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The Nearly Invisible Trump Tax Plan Proposal That Could Threaten Social Security

Dan Caplinger, The Motley Fool

The Trump tax plan has gotten a lot of attention because of its direct impact on American taxpayers. With promises of a major tax cut for tens of millions of taxpayers, the proposal has had proponents and critics disagreeing about whom it will actually help the most and how much of a difference it will make to the average American.

Yet within the Trump tax plan, there's a provision that hasn't gotten a lot of attention. Nevertheless, if enacted into law, it would mark a landmark shift in the way that the government handles a key issue. That could have implications down the road for Social Security -- implications that could lead to reduced benefits over time for retirees.

Keyboard with blue Tax key.

Did you see this in the Trump tax plan?

The tax proposal from Republicans released in late September deals in broad brushstrokes with key issues in the tax system. Among its main provisions is a higher standard deduction that's intended to become the primary reduction to taxable income, taking the place of many itemized deductions that would be eliminated as well as the personal exemption. The proposal also creates a three-bracket tax rate structure, which is down from the seven tax brackets that apply currently.

At the end of the section of the proposal on individual tax rates, there's an innocuous-sounding provision that would be easy to overlook:

The framework also envisions the use of a more accurate measure of inflation for purposes of indexing the tax brackets and other tax parameters.

The Trump tax plan doesn't specifically state what it means here. However, most economists agree that the intent is to switch from the current Consumer Price Index to an alternative measure called the chained CPI. Although this shift would have a direct impact on the way that tax brackets and deductions get indexed for inflation, use of the chained CPI in one government context might well lead lawmakers to apply it to other situations as well -- such as Social Security.

What the chained CPI is and why you should care

The chained CPI is a modification to traditional inflation calculations. The Bureau of Labor Statistics started calculating it almost 15 years ago, seeking to find a way to take into account a known economic phenomenon called substitution bias. When prices of similar, substitutable goods change relate to each other, consumers tend to shift toward whichever of the goods is cheaper. However, the traditional CPI's fixed category weights for various types of goods don't allow for substitution effects to show up. The chained CPI does.

Proponents of the chained CPI argue that the traditional inflation metric overstates the actual cost increases that people face. Estimates suggest that by using chained CPI rather than the current measure, annual increases in the tax provisions linked to inflation would be about a quarter percentage point lower than they are currently. That's a small amount, but it adds up over time to slow the rate of growth of key deductions, credits, and other important numbers in the tax code.

What does this have to do with Social Security?

Social Security has also seen debate over the appropriate measure of inflation. Some have advocated using a chained CPI approach because it would lead to slower annual increases in benefits. The figure used for calculating annual cost-of-living adjustments for Social Security is slightly different from the one that the tax laws use to calculate things like bracket and deduction adjustments, but a similar methodology in adjusting that measure to a chained approach would lead to roughly the same reduction in the inflation measure over time.

Others believe that a completely different inflation measure is necessary to reflect accurately the cost increases that seniors in particular face. The proposed CPI-E measure of prices for the elderly would have different weightings in the basket of goods used to calculate inflation, with the idea that older Americans have different needs from the working-age Americans whose spending behavior goes into the current CPI. Based on the recent past and on projections for the future, the CPI-E would lead to higher cost-of-living increases in the future.

Drawing a line in the sand

Many people will find it surprising to hear lawmakers arguing about a relatively obscure provision of the Trump tax plan that deals with the way that deductions and tax bracket amounts change from year to year. Yet the implications for changing the way the federal government measures inflation go far beyond the tax laws. Adoption of a chained CPI approach would be a potential threat to Social Security COLAs, and that's getting perilously close to the political third rail that many politicians will want very badly to avoid.

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