A new way to calculate inflation included in President Donald Trump’s sweeping tax reform reportedly will push more Americans into higher tax brackets at a quicker pace.
The new method will use the "chained" consumer price index to determine when to adjust tax brackets and eligibility for deductions, NPR reported.
In the past, the tax code used the traditional CPI measure issued by the Labor Department each month.
By switching to this new method, the government will bring an additional $134 billion into federal coffers over the next decade, NPR reported, citing the Joint Committee on Taxation.
“The chained CPI makes inflation appear lower, and that means tax brackets will be adjusted upward more slowly — but lots of workers will continue to get raises based upon the faster-rising traditional CPI. In other words, your income may rise faster than the inflation adjustments, forcing you to pay taxes at a higher rate — even though you may not feel any richer,” NPR explained.
"Compared to where taxpayers would be under present law, by 2027 most individuals will actually pay more taxes," said Steve Rosenthal, senior fellow at the Urban-Brookings Tax Policy Center.
The difference will be slight, "but over time, these fractions of a percentage point add up and can amount to a fair amount of money," NPR quoted him as saying.
The government for decades has been indexing tax rates to inflation, to prevent "bracket creep" — the steady movement of more and more taxpayers into higher tax brackets, NPR reported.
"These adjustments prevent taxpayers from being pushed into higher tax brackets when their incomes rise just enough to keep up with inflation," NPR explained, citing a report from the Brookings Institution.
"The usual way to do an index for inflation is to look at a basket of goods, see how much it costs you in, say, 2016, go back, get the next basket of goods and see what it costs you in 2017, and compare the same basket over two years," says Douglas Holtz-Eakin, former director of the Congressional Budget Office. "Unfortunately, when prices for goods go up, people tend to purchase less of them" and buy substitutions.
Chained CPI is calculated by the Labor Department to account for these real-world purchasing decisions. This alternative inflation measure “is seen by many economists as more accurate. The administrations of George W. Bush and Barack Obama proposed switching to chained CPI as part of a broader tax reform,” NPR explained.
"What the tax-reform bill does is actually just substitute what everyone agrees is a more accurate measure of inflation for the old measure," says Holtz-Eakin, president of the American Action Forum.
To be sure, Wall Street’s rally could have another leg up next year thanks to a sweeping tax cut and economic momentum, but investors are counting the risks such as roaring inflation that could abruptly end the party.
The S&P 500 is up about 20 percent with less than a week to go of 2017, and many strategists expect the bull run that began in 2009 to extend into next year, albeit with smaller gains. Optimism is high following sweeping tax cuts passed by Congress last week that are expected to give an added boost to corporate profits next year.
But strategists and investors highlight risks for the year ahead such as rate hikes and inflation, Reuters reported.
Some strategists fear inflation will accelerate too quickly as economic growth picks up, creating margin pressure and putting pressure on the Fed to bump up rates faster than investors expect.
“Inflation could be a global game-changer for stock and credit markets,” Bank of America Merrill Lynch analysts said in their 2018 outlook this month, adding that wage inflation was potentially the most important factor for the stock market.
Meanwhile, the Trump tax plan also very well could change how Wall Street works as the new legislation offers traded partnerships options for change amid a linger question of whether becoming a corporation is worthwhile taxwise, Bloomberg reported.
Publicly traded partnerships, including private equity firms Apollo Apollo Global Management LLC, Blackstone Group LP and Carlyle Group LP, are taxed differently than corporations.
So should they take advantage of the overhauled tax rules to pay less in taxes? Or should they use this chance to change to an Inc. from an LLC or LP, which would increase tax bills but allow them to attract investments from mutual funds that have previously been out of reach?
“We’re still analyzing,’’ Black told the Goldman Sachs U.S. Financial Services Conference Dec. 6. “It’s an uncertain outcome.’’
Either way, it’s most likely a money-making outcome. The tax changes are a boon for firms such as Apollo, where Black is chief executive officer. The new lower corporate rate has made it possible for bigger publicly traded partnerships to consider the change. As it is, management fees, which typically account for 30 percent or more of their earnings, are already taxed at the corporate rate. That will drop. The legislation scarcely touched the 23.8 percent rate paid on incentive fees, also called carried interest, which incur no additional levy when paid out to shareholders.
If the partnerships converted to corporations, the incentive fees would be hit with a second layer of tax when they’re paid out. That would push the combined tax rate on incentive income paid out as dividends to nearly 40 percent, according to Peter Furci, co-chair of Debevoise & Plimpton’s global tax practice.
But it would also allow the newly minted corporations access to indexes, and therefore the mutual-fund and ETF markets. About $2.2 trillion follows the S&P 500 Index, according to its website. As of June, $122.6 billion in assets tracked the Russell 2000 Index, the best-known small-cap U.S. stock index, and there was $1.1 trillion bet on Russell U.S. indexes overall, according to the company.
The bigger universe of investors would likely boost the trading multiples of the firms’ stocks. It’s unclear how big the economic benefit of increased ownership would be, so the question is whether it would make up for the higher taxes.
“There’s no way to say how much multiple expansion you could get by converting,’’ said Gerald O’Hara, who follows private equity firms for Jefferies Group. “That’s the question here that I think these firms are wrestling with.’’
(Newsmax wire services contributed to this report).
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