Most students of elementary economics — at least back in my day — learn the perils of the “wage-price spiral.” When a source of income, whether wages or entitlements, is automatically indexed to inflation, the added money will simply help to fuel even more inflation, which will then drive higher “cost of living adjustments,” which will drive higher inflation, and so on. Automatic COLAs are the fiscal equivalent of Oxycontin — they may ease your economic pain in the short run, but over time they can cripple you worse than your original illness.
Of course, the same process works, but in reverse, when the COLA is applied, not regarding money from the government, but rather money to the government:
The tax code has many adjustments for annual increases in the price level, or what are commonly called “adjustments for inflation.”
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[T]he time period of September 2005 – August 2006 was relatively high as a result of the run-up in energy costs. The CPI-U increased by an average of 3.9037 percent in that time period, which is the highest change since 1990.
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[This] means that the bracket and other statutory adjustments will be fairly significant.
In other words, even though marginal tax rates are not changing, effective tax rates will decline due to higher deductions, exemptions, tax brackets and other factors that are automatically increased by COLAs. If you earn exactly the same this year as you did last year, then you will pay less federal income tax.* Yay for COLAs!
On the other hand:
–The Alternative Minimum Tax, unlike the Federal Income Tax, is not adjusted for inflation. This is the primary reason that this “only for super-rich tax avoiders” scheme will soon apply to over one-third, and eventually to two-thirds, of middle-class households. While Congress does absolutely nothing about it.
–COLAs of course also apply to Social Security benefits. The unusually high CPI will lead to an unusually high benefits COLA, which in turn will exacerbate the Social Security crisis. While Congress does absolutely nothing about it.
–The wage cap for Social Security is also tied to the CPI. So anyone making over $94,200 (the current ceiling) will see a tax increase. While Congress does absolutely nothing about it.
As with all public policy, especially all tax and entitlement policy, some people benefit at the expense of others. No program, and no change to it, is ever “good for everyone.” Something to keep in mind the next time you hear how wonderful COLAs are, or how “unfair” the income tax is, or how “successful” Social Security has been.
(*Actually this particular COLA will take effect for Tax Year 2007 — i.e., the tax returns due April 15, 2008.)
