By John W. Diamond
Social Security is set to boost the benefits it provides retirees by 8.7%, the biggest cost-of-living adjustment since 1981. It comes as sky-high inflation continues to eat into incomes and savings.
The changes are set to take effect in January 2023 and were announced following the release of the September 2022 consumer price index report, which showed inflation climbing more than expected during the month, by 0.4%.
The automatic adjustment will surely come as a relief to tens of millions of retirees and those who receive supplemental security income who may be struggling to afford basic necessities as inflation has accelerated throughout 2022. But an annual adjustment wasn’t always the case – and other government benefits and programs deal with inflation differently.
John Diamond, who directs the Center for Public Finance at Rice’s Baker Institute, explains the history of the Social Security cost-of-living, or COLA, increase, what other benefits are adjusted for inflation and why the government makes these changes.
1. How fast is the cost of living rising?
More troubling, so-called core inflation – which excludes volatile food and energy prices – gained even more in September, ticking up by 0.6%. Core inflation is a measure that’s closely watched by the Federal Reserve, as it helps show how pervasive and persistent inflation has become in the economy.
2. How are Social Security benefits adjusted for inflation?
Automatic adjustments to Social Security benefits began in 1975 after President Richard Nixon signed the 1972 Social Security amendments into law.
Before 1975, Congress had to act each year to increase benefits to offset the effects of inflation. But this was an inefficient system, as politics would often be injected into a simple economic decision. Under this system, an increase in benefits could be too small or too large, or could fail to happen at all if one party blocked the change entirely.
Not to mention that with the baby boomers – those born from 1946 to 1964 – entering the labor force it was already clear that Social Security would face long-term funding issues in the future, and so putting the program on autopilot reduced the political risk faced by politicians.
Since then, benefits have climbed automatically by the average increase in consumer prices during the third quarter of a given year from the same period 12 months earlier. This is based on a version of the consumer price index meant to estimate price changes for working people and has been rising slightly faster than the overall pace of inflation.
While helpful, these inflation adjustments are backward-looking and imperfect. For example, 2022 Social Security benefits increased by 5.9% from the previous year, even though inflation throughout this year has been significantly higher – which means the higher benefits weren’t covering the higher cost of living. Thus, the 2023 increase in benefits primarily offsets what was lost over the previous year.
3. Are the benefits taxable?
A growing portion of Social Security benefits are taxed in the same way as ordinary income, except at different threshold with various caps and percentages. Only 8% of benefits were subject to taxation in 1984, but that’s climbed to almost 50% in recent years. That percentage will likely continue to increase as the taxable thresholds are not adjusted for inflation.
For example, if an individual filer’s income, including benefits, is below US$25,000, none of that is taxed. But up to 50% of a person’s benefits may be taxed at incomes of $25,000 to $34,000. After that, up to 85% of their benefits may be taxed.
Such a big increase in Social Security benefits likely means some people who paid no tax will now have to pay some, while others will see larger increases in their tax liability.
4. Why does the government adjust benefits for inflation?
Rapid gains of inflation, like the kind the U.S. and many other countries are currently experiencing, can have significant impacts on the finances of households and businesses.
For example, it might mean seniors cutting back on heating or food. Government policies generally try to account for this to reduce the negative impacts that rising prices can have on those with limited or fixed resources.
In addition, reducing the impacts of price changes creates a more efficient and fair allocation of resources and reduces the arbitrary outcomes that would otherwise occur.
5. What other government programs typically get a COLA?
Other government programs and benefits also increase to account for inflation.
The U.S. Department of Agriculture estimates the cost of its Thrifty Food Plan each June and adjusts Supplemental Nutrition Assistance Program or SNAP benefits – formerly known as food stamps – in October of each year. Beginning in October 2022, food stamp benefits rose by 12.5%, which helps make up for the largest increases in food prices since the 1970s.
In addition, the federal poverty level is adjusted for changes in the consumer price index annually by the Department of Health and Human Services, an adjustment that affects a number of government-provided benefits, such as housing benefits, health insurance and others, including SNAP benefits.
6. Does the tax system also adjust for inflation?
While some aspects of the tax code adjust for inflation, others do not.
For example, income tax bracket thresholds, the size of the standard deduction, alternative minimum tax parameters and estate tax provisions all increase annually for inflation. That means come tax filing season next year, U.S. tax filers will likely see big changes in all these items.
But examples of provisions that are not adjusted for inflation include the maximum value of the child tax credit and the $10,000 cap on the deduction of state and local taxes. In addition, the threshold that determines who is liable for the net investment income tax – the additional 3.8% tax on investment and passive income for taxpayers above a certain income level – doesn’t adjust, which means each year more individuals are subject to it.
John W. Diamond is Director of the Center for Public Finance at the Baker Institute, Rice University.
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