On January 24, the White House announced that the administration will send its Fiscal Year 2015 budget proposal to Congress on March 4. Republicans controlling the House of Representatives will most assuredly ignore its major recommendations, which include a tax increase on wealthier individuals and corporations. But what might catch Republicans’ eye is a proposal Obama included in his Fiscal Year 2014 budget, and will likely include this year: “chained” consumer price index (CPI).
Obama’s decision to include chained CPI in his Fiscal Year 2014 budget drew the ire of Democrats, who criticized it as a way to shrink Social Security payments to seniors. “Millions of MoveOn members did not work day and night to put President Obama into office so that he could propose policies that would hurt some of our most vulnerable people,” read a statement from Anna Galland, executive director of the group. Republicans, in contrast, embraced the proposal. “I want to say something I don’t say much, which is, I congratulate the president on acknowledging we have a problem [with Social Security],” said Rep. Tim Griffin (R-Ark.).
If you’re not sure what “chained CPI” is, you’re not alone. The fact that chained CPI is a wonkish topic is a feature, not a bug. In fact, chained CPI’s innocuous sounding name might just be the reason it could be included if comprehensive deficit reduction ever materializes.
But that is not necessarily a good thing. The less you know about chained CPI, the more likely you can be misled. So let’s clear the weeds. Here’s how chained CPI works.
Inflation is defined as a persistent increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money. In the context of the federal government, in the absence of an inflation adjustment (i.e. indexation), this loss of real value in the medium of exchange means that the purchasing power of many federal benefits would decline and tax rates would rise as general price levels rise. After indexation, however, only the effects of real economic growth remain. In essence, therefore, indexing for inflation protects beneficiaries’ buying power from being relentlessly eroded, and similarly protects taxpayers from being forced to pay higher taxes for what is essentially the same amount of income they had previously.
The level of indexation is determined by which method is used to measure inflation. Federal programs are currently adjusted for inflation using the Consumer Price Index for All Urban Consumers (CPI-U) or the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The CPI-U, which is the basis for adjusting personal tax parameters to keep up with inflation, measures changes in the prices paid by urban consumers for a fixed representative basket of goods and services. The CPI-W, which is the basis for adjusting Social Security benefits, measures changes in prices paid by urban wage earners and clerical workers. There are other ways to measure inflation. The Federal Reserve’s preferred measure of inflation, for example, is Personal Consumption Expenditures (PCE), which is produced by the Bureau of Economic Analysis (BEA). Moreover, other measures – such as the GDP deflator and the Price Producer Index (PPI) – can also be used to measure aspects of inflation. Regardless of the method used, however, measuring inflation mostly involves measuring changes in the price of a representative basket of goods and services.
As noted above, the CPI-U and CPI-W are currently used to adjust current federal programs and tax parameters for inflation. However, there has been a long-standing concern among economists that the CPI-U and CPI-W systematically overstates inflation in the economy, for three primary reasons.
First, the CPI-U and CPI-W does not adequately take into account “substitution bias” – changes in consumers’ spending patterns in responses to changes in the relative prices of goods and services. For example, if the prices of both apples and oranges rise, consumer spending will generally shift toward the good whose price rises by the smaller percentage. But the CPI-U and CPI-W updates the “market basket” only periodically, meaning that the basket would not adequately reflect this shift in consumer spending patterns. In fact, the market basket used in CPI-U and CPI-W is often based upon spending patterns that are between two and four years old.
Second, the CPI-U and CPI-W does not adequately take into account “outlet substitution bias.” This type of distortion can result when consumers shift their patronage from one retail outlet to another, as when consumers offset a portion of a price increase by purchasing the same good from a lower-cost outlet. As superstores and warehouse-type stores continue to open and capture a larger share of the market, the existing CPI sample becomes increasingly unrepresentative. If the prices are lower at the new outlets and this decrease in costs is not accurately captured in the CPI, the index will exhibit an upward bias. Admittedly, the size of this outlet substitution bias should be quantitatively smaller than the substitution bias, but this too can result in CPI-U and CPI-W overstating inflation.
