Economics, U.S. Economy

A CPI-fix for the fiscal cliff?

Image Credit: Shutterstock

Image Credit: Shutterstock

A change in how we measure inflation and how we implement it through federal policy is reportedly on the table to avert the upcoming “fiscal cliff.” Specifically, the idea is to use the “chain-weighted” Consumer Price Index (C-CPI) to calculate Cost of Living Adjustments (COLAs) for Social Security and other federal benefits and to index the income tax brackets. Currently, the standard CPI is used for these purposes, but it frequently overestimates the actual increase in the cost of living by not accounting for customer substitution. The Bureau of Labor Statistics states, and most economists seem to agree, that the C-CPI is “designed to be a closer approximation to a cost-of-living index than other CPI measures.”

The application of the C-CPI to Social Security has received a great deal of attention, but less has been paid to the tax code. Because incomes grow faster than inflation, an ever-greater share of incomes is subject to higher tax rates due to the so-called “real bracket creep.” The CBO projects that this effect will boost income tax revenues by around 2.6 percentage points relative to GDP over the next 25 years, a nearly one-third increase versus the 8.2% of GDP historical share collected through personal income taxes. A lower CPI in the form of a chained CPI would only exacerbate this autopilot trend toward higher taxes. A better approach would be to index the tax brackets to the growth of incomes; this would stabilize average tax rates over time and force Congress to make tax increases explicit.

Moreover, while the Obama administration surely would prefer to apply the C-CPI to taxes as well as Social Security benefits, doing so would violate their pledge not to raise taxes on households earning less than $250,000 per year. They might argue that the chained CPI is merely a technical fix to better measure inflation, but it’s unclear whether Americans will accept it.

3 thoughts on “A CPI-fix for the fiscal cliff?

  1. if you cant afford steak, and buy chicken instead, then your COLA goes down…then when you cant afford chicken anymore & buy dogfood instead, your COLA is cut again..

    • This is a common misconception regarding the chained CPI, that it effectively introduces a ‘race to the bottom’ in terms of prices and the standard of living. These kinds of examples — say, that steak becomes more expensive so you buy more chicken — have that implication. But note that if chicken becomes more expensive, people will buy relatively more steak. In other words, it goes both ways.

  2. I’d actually support the chained CPI – as long as it applied to ALL pensions including military pensions.

    If it does end up adversely affecting EVERYONE – there is a much better chance that a CPI-FIX would ensue.

    We keep acting like it’s SS alone that has this problem.

    Think about this – SS is an ANNUITY. Most private and military pensions are ALSO annuities even if you think they are not.

    What that means is that from an actuarial point of view – the money on the front in – FICA taxes and Military contributions to pensions – has to be high enough to pay the CPI on the back end.

    A chained CPI makes sense only as long as it has a correcting mechanism if it goes too low.

    It ought to not pay in excess of conditions but it also ought not to fall behind either.

    if it is indexed to real world conditions, it would be fine and correct.

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