Why the new tax law amounts to a 'stealth' tax increase

The government will use an inflation measure that causes things like marginal income tax rates to rise more slowly

Feb 7, 2018 @ 2:30 pm

By Greg Iacurci

The new tax law changes how the federal government adjusts certain measures in the tax code for inflation, which could cost advisers' clients substantially over the long term. The change also could signal how lawmakers will elect to treat certain benefits like Social Security down the road.

"It's kind of a stealth tax increase," Tim Steffen, director of advanced planning for Robert W. Baird & Co.'s private wealth management group, said of the change. "On a cumulative basis, it will have a meaningful impact."

Until President Donald J. Trump signed the Republican tax bill into law in December, the government made inflation adjustments in the tax code based on the consumer price index (CPI-U). Going forward, the Internal Revenue Service will do so based on the "chained" consumer price index (C-CPI-U).

This is a big deal. Economists say anything in the tax code indexed to inflation — marginal tax rates, the standard deduction, and 401(k) and IRA contribution limits, for example — will rise more slowly as a result.

Over time, advisers' clients may find themselves creeping more quickly into higher income brackets, for example. It also may take longer before the annual amount clients can gift tax-free rises, or for the amount of an estate exempted from tax to change.

One practical way this could play out: Retirees on a fixed income from Social Security and pension payments would normally expect to see a slight tax reduction from year to year, since their income remains the same relative to marginal tax rates that increase each year. Under the new system, that reduction would be less if brackets move up more slowly.

"On a year-by-year basis, the impact will be pretty minor, but over a longer period of time the compounding effect could become substantial," Mr. Steffen said.

(More: Tax reform: 7 essential strategies for financial advisers)

Since 2000, the primary CPI measure has risen by 45.7%, while "chained" CPI only grew by 39.7% — a difference of 6 percentage points, according to a Brookings Institution analysis. The federal government estimates the new inflation measure will raise $134 billion in tax revenues through 2027.

The difference in primary versus chained CPI boils down to a difference in accounting for consumer behavior. Chained CPI assumes that when prices for one thing go up, consumers sometimes turn to cheaper substitutes, AARP says. (For example, if beef prices go up, they'll buy more chicken and less beef.)

Chained CPI was a concept that President Barack Obama floated in his second-term budget proposals. The idea, which lawmakers ultimately rejected, would have helped reduce the federal deficit by also changing cost-of-living adjustments to Social Security benefits.

That's not the case under the new tax law. But Steven Rosenthal, a senior fellow at the Urban-Brookings Tax Policy Center, believes the concept could resurface, given chained CPI's presence in the tax bill and Republicans' wish to reform entitlement programs.

"It augurs for Social Security benefits at some point using chained CPI as opposed to regular CPI," Mr. Rosenthal said. "I don't know when that will be. There's a whole bunch of politics in D.C."

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