For the October to October annual cost of living adjustment, the United States had its second largest increase in 40 years, resulting in bigger changes to payroll-related figures like the Social Security taxable wage base in 2023.
On April 12, 2023, the U.S. Bureau of Labor and Statistics (BLS) announced that the Consumer Price Index (CPI) increased 0.1% in March and increased 5.0% over the last year, which was the smallest increase since the period ending May 2021. The CPI and payroll are intertwined in a variety of ways. Employers and payroll professionals look to these monthly numbers to make changes and adjustments to payroll systems and also to forecast possible impact on the business in the near future. Recently, an economist went over the finer points of the CPI and how it relates to payroll.
What is the CPI?
The CPI is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods. “This is a group of both services and goods that consumers use on a daily, weekly, [and] monthly basis,” said Boyd Nash-Stacey, Principal Economist and head of the Center of Excellence at Prevedere.
What are the differences between CPI-U and CPI-W?
The BLS posts the CPI each month for a number of geographic regions in the United States. Other regions are only measured twice a year or annually. The indexes cover the following two population groups: (1) CPI for All Urban Consumers (CPI -U), which covers 93% of the U.S. population; and (2) CPI for Urban Wage Earners and Clerical Workers (CPI -W), which covers 29% of the U.S. population. The CPI -U refers to all consumers regardless of wage-earning status, while the CPI -W refers specifically to wage earners and clerical workers.
Inflation high but showing signs of easing
For months after the height of the COVID-19 pandemic, the BLS has continued reporting higher-than-usual CPI numbers. For example, in June 2022, the BLS reported the largest CPI increase since February 1981.
The February 2023 report showed an increase of 0.4%, meaning that “things are still running very hot” said Nash-Stacey, who has published research on factors driving the slowing prime-age labor force participation. The March 2023 report shows that things are starting to cool down, at least in the short term. “We do expect inflation to ease or slow down this year,” Nash-Stacey noted.
CPI uses in payroll
Many employers and payroll professionals view the CPI for several noteworthy annual adjustments. Typically, in October and November, the Social Security Administration (SSA) and IRS announce a number of payroll-related tax inflation adjustments for the following calendar year. Nash-Stacey explained that keeping an eye on these major annual developments is “extremely important.”
Wage base increase
One of the more important determinations is the announcement of the Social Security taxable wage base increase. Both employers and employees pay a 6.2% tax on workers’ wages earned each year up to that year’s wage base. In 2022, that base was $147,000. For 2023, the taxable wage base jumped by $13,200 to $160,200.
The SSA uses the Cost of Living Adjustment (COLA) to determine the taxable wage base, which is based on the CPI-W. “COLA adjustments are based on the October to October change in the Consumer Price Index,” Nash-Stacey said, adding that the COLA adjustment for 2023 increased 8.7%, “which is the second largest since the 1980s when it increased by 14.3%.”
Key tax figures
In mid-October 2022, the IRS announced the adjustments of several key tax figures for 2023, including qualified transportation fringe benefits, long-term care premiums, payments received under qualified long-term care insurance, Archer MSAs, the limit on health FSA salary reduction contributions under a cafeteria plan, the small employer health insurance credit, the adoption exclusion, and the foreign earned income exclusions, among other items.
Annual dollar limitations
The IRS also announces the annual dollar limitations for pension plans each year. Later in October 2022, the IRS reported increases occurring in 2023 for things like elective deferrals, defined benefit plans, highly compensated employees, catch-up retirement plan contributions, and the dollar amount for determining the maximum account balance in an employee stock ownership plan (ESOP) subject to a five-year distribution period (see Payroll Guide ¶3115).
The IRS uses the CPI to make these annual determinations. Understanding when and how the IRS and SSA use the CPI for annual benefit adjustments is important, so payroll departments and professionals can properly prepare systems and programs for the following calendar year.
The CPI and minimum wage rates
Another component of the CPI that relates to payroll has to do with the minimum wage rates in many states and localities. In many jurisdictions, the CPI determines how much the next year’s minimum wage rate may increase. California, for example, has both a state minimum wage rate and more than 40 local minimum wage rates. The state and many local rates are based on the CPI. Inflation triggered the most recent minimum wage rate increase of $0.50 per hour for all California employers. These increases can be predicted and helpful for employers that have a number of employees in an affected jurisdiction.
“If I have a significant portion of my workforce close to or at the minimum wage line, and it is subject to changes from the CPI, then I would plan for higher than average wage costs,” Nash-Stacey explained. He continued by saying, “There’s definitely something to be said for being aware of wage growth in the next few years.”
Federal tax brackets
Each year, the IRS adjusts tax brackets for COLA to calculate federal tax liability. The federal income tax brackets are located in IRS Publication 15-T, Federal Income Tax Withholding Methods. This publication also contains other information for automated and manual payroll systems. For some time, the brackets were part of IRS Publication 15 (Circular E), Employer’s Tax Guide. However, after the IRS significantly revised Form W-4, Employee’s Withholding Certificate, in 2020, the IRS began putting the bracket tables in Publication 15-T.
To make adjustments to the federal tax bracket tables, the IRS looks at the CPI-U from September to August and compares that average with the one for the preceding 12 months. The IRS says that making these adjustments from the CPI has the effect of preventing taxpayers from being moved into higher marginal tax brackets for increases that do not exceed inflation.
Payroll professionals, plan ahead for CPI announcements
The IRS begins making calculations for adjustments to its annual federal tax bracket tables and the standard deduction after the August CPI-U is published each September. It is a good practice that employers and payroll professionals set a reminder on their calendars so that they may plan ahead for upcoming changes. A lot of payroll departments start to gear up for the busy “year-end” period in the late summer to early fall. Staying on top of the CPI can help for a smooth transition for the next calendar year.
For more information on the CPI, see Payroll Guide ¶1601.
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