The tax reform laws passed at the end of 2017 brought substantial tax breaks for millions of Americans. But one little-noticed element that got included in the final version of the tax law changes will have a detrimental impact on taxpayers over the long run, and some of its effects are already starting to hit taxpayers this year.
The Internal Revenue Service published a revenue procedure on March 5 that, on its face, looked like dozens of similar procedures that the tax agency provides to taxpayers on a weekly basis. However, this one made changes to many of the thresholds, limits, deductions, exemptions, and other tax attributes that are indexed for inflation on a yearly basis. The reason: Initial estimates for the 2018 tax year were based on the old way of figuring inflation adjustments, and tax reform incorporated what's known as the chained CPI. The result is smaller inflation-related increases for 2018, and in some cases, the difference was enough to affect key tax provisions.
What the chained CPI is
The chained CPI is an alternative to the current measure of inflation in the Consumer Price Index. Critics have argued for years that the original CPI fails to take into account an economic phenomenon known as substitution bias, whereby consumers react to rising prices of one good by substituting similar goods instead. For instance, if someone likes potato chips and pretzels equally and the price of chips goes up, then that person will typically buy more pretzels. Chained CPI makes adjustments based on substitution behavior.
The result tends to be smaller upward adjustments in inflation. That was appealing to lawmakers who were trying to keep the costs of tax cuts as low as possible, because by tying inflation adjustments to a measure that will rise more slowly, the value of key tax breaks will be lower than it would be under the old inflation measure. Over time, the impact of using the chained CPI will be substantial.
How chained CPI is affecting your taxes in 2018
Yet already, tax reform's imposition of the chained CPI is changing some of the numbers that the IRS had already given taxpayers. Below is a sample of some of the tax provisions that the chained CPI affected in 2018:
- The maximum amount of the adoption credit will be $13,810, down $30 from the original projection of $13,840.
- The maximum earned income credit will be $6,431, $13 lower than originally stated, and maximums for other family sizes are similarly affected.
- The exclusion amount for estate tax will be $11.18 million instead of $11.2 million.
- The maximum contribution to health savings accounts for family coverage will be $6,850, down $50 from the original projection.
- For those who work overseas, the foreign earned income exclusion will be $103,900, $200 less than stated previously.
In addition, many less commonly used tax provisions will be affected. For instance, income phaseout limits above which taxpayers can no longer claim tax-free savings bond interest when proceeds are used for higher education expenses got reduced under the chained CPI calculations.
This is just the beginning
Millions of taxpayers use the tax breaks listed above, but even if you're not affected in 2018, you almost certainly will be in future years. Inflation adjustments affect the way in which the new tax brackets will rise over time, as well as the maximum contributions you're allowed to make to IRAs and 401(k)s, eligibility for key breaks like education credits, and the amount of the newly increased standard deduction.
So far, the use of chained CPI is limited to the tax code. Other key areas in which inflation adjustments play a role -- especially annual Social Security cost-of-living adjustments -- have thus far not been affected. Yet as these small changes show, chained CPI will have a negative impact on taxpayers, and that effect will grow larger as time passes.
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