Third, the CPI-U and CPI-W are calculated using only a small portion of items in the economy. This concern, which is often referred to as “small-sample bias,” is grounded in the fact that it is impractical, and extraordinarily costly, to collect price information for every good and service in the economy. The Bureau of Labor Statistics (BLS) produces an inflation index for an item in a specific region by averaging the growth rates of a sample of prices for that item in that locale. However, although there can be thousands of prices for items in each geographic area, BLS creates the item-area indexes using, on average, prices of only about 10 examples of each item. This small sample size creates a measurable upward bias in those indexes, which carries through to the overall CPI.
The chained CPI was designed to address these problems and provide a more accurate measure of inflation. In particular, chained CPI utilizes yearly updating of consumer patterns, and provides a more accurate estimate of changes in the cost of living from one month to the next by using market baskets from both months (thus “chaining” the two months together). As a result, chained CPI significantly reduces the potential overstatement of inflation in the CPI-U and CPI-W attributed to the substitution bias and outlet substitution bias. Furthermore, the chained CPI combines item-area indexes when calculating price information for goods and services in the economy, effectively making the number of elements in the geometric average much larger. This larger sample size essentially eliminates the small-sample bias.
Adopting the chained CPI for inflation adjustments would also have significant budgetary and distributional effects. Using an inflation measure that overstates inflation increases the budget deficit. As a more accurate measure of inflation, using the chained CPI to adjust for inflation is projected to reduce the budget deficit. According to the Congressional Budget Office (CBO), adopting the chained CPI would have reduced the deficit by $3.4 billion in 2014, rising to $69.3 billion in 2023. In addition to its budgetary effects, the adoption of chained CPI would alter the distributional burden of the tax code and the benefits of federal spending. According to a 2011 Joint Committee on Taxation (JCT) report, adopting the chained CPI would reduce the progressivity of the tax code. In fact, ten years after switching to the chained CPI, the Urban-Brookings Tax Policy Center estimates that taxpayers in the bottom quintile would face an increase average tax burden of $55, while taxpayers in the top quintile would face an average increase in their tax burden of $364 (those in the top 0.1% would have an average increase in their tax burden of $1,476).
But while many analysts consider the chained CPI to be a more accurate measure of the cost of living than the traditional CPI, using it for indexing could have disadvantages. It’s not as simple as merely getting a more accurate measure of inflation.
In fact, utilizing the chained CPI could lead to worse public policy.
Consider, for instance, the effect of substituting the chained CPI for the CPI-W, which is used to calculate annual cost-of-living adjustments (COLAs) for Social Security. According to the Social Security Administration, once fully implemented, the top and bottom quintiles of household income would see a 4% decrease in their benefits in 2070 from adopting chained CPI, while the middle three quintiles would see a 3% reduction in benefits. For the average worker retiring today, this change amounts to a cumulative benefits cut of $28,000 by age 95.
Furthermore, unlike most reforms, COLA reductions fall hardest on the elderly, who are most at risk for poverty, compared to the overall population. And because the chained CPI doesn’t account for the fact that older retirees spend disproportionately on health care, a sector in which inflation is particularly high and rising still (albeit at a slower pace than a decade ago), smaller COLAs would fundamentally weaken the promise of Social Security. Simply stated, it is difficult to justify chained CPI as a more accurate measure of inflation for the elderly and people with disabilities, for it targets the very old and people with long-term disabilities for the deepest cuts.
So what’s the takeaway from all of this?
There is growing recognition that Social Security needs to be fixed, and that lower benefits for middle and high earners should be part of the equation. But to fix any of this, we need clarity. The debate over chained CPI has been obscured by rhetorical smoke and mirrors from politicians in both parties. Democrats have opposed chained CPI on the basis that it represents an unacceptable cut to Social Security. Republicans have championed the idea as a necessary reform to the social safety net for current and future retirees. What is clear, however, is that the debate is much more complicated than what either party would have you believe.
In fact, the absence of stand-alone proposals to adopt technical correction suggests that technical merit is not the main driver of interest in adopting the chained CPI. If not technical merit, what then? The fact is, the proposal to switch Social Security to the chained CPI has much more to do with politics than with economics. And that’s a shame, because this is one proposal that is worthy of thoughtful and considered debate.