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The Revenue Aspect of the “Chained CPI” Option for Deficit Reduction

July 8, 2011 at 5:58 PM

Information from Congress’s Joint Tax Committee (JCT) appears to show that a deficit-reduction proposal that President Obama and congressional leaders are reportedly considering would have a regressive effect by raising taxes considerably more for lower-income people than for higher-income ones.  But that is because the Joint Tax Committee data are based on the assumption that relief from the Alternative Minimum Tax will end, subjecting over 40 million tax filers to the AMT, something no observer expects to happen.  A new analysis by the Urban-Brookings Tax Policy Center (TPC), based on the more realistic assumption that AMT relief will continue, shows that the proposal’s impact would be roughly the same in most income groups.

Under the proposal, the federal government would switch to a different measure of inflation — known as the “chained CPI” — when calculating annual updates in the tax code, like the dollar thresholds for different income tax brackets.  (The chained CPI would also be applied to annual cost-of-living adjustments in Social Security and other benefit programs.)  Most experts believe that the current inflation measure slightly overstates the general inflation rate.  Switching to the chained CPI, which grows slightly more slowly than the traditional CPI, would save the government money on both the tax and expenditure sides of the budget.

The primary source of confusion over the JCT analysis is that JCT assumed that the AMT will explode in coming years to hit millions of additional Americans, which would blunt the impact on upper-income families of switching to a chained CPI.  The AMT (which, unlike the rest of the tax code, is not indexed for inflation) will indeed explode under current law, and JCT is required to compare proposed policy changes to current law.  But Congress almost certainly will not allow that to happen; in recent years, it has consistently prevented the AMT from exploding by enacting one- or two-year “AMT patches.”

The Tax Policy Center, which does not face the same current-law requirement, has conducted a parallel analysis that gives a more realistic assessment of how switching to the chained CPI would affect different income groups.  The results show that the percentage reduction in after-tax income — the best way of measuring the progressivity or regressivity of a tax policy change — is modest and nearly identical in all income brackets.

In 2021, the reduction in after-tax incomes would average two-tenths of 1 percent for households in every income bracket up to $500,000 a year, except for people with incomes below $10,000 (for whom there would be no impact) and people in the $30,000-$40,000 range, for whom the average reduction would be three-tenths of 1 percent.  The average reduction would be smaller for the top 1 percent of the population with incomes above $500,000, primarily because there are no additional tax brackets for them to be moved into.

If policymakers choose to include this measure in a deficit-reduction agreement, it should be part of a revenue component of the larger package that is significantly more progressive, given the nation’s large income disparities (which the 2001 and 2003 tax cuts have exacerbated).  Policymakers also could mitigate any impact of the chained CPI at the lower end of the income spectrum with targeted provisions, such as a strengthening of the Earned Income Tax Credit, without significantly reducing the budget savings generated.


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