While you’re busy preparing your 2017 tax returns, it’s never too early to look ahead to next year.
The Republican Tax Plan made numerous changes to how you will report, deduct and pay taxes beginning next year for income earned in 2018. One of the changes made impacts everyone: new tax brackets.
Compared to what you paid in 2017, the new tax brackets for income earned in 2018 are:
Source: Tax Policy Center
To summarize, the lowest income earners will be taxed the same in 2018, at 10%. Middle- and high-income earners will receive a slightly lower tax rate than in previous years.
But there’s more to these tax brackets than meets the eye — and the trick here is how inflation is figured into tax bracket changes in future years.
Inflation changes are most important
The Internal Revenue Service (IRS) will now measure inflation differently when making adjustments to these brackets in the coming years. This will essentially equal a tax increase over time, as peoples’ incomes will increase more quickly than the consumer price index (CPI) measure included up through tax year 2017.
How does that work?
Taxpayers will suffer what is termed bracket creep, when they move up into a higher tax bracket despite no real increase in income. True, their income may have increased from the previous year, but not enough to actually up their purchasing power since inflation exceeded their income increase.
The CPI measure to be used in 2018 is called chained CPI. The difference between the new measure and the way inflation was previously measured is primarily that the new measure accounts for consumer substitution patterns.
Consider the example used by the Bureau of Labor Statistics (BLS), which publishes the chained CPI figure. When the price of beef rises, the traditional form of CPI would use this higher price of beef to increase the CPI measure directly. But the chained CPI figure accounts for consumers who might actually substitute another meat which hasn’t experienced a price increase, say, pork.
The argument for using the chained CPI is that it’s a more accurate representation of inflation. But the overall effect is for chained CPI to rise more slowly than the traditional CPI measure.
This impacts tax brackets because the brackets will also rise more slowly, meaning when household income rises in the future, people will be shifted into higher tax brackets more quickly than they would have under the old measure when inflation elevated these brackets in step with incomes.
For a historical example, see how chained CPI has moved more slowly than the traditional CPI measure in the past:
The Tax Policy Center estimates the new CPI measure will equal an additional $125 billion in tax revenue by the year 2027, paid mostly by middle-income earners. This increase will be small at first, but add up to more money paid each year by taxpayers who are bumped into higher tax brackets.