It’s my annual Taxes from A to Z series! If you’re wondering how to figure basis for cryptocurrency or whether you can claim home office expenses during COVID, you won’t want to miss a single letter.

I Is For Inflation.

Inflation is the measure of the rate at which the average price of goods and services increases over a period of time. As prices go up, typically the buying power of currency – in our case, the dollar – goes down so that currency buys less than it did before. Put another way, inflation is a decrease in buying power so that it costs more money to buy the same thing as before.

So what does that have to do with tax? 

For one, many government benefits – like Social Security benefits – are tied to inflation.The procedures outlined at section 215(i)(2)(A) of the Social Security Act generally require the government to examine the overall cost of living and determine whether an increase in benefits is necessary. The easiest way for most folks to determine whether those numbers will be on the way up or down is to look at the consumer price index (CPI). The U.S. Bureau of Labor Statistics reports whether the CPI has moved up or down. That’s important because the CPI measures the cost of goods and services – in other words, your cost of living. The CPI tends to signal what’s going to happen with interest rates – and inflation. A number of those the items you’ll see in the Tax Code are dependent on inflation.

The same is true for many tax characteristics – like tax brackets – which change based on the economy. And beginning in 2018, thanks to the Tax Cuts and Jobs Act (TCJA) , the “normal” CPI has been replaced with a “chained” CPI. The chained CPI measures consumer responses to higher prices rather than simply measuring higher prices. 

Here’s an example of the two (CPI and chained CPI) are calculated:

Let’s say that in 2019, coffee was $10/pound and tea was $10/pound. And because I tend to drink more coffee, I bought 10 pounds of coffee and 2 pounds of tea. 

In 2020, let’s say that coffee jumped to $15/pound and tea went up to a mere $11/pound. 

Even though I love coffee, let’s say I switched to tea because it was cheaper (again, this is just a hypothetical – I am not, I repeat, not changing my coffee consumption) and bought 5 pounds of coffee and 7 pounds of tea. I still bought 12 pounds of caffeinated beverages but I altered the proportions because of the pricing. The theory is that most folks react in a similar manner – you alter your spending to compensate for increases.

Here’s how the “normal” CPI calculations based solely on price increases would look:

(10 x 15) + (2 x 11)/(10 x 10) + (2 x 10) = 1.4333

But the “chained” CPI calculations which reflect the change in my behavior would look like this:

(5 x 15) + (7 x 11)/ (10 x 10) + (2 x 10) = 1.267

In my examples, the “chained” CPI results in a lower number – that tends to be the pattern. While that means a lower payout for benefits – like Social Security – over time, it’s considered by many to be a more accurate capture of spending power.

The annual inflation rate for the United States is 0.1% for the 12 months ending May 2020; that’s the lowest rate of inflation in about five years. The Federal Reserve doesn’t have a formal inflation target, but generally, an acceptable inflation rate is around 2%. The next inflation update is scheduled for release on July 14, 2020.

You can find the rest of the series here:

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