Last year, inflation in the United States reached its highest level since 1981. As a result, the IRS announced the largest inflation adjustment for personal taxes in decades: 7.1% for the 2023 tax year.
To help people understand what inflation related tax adjustments may lead to in 2024, I have written a new summary explaining the reasons for issuing inflation adjustments. The way it operates and the shift from using the so-called consumer price index (CPI) to concatenating CPI have influenced the inflation adjustment.
Part of the content of the Tax Law was included in the inflation index in the early 1980s, when the annual inflation rate reached a peak of 13%. This has led to concerns about a “framework upgrade” as income increases to accommodate inflation, but the tax framework, deductions, and exemptions are set at fixed dollar levels. For example, in December 1981, the taxpayer’s 30% framework started at $15000, the same as in January 1979, despite inflation rates exceeding 37%. Therefore, synchronizing wage increases with inflation often leads to higher marginal tax rates and larger tax bills for taxpayers. All this means increased federal revenue without the need for a clear vote by Congress on tax increases. Therefore, inflation is known as a “hidden tax” The Tax and Economic Recovery Act, passed in August 1981.
By the mid-1990s, some people were concerned about the opposite problem: tax regulations were overly indexed, rather than not indexed. If so, it means that federal income is below its due level. Economists from the Bureau of Labor Statistics have published several articles arguing that headline CPI may have overestimated inflation, leading to the establishment of the Boskin Committee in Congress. The committee made a number of recommendations, including the conversion of the title index to a chain index by the Bureau of Labor Statistics. The chain index more accurately reflects changes in the cost of living because it measures the response of expenditures to price changes. However, the Bureau of Labor Statistics did not replace CPI – U, but instead created chain CPI as an additional indicator.
Since then, policy analysts have occasionally suggested linking some tax laws to CPI rather than headline CPI. This ultimately occurred in December 2017, when the Tax Reduction and Employment Act was passed. The use of the chain consumer price index is expected to help offset declines in income elsewhere in the law. One disadvantage of chain CPI is that it is necessary to use some initial and intermediate values for inflation adjustment, as once adjusted, all final values are unavailable. As I described in a previous blog post, the growth of chain CPI is generally slower than headline CPI, but the recent rise in inflation has led to faster growth.
In the past 15 years, the annual inflation rate of the relevant CPI has twice been higher than the overall CPI. Although there is no data to reveal why this happened in 2008, it occurred during the pandemic, when initial closures reduced demand and prices fell. Therefore, if the headline CPI is used for indexing, the inflation adjustment for the 2022 tax year will be smaller.
