Hey, Wait a Second…

It's the little things that matter and the devil's in the details, two idioms that apply to the current tax debate, as well as anything having to do with your finances. With all the headlines coming out following the Senate's passing of their tax plan last Saturday, it's far too easy to get stuck on the soundbites of who will save this, and who will pay that. Important details can get overlooked. In this case it's an obscure add-in to help pay for the plan.

The House and Senate plans differ in many areas, but let's review one point of agreement that could have lasting ramifications for savers and retirees: the use of Chained CPI to calculate inflation. Sounds pretty boring, right? People often say don't sweat the small stuff, but in this case the small stuff is incredibly important. In fact, this seemingly insignificant change is one of the larger levers that help pay for the tax plan over time.

We've all experienced head-scratching moments while reading the government's inflation numbers and wondering how they come up with their data. Everything seems more expensive than the current 2% inflation the Bureau of Labor Statistics (the government office that calculates inflation) says. We see every day how the prices of housing, food, energy, healthcare, to name a few, are all growing faster than that. But still the so-called headline inflation number remains low.

The traditional way to calculate inflation is to monitor the prices of thousands of items across the country to see how they change over time. This is intuitive but becomes problematic when trying to account for price changes nationally. We're a diverse country and people in various demographic groups and geographic areas spend money differently.

This brings us to Chained CPI, a fairly young measurement tool from the mid-90's that gained some support in the early-00's. More recently, President Obama tried to get behind the concept to help save Social Security (more on that later). This CPI metric is "chained" in that it ties together price changes over time and tries to account for substitutions made by consumers as prices rise.

The idea is that if the price of steak, for example, was rising faster than chicken, you wouldn't stop eating meat but instead would opt for chicken. Then, when the price of chicken was too high, maybe you'd substitute sausage. The result being a situation where you're used to paying $10 for meat but are now eating sausage instead of beef. This is supposed to reflect the buying habits of consumers more accurately, but maybe masks actual inflation as consumers move down-market while still spending the same amount. This substitution issue is estimated to shave off perhaps 0.3% per year from inflation. So, instead of 2% currently, the Chained CPI number would be more like 1.7%. Which is the most accurate? That's up for debate.

How does monitoring inflation impact tax policy? Lots of our financial lives are tied directly or indirectly to the government's inflation numbers, so this data is very important. Tax brackets are tinkered with annually by Congress to keep pace with inflation. As inflation rises, the brackets are raised, and this is supposed to keep households from creeping up into the next higher bracket faster than warranted by increased earnings. This is good for the household by helping cap taxes but hurts the Treasury for the same reason.

Since Chained CPI rises more slowly than traditional CPI, switching to this calculation method could lead to tax brackets being raised slower than actual inflation. The result could be moving tax payers up to that next higher bracket faster, slowly increasing the average tax rate households pay. This would hit taxpayers with an incremental shadow tax increase that adds up to big money over time.

Oh, I mentioned Social Security before and how it's also impacted by this. Given that annual Cost of Living Adjustments to retiree's benefits are tied to CPI, if Chained CPI were used instead, benefits would increase at a slower rate going forward. This would further compound cash flow issues for many retirees who are already mystified by the low official inflation/low COLA conundrum. But it would benefit the Treasury as payments would rise more slowly, making the long-term budget and Social Security math look better.

We won't know the final details of the tax overhaul until later this month and much could change, including the switch to Chained CPI. But since the House and Senate seem to agree on using Chained CPI, and since doing so helps pay for the tax cuts (and other government programs as well), we're probably going to see this change take effect. Time will tell what the ultimate impact will be.

So, for now it looks like tax cuts but potentially incrementally higher taxes down the road to pay for them. There ain't nothing free in this world, and that's a fact.

Have questions? Ask me. I can help.