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How 'Chained CPI' Will Hit Your Pocketbook

By Chuck Saletta

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President Obama’s new budget proposal includes changing a couple of key inflation calculations to something called a “chained CPI.” The shift is getting a lot of attention right now because of the expected effect it will have on individuals.

There are two key places where a chained CPI — short for consumer price index — will have a direct impact on your pocketbook: income taxes and Social Security benefits. All else being equal, over time, your income taxes will be higher and your Social Security benefits will be lower than they are under current inflation calculations.

The key difference between the chained CPI and the traditional consumer price index is how the index measures consumer behavior. The chained CPI assumes that as prices rise on one product, some portion of consumers will be willing to substitute less expensive alternatives for what they used to buy.

That changes the product weightings used in the inflation calculation. By incorporating information from those new product weightings, the chained CPI typically produces a lower inflation level.

Here’s how it works.

The Impact on Income Taxes

If you pay income taxes, your tax bracket is determined by the amount of taxable income you make. The cutoffs for each bracket generally rise over time with inflation.

The two charts below show the IRS “Schedule X” brackets for single taxpayers; the first is for 2012, and the second is what’s currently expected for 2013:

Chart for 2012 from the U.S. Internal Revenue Service
Chart for 2013 from the U.S. Internal Revenue Service

While the 39.6 percent tax rate is new for 2013, note that the other brackets have higher cutoffs for 2013 than they did for 2012. That’s thanks to the inflation adjustment made to the tax brackets.

If the law is changed so that the chained CPI is used, the tops of those brackets are expected to rise more slowly, exposing more of your income to higher tax rates than under current law.

The Effect on Social Security Benefits

Similarly, Social Security benefits are increased based on the inflation rate. By tying the payment increases to the chained CPI — an inflation rate that grows more slowly than the current measure — those benefit payments will grow less quickly as well. As a result, over time your Social Security checks will be smaller than they would have been under the old inflation calculation.

The annual changes aren’t too extreme — they’re estimated to be somewhere in the vicinity of 0.1 percent to 0.3 percent per year, depending on what the future brings. But …read more

Source: FULL ARTICLE at DailyFinance