Will Chained Consumer Price Index Punish the Taxpayers?

Leave it to government to try to reduce the budget deficit on the backs of elderly taxpayers. Bureaucrats have decided that the cost of living adjustments (COLAs) have been too generous and must be scaled back. COLAs are made yearly to offset the loss of purchasing power of money due to inflation.

Simply described, inflation refers to a sustained increase in the general price level. Inflation is calculated as an average since not all prices rise, some remain the same, and some even drop. Rapid inflation and currency depreciation can occur if money is overprinted (quantitative easing), by increasing the money stock without the backing of goods and services to justify the printing.

The Bureau of Labor Statistics (BLS) calculates the unemployment rate and two types of inflation: The Consumer Price Index for all Urban Consumers (CPI-U) and the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).

The traditional measurement has been CPI for all consumers, by using a “basket of goods” which changes over time. The “basket of goods” used to calculate inflation include eight major categories with more than 200 groups:

-          food and beverage (cereal, milk, coffee, chicken, wine, snacks, restaurant meals)

-          housing (rent, owners’ rent, fuel oil, bedroom furniture, water and sewage fees)

-          apparel (men’s shirts and sweaters, women’s dresses, jewelry)

-          transportation (new cars, airline tickets, gas, car insurance, car tolls, auto registration fees)

-          medical care (prescription drugs, medical supplies, doctor’s services, eyeglasses, eye care, hospital services)

-          recreation (TV, cable, pets, pet products, sports equipment, admission tickets)

-          education and communication (college tuition, postage, telephone services, computer software and accessories)

-          other goods and services (tobacco, haircuts, personal services, funerals).

Sample goods in each category are chosen “using scientific statistical procedures.” For example, in the apple category, a 4.4 pound bag of golden delicious apples, U.S. extra fancy grade is used. As a consumer, I prefer Gala and Fuji apples.

http://www.bls.gov/dolfaq/bls_ques3.htm

Sales and excise taxes directly associated with the price of specific goods and services are also included in CPI calculations. Income, Social Security taxes, investments such as stocks, bonds, real estate, and life insurance are not included by the Bureau of Labor Statistics (BLS) in CPI calculations.

Since inflation rate has been reported for January (1.6 %), February (2.0 %), and March (1.5 %), (http://www.usinflationcalculator.com/inflation/current-inflation-rates/) and prices in grocery stores and at the gas pump contradict the rosy picture, I am not convinced that food and gasoline prices are included in the CPI currently.

Generic CPI is important because it is a powerful policy control. CPI-W is used to calculate cost of living adjustments (COLAs) for Social Security retirement benefits. CPI-U is used to calculate “annual inflation adjustments to personal income tax brackets,” affecting outlays and revenues. Outlays are government-speak for spending. www.fas.org/sgp/crs/misc/RL32293.pdf

Since 2002, the Bureau of Labor Statistics (BLS) published a Chained Consumer Price Index for all Urban Consumers (C-CPI-U) in order to report CPI “free of substitution bias.” Substitution is an economic term which refers to consumers who change their buying pattern as a direct result of changing relative prices. Consumers buy goods and services more when their prices increase slower over time. If prices rise sharply, consumers substitute those goods.

Policy-makers believe this substitution effect protects consumers from the full effect of rising prices. Neither CPI-W nor CPI-U entirely accounts for substitution thus overstating “the impact of inflation on consumer well-being.” (Julie M. Whittaker, The Chained Consumer Price Index: What Is It and Would It Be Appropriate for Cost-of-Living Adjustments, May 8, 2013)

If I have to switch the quality and type of food I buy (substitute it) for a cheaper or different alternative, it does affect my standard of living. I have insulated myself from higher prices (inflation) but the quality of what I eat has gone down.

Accounting for consumer substitution, the Chained Consumer Price Index (C-CPI-U) has increased less than CPI-U or CPI-W. Politicians argue that less cost of living adjustments (COLAs) should be made to various benefits.

To decrease the budget deficit, lawmakers recommended in reports such as the “2010 Simpson-Bowles” and the April 2013 President Obama’s Fiscal Year 2014 Budget, a government-wide replacement of the CPI-U and CPI-W with the Chained Consumer Price Index  (C-CPI-U) “when calculating automatic adjustments to inflation-indexed federal tax programs and individual tax provisions.”

Wage rates, pensions, interest payments on bonds, income taxes, and many other benefits would be indexed based on the Chained Consumer Price Index which would take into account the substitution effect.

Indexing Social Security benefits, federal and military pensions based on the Chained Consumer Price Index formula will decrease the population’s standard of living if prices increase at an above-average rate. The elderly spend more on health care and prices for such services have increased at an above-average rate. (CRS Report RL32293, Julie M. Whittaker, May 8, 2013, p. 14)

The U.S. Congressional Budget Office (CBO) has calculated that, if the Chained Consumer Price Index (C-CPI-U) will be used:

-          Government revenues between FY2014 and FY2023 will increase by $123.7 billion from the indexation of tax code provisions.

-          The cost of living adjustments (COLAs) for Social Security benefits will result in a decline in outlays of $127.2 billion in the same time period.

-          The cost of living adjustments (COLAs) for federal and military pensions would decline in outlays of $37.5 billion in the same time period.

(Julia M. Whittaker, CRS Report RL32293, May 8, 2013, pp. 15-16)

Once again, switching formulas to the Chained Consumer Price Index (C-CPI-U) and manipulating the math, the government out-of-control spenders win and the retirees, the elderly, the pensioners, and the saving taxpayers lose.