI, to measure inflation is interesting, but basically flawed.  It claims that during periods of slow growth and flat or declining incomes,  adjusting the price basis of each category of goods in the index to take account of the shift of the consumption mix to lower priced goods lowers the rate of inflation compared to the standard CPI.  So it claims that the Cost of Living does not rise so much.  However, lower priced goods have generally lower quality and provide less satisfaction, so the Quality of Living declines by the difference between the standard CPI and the C-CPI, which distorts the measure of inflation.  And conversely, when the economy recovers and people shift to higher prices goods in the categories, the C-CPI will show a higher rate of inflation than the standard CPI, as the Quality of Living rises.  It makes much more sense to keep the standard CPI, and fix any internal flaws, as the better, but not perfect, measure of the rate of inflation related to the Cost of Living at a standard Quality of Living.

 

You need to think carefully about these things.  Jed

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