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Capital Comments: Cost of Living Adjustments


First, I congratulate myself for not making a COLA joke. I’m a serious economist. Also, I couldn’t think of one.

COLA stands for cost of living adjustment, and both the Social Security Administration and the Internal Revenue Service have just announced big COLAs for next year. COLAs are nothing new. They’ve been happening for decades. But inflation has been so low for so long that we hardly noticed them. Now inflation is the highest it’s been in 40 years, and COLAs are in the news.

Suppose we measure income based not on the dollar amount of a paycheck or benefit payment, but based on the collection of goods and services that the income can buy. Call it “real income.” If the prices of goods and services go up, but the dollar amount on a paycheck does not, less can be purchased. Income doesn’t buy as much. Real income has decreased. If paychecks are unchanged and prices are rising a lot, real income can decrease a lot.

That used to be a problem for Social Security beneficiaries. Before 1975, price increases reduced what benefit checks could buy. Real Social Security income decreased. Inflation rose to 11 percent in 1974, which took a big bite out of people’s budgets. Sometimes Congress would pass a law to raise benefits to match inflation. Sometimes not.

That changed in 1975. Congress passed an annual cost of living adjustment. Now, Social Security benefit payments automatically rise to cover price increases. Real incomes are maintained. The increase is based on inflation as measured by the consumer price index, which is an average of the prices of products that households typically buy each year. In the first eight years of the automatic COLA, the adjustment averaged almost 9 percent per year. Without it, real benefit payments would have been cut nearly in half.

Inflation subsided after 1982. The COLA topped 5 percent only twice in the 38 years from 1983 through 2020. But with inflation so high in 2022, benefit payments will rise 8.7 percent, effective in January. It’s the biggest COLA since 1981. It will help maintain the real incomes of the 70 million Social Security beneficiaries. The average benefit will rise from $1,681 to $1,827 per month.

The U.S. income tax has an inflation problem too. Suppose a paycheck’s dollar income rises by 7 percent, but prices rise by 7 percent too. Real income is unchanged—it still buys the same goods and services as before. But suppose the paycheck increase moves the income earner into a higher tax bracket. Maybe the taxable income rose from $40,000 to $43,000, crossing the $41,775 threshold from the 12 percent to the 22 percent tax bracket. Now part of the income is taxed at 22 percent instead of 12 percent. The share of that paycheck paid to the IRS goes up, even though real income was unchanged. After-tax real income would be lower.

The standard deduction is a problem too. The single taxpayer deduction is $12,950 this year. If that were unchanged, but inflation increased incomes, a greater share of total income would be taxable. That would decrease after-tax real income too.

The big tax reform in 1981 took care of this problem. Inflation had been running in double digits, pushing people into higher tax brackets and making a bigger share of income taxable. Starting in 1985, deductions and tax brackets were adjusted for inflation each year. The IRS just announced the new brackets and deductions for 2023 incomes (for tax payments in 2024). They’ll rise by about 7 percent. The threshold for the 22 percent tax bracket for individuals will rise from $41,775 to $44,750. That taxpayer with the $43,000 income would remain in the 12 percent bracket. The individual deduction will increase from $12,950 to $13,850 too. With the new brackets and deductions, after-tax real income would not change.

For almost 30 years, from 1992 through 2020, inflation averaged near 2 percent, and cost of living adjustments were small. Social Security payments increased by dozens of dollars. Tax brackets and deductions increased by a few hundred. It made a big difference over the decades, but we hardly noticed year-to-year.

Now inflation is high again, and COLAs are no joke.

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