The Way Tax Reform Changed the Inflation Calculation

One of the least talked about parts of tax reform is the change in how inflation is calculated for the tax code. Perhaps it’s not considered big news because many people don’t understand it. Or maybe it’s because the change in the inflation calculation won’t make a huge difference in the short term.

However, over the long term, inflation calculations in the tax code can be very important. Here’s how it works, and what it may mean for you.

What is inflation, and why does it matter how the IRS calculates it?

Simply stated, inflation is the devaluing of money over time.  When the general pricing for certain items or services increases over a period, that means the value of each dollar used to pay for those items decreased. After years of inflation, what was once considered to be a lot of money is no longer viewed the same. For example, 40 years ago, a $10,000 salary was respectable, and a millionaire was a very rich person. Now, it’s incredibly hard to get by on $10,000 (impossible in many places), and you’d probably expect to have more than $1,000,000 before you felt wealthy.

Looking at it that way, however, gives inflation a negative spin. But in reality, inflation is not all bad. In fact, a healthy, growing economy should generally experience inflation. Where the negative, unintended consequences begin is when laws don’t adequately consider inflation throughout their changes.

Some tax calculations are true to the inflation rate as the IRS calculates it. For example, the annual exemption for the gift tax laws, the Earned Income Tax Credit, and limitations based on income for education credits all rise with inflation. Either as a dollar amount or when the adjusted amount reaches a certain level. For instance, in 2005 you could give another person up to $11,000 per year without having to file a gift tax return. And now in 2018, you can give up to $15,000 to each person before you may need to file a gift tax return.

Ultimately, the inflation calculation influences how the tax calculations that are dependent upon the inflation rate are performed. It is usually to most taxpayers’ benefit for the IRS limitations and other tax amounts to be calculated at a higher rate than determined by a lesser one.

How does the new tax law change the inflation calculation?

Previously, the IRS used inflations measured by the consumer price index for urban consumers, known as the CPI-U. That index tracks the cost of certain goods and services the typical household buys, from bread and soap to the cost of utilities.

Under tax reform, inflation is measured using something called Chained CPI. With Chained CPI, the people measuring inflation assume buyers have choices when they spend money, and they shift from one product to another when the price of that product goes up. For example, if the price of coffee beans increases too much, you may start drinking tea. If you don’t like tea as well as coffee, you may argue that you are worse off now because you can’t afford your favorite beverage. But to the economists measuring Chained CPI, you found a cheaper replacement, and that’s what matters.

Using Chained CPI, tax benefits and limitations don’t rise as quickly or as high as they would under the old measurement system.

Will this affect me now?

You won’t notice any difference in current tax law because of this change. That’s partly due to the much larger changes in the tax code for 2018. But it’s also because the effect of lower inflation adjustments is small at first.

Over time, however, a small difference in the inflation calculation makes a bigger difference. Each year’s inflation rate is applied to last year’s tax limitations and other amounts, compounding its effect. Even a small change in the inflation calculation can make a big difference over five, ten, or more years.

Is this method of calculating inflation likely to change again?

If there’s one thing you can be sure of with the tax code, it’s that it is always subject to change. The legislation enacted by the Tax Cuts and Jobs Act is in effect until 2026, but there is no way to predict if anything will change before then – or after.

About Sally Herigstad

Sally Herigstad is a certified public accountant and personal finance columnist and author of Help! I Can't Pay My Bills, Surviving a Financial Crisis (St. Martin's Griffin). She writes regularly at CreditCards.com, Bankrate.com, Interest.com, RedPlum, and MSN Money. She is an experienced speaker and a member of Toastmasters International. Follow Sally on Twitter.

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