Taxes

There's an Increase Hiding in the Republican Tax Cuts

Changing how inflation is measured could cut increases in future Social Security benefits and push people into higher tax brackets.

Very funny.

Photographer: Andrew Harrer/Bloomberg

There's an argument in policy circles that goes something like this: If only we could lower inflation as reported in the consumer price index, we could afford more tax cuts.

You are going to be hearing a lot about his concept in the coming weeks if the Republican tax bill becomes law.

Over the years, I have argued that official government inflation models like the CPI tend to underreport price increases.

What does this have to do with the proposed Republican tax plan? The new tax proposal would replace the current CPI, which is based on changes in prices for urban consumers, with a new version called the chained consumer price index. Various estimates conclude this new measure would lower reported inflation, which is already lower than it actually is, by as much as 0.30 percent a year. 1

QuickTake Chained CPI

But this yardstick would do something else: It would allow Congress to come up with about half of the funds needed to cover the proposed GOP tax cuts by pushing more people into higher tax brackets and potentially creating a hidden tax on everyone who will ever get Social Security in the future. But for the purposes of today's discussion, let's focus mostly on the latter.

The way we measure inflation matters because it goes into calculations used in cost-of-living adjustments that affect many government benefits. If the measure of inflation is reduced, then the increases in Social Security payouts to the public would also be lowered.

If this sounds familiar, it is because we have been down this road before. The Boskin Commission in the mid-1990s made the dubious claim that government statistics overstated inflation by 1.1 percent. It recommended numerous changes to the ways inflation is measured in order to lower it. One of the key suggestions by the commission involved substitution, meaning that people switch to less expensive products when other goods rise in price.

I have long argued that this approach would distort the CPI, making it less useful as a metric to policy makers. Its goal was an obvious backdoor way to suppress Social Security COLA adjustments. Rather than have an honest conversation about the cost of entitlements, this was a deceptive way to cut benefits without publicly saying so.

Regardless, let’s look more closely at the concept of substitution. It gets the concept of what inflation is precisely backward.

Substitution adjusts inflation for consumer behavior. When steak prices rise, consumers switch to less expensive proteins such as chicken or hamburger. Thus, goes the theory, the consumer is spending no more on meat than before, and -- voila! -- there's no inflation. In reality, the consumer has been priced out of steak due to its rising cost. In other words, inflation hasn't disappeared; it's been masked. This is what chained CPI is in a nutshell; prices in the real world may still be rising, but that won’t be reflected as much in the official numbers.

Let's take another example. Imagine you live in an apartment in Manhattan. Sure, it isn't cheap, but you are in one of the world’s most desirable, vibrant cities, filled with museums, restaurants, culture, theater -- and you might be able to walk to work. It’s great, until prices rise. Eventually, the cost becomes too much and you move to Brooklyn. At the same price for housing, you now have to ride the subway to work; many of the same appealing features of big city living are there, but not all of them. A few years go by and you get priced out of Brooklyn, and move to Hoboken, New Jersey. The same rent you used to pay now has you on the other side of the Hudson River, with a much longer commute to work, and a very different quality of life (no offense Hoboken, really).

According to substitution, nothing has truly changed, as you merely swapped one housing option for another (and again for another). In reality, your living standard has declined even if your housing costs are little changed. This, in fact, is the very definition of inflation, but if you subscribe to theory of substitution there is no effective price increase.

Note that this stands in stark contradiction to the other major Boskin Commission concept: hedonic adjustments for quality improvements. Rising product quality, the commission said, causes inflation to be overstated. At the same price, new computers are faster, smaller and better than old ones; new cars are safer, more efficient and have more features than the comparably priced cars they replace. Better for the same price is somehow not a reflection of the human technological progress, but rather, falling prices.

This lack of symmetry is intellectually dishonest. Note that hedonic adjustment only seems to go one way. Let's face it, if you switch to hamburger from steak or from Manhattan to Hoboken -- and you're still paying the same price for either -- shouldn't a hedonic adjustment be made to reflect declining quality and thus rising inflation?

The obvious answer is yes. That’s how you know the Boskin Commission was a politically motivated attempt to provide cover to lower Social Security payments. Adopting chained CPI would be the set-up to reduce future Social Security payments without having any sort of honest debate about it.

When both the deception and motivations are this obvious, it is incumbent upon us to call out those who seek to mislead the public. The reality is, adopting chained CPI would entail both future tax increases and lower benefits for Social Security recipients down the road in order to pay for a tax cut today.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
  1. You can compare the two measure of inflation side by side at this Bureau of Labor Statistics page: Chained consumer price index for all urban consumers (C-CPI-U) and the consumer price index

To contact the author of this story:
Barry Ritholtz at britholtz3@bloomberg.net

To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net

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