Washington is full of speculation this week as Democrats and Republicans examine different ways to cut spending, raise revenue and reform entitlements to avert the so-called “fiscal cliff.” One policy getting more attention is a new way for the government to calculate inflation. So what does that actually entail, and how much would it matter?
Over time, the federal government makes cost-of-living adjustments to benefit programs like Social Security. As time passes, payouts increase to keep up with inflation. The size of that adjustment is based on a consumer price index, a measure of how much a fixed group of goods and services costs at any given time. The Bureau of Labor Statistics monitors people’s spending habits, as well as the prices of everything from bus fares to ladies’ dresses to broccoli, and produces a variety of indexes.
Social Security cost-of-living adjustments and federal retirement benefits are based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), the only index that was around when Congress mandated inflation-adjusted increases for Social Security and Supplemental Security Income in the 1970s. The CPI-W essentially estimates how much blue-collar urban workers have to spend each month to keep up the same standard of living. But many economists say this measure overestimates the effect of inflation.
In recent years, some policymakers have suggested the government use a different measure of inflation–the Chained Consumer Price Index for All Urban Consumers, known by the cumbersome acronym C-CPI-U. The “chained” index, instituted in 2002, more heavily weighs consumers’ tendency to substitute which goods they’re buying when prices change.
For example: If the cost of cashews skyrockets, people might plop peanuts in their grocery baskets. If the price of steaks rises faster than the price of poultry, a household might eat more chicken. The chained index accounts for this by linking monthly data together rather than using a biennial estimate of which goods and services are being purchased, like the CPI-W does.
So why would using chained CPI reduce the deficit? It grows more slowly—by about 0.3 percentage points annually–than traditional CPIs according to the Congressional Budget Office. That means cost-of-living adjustments for programs like Social Security would increase more slowly.
The latest cost-of-living adjustment announced by the Social Security Administration was an increase of 1.7%, which goes into effect for benefits paid in January, and will continue for 2013. Had economists used chained CPI instead of the CPI-W, BLS economist Darren Rippy estimates that the increase would have instead been 1.5%. The average payment to beneficiaries last month was $1,131.32: increasing that by 1.7% yields an additional $19.23 per month, while using the lower C-CPI-U number yields $16.97. But when those savings are totaled up for all beneficiaries over time, the result is significant. In a 2009 report, the CBO estimated that adopting the chained index would reduce Social Security outlays by $108 billion over a decade.
Applying the chained index to budgetary matters beyond Social Security could yield revenue, too. If it were adopted for the tax code–which currently uses an index called All Items CPI for All Urban Consumers (CPI-U)– the inflation adjustments for federal income tax brackets would grow more slowly, meaning more people would fall into higher tax brackets and send the government more money.
With the potential to produce revenue and cut spending, the chained index has gained high-profile bipartisan support. The Simpson-Bowles commission, the President’s deficit reduction team, recommended moving to the chained index for Social Security benefits and all other mandatory spending in their 2010 report. The Gang of Six, a bipartisan group of Senators tasked with producing a deficit reduction package last year, suggested a “government-wide” adoption.
Critics say chained CPI’s assumption that people will automatically switch to cheaper items—which may not be what they actually want—amounts to a lowered standard of living and a misrepresentation of the real cost of inflation. Interest groups such as the AARP–no fan of reducing Social Security payouts–oppose such a change, saying that the elderly population would suffer.
As the AARP points out, none of the official indexes are perfect measures of how costs change for the elderly; how a 70-year-old spends money is rarely close to the breakdown for a 40-year-old or 18-year-old. The BLS has started experimenting with an index specifically tailored to the elderly’s expenses, called the CPI-E. It assigns more weight to things like prescriptions and less to, say, cell phone bills, but Rippy says there’s no timetable to make the index official.
For now, the prospect of switching to the C-CPI-U has an additional catch: it takes longer for BLS economists to calculate accurate data for the chained index. The index is revised as data required for more accurate results comes in, much like monthly jobs numbers are. Monthly CPI-W numbers, by contrast, are not revised. Although the chained numbers are typically only changed a tenth of a percent or so, Rippy says, that difference makes linking them to Social Security a trickier business. “Each index has it’s own limitations,” he says, “and it’s really up to Congress to weigh the benefits and the costs.”