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1985 Federal Tax Policy Memo 1 (1985)

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L_ FEDERAL TAX POLICY MEMO

Editor: Edward A. Sprague, Vice President-Tax and Economic Affairs
Some Second Thoughts on Indexing

Some Tax Foundation members will recall our Federal Tax
Policy Memo which was issued as a separate publication on a
regular basis from 1978 to 1982 and sporadically since then. We
have decided to revive this piece and extend its circulation by
including it as an insert in most issues of Tax Features.
As indicated by its title, Federal Tax Policy Memo will
focus on current tax issues in an analytical and hopefully
understandable manner. We will go light on the statistical
tables although not promising never to use them. We hope to
provide some useful observations on tax reform, tax burdens,
budget policy and other such matters that the Congress and
Treasury are, and will be, grappling with in our capital city.
Reader suggestions and comments are most welcome and may
be addressed to the Editor, Federal Tax Policy Memo.
This year marks the start of indexing the Federal per-
sonal income tax for inflation. The rate brackets and per-
sonal exemptions are now adjusted to remove the effect of
inflation as measured by the increase in the consumer
price index (CPI) from October 1983-September 1984 over
the previous 12-month period. That means a 4.1 percent
factor applying to 1985 withholding tables as of January 1,
1985.
As reported in the November-December 1984 Tax Fea-
tures, indexing is expected to save individual taxpayers
$8-10 billion in calendar 1985, with the largest percentage
benefit going to middle-income taxpayers. The dragon of
bracket creep has been slain! Presumably there is some
rejoicing in the ranks.
In the meantime, the Treasury Department has been
busy putting together a plan for vast expansion of tax
indexing throughout the economy for capital gains, inter-
est, depredation and inventories. The revenue impact of
such indexing would be very substantial even if inflation
itself remains in the relatively modest 4-5 percent per year
range. The revenue impact, of course, must be considered
in the context of base-broadening measures in the reform
plan designed to increase revenues and balance the overall
program.
Over on the budget expenditure side there are new
efforts to restrain the cost of indexing entitlement pro-
grams. The Administration/Senate budget proposal for
fiscal 1986 for the first time would set across-the-board
limits on automatic benefit increases under Social Security
and Federal entitlement programs--in effect, reducing the

inflation adjustment by two percentage points. The
cumulative impact of this for fiscal 1986-88 would be bud-
get savings of approximately $28 billion (with the inflation
trend projection of about 4 percent a year under the Ad-
ministration's original budget assumptions). Already, of
course, there are instant warnings of hundreds of thou-
sands of elderly being thrown back under the poverty line
and other political rumblings that could derail such a bold
move. But the logic of restraint here is compelling-both in
terms of the deficit problem and sound long-term policy.
Eventually, it should prevail.
Indexing for entitlement benefits and indexing for taxes
have distinctly different rationales. The former is a deliber-
ate attempt to shield a segment of the population-mainly
retirees-from the effects of inflation. The latter aims to
correct for the unintended impact of inflation interacting
with the progressive rate structure of the income tax and
historic measurement of income. More broadly, tax index-
ing aims to eliminate the unlegislated tax increase that has
occurred because of the interaction of inflation and the tax
structure, thus forcing Congress to make more explicit
policy decisions with regard to both taxes and expendi-
tures. Supporters of indexing refer to it as an honesty in
budgeting tool. But, particularly if inflation adjustment
limits are set for entitlements to bring them under better
budget control, new questions are going to be asked about
the extent of tax indexing, too.
CPI Minus Two
There was proposed legislation in the 98th Congress
to limit the Social Security and Federal retirement cost-
of-living adjustments (COLAs) to inflation rates above
the first two or three percentage points of the CPI.
There have been repeated proposals to delay COLA
adjustments for six months or even a year. The mechan-
ics of the present proposal give a little better break to
beneficiaries by guaranteeing a two percent inflation
adjustment and allowing almost full adjustment if infla-
tion reignites to double digits but continuing the re-
straint program over a more sustained period. This
would result in quite significant future budget savings
regardless of the specific rate of inflation (assuming it
will stay above three percent). The projected COLA
savings in fact are the single largest item in the Admin-
istration/Senate deficit reduction plan next to reduction
in defense from the earlier budget base line.

Material in Federal Tax Policy Memo inaiy be reproduced freeh/. Credit to Tax Foundation, Incorporated, would be appreciated.

:MAY 1985

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