A number of commenters have expressed interest (or worse) in my views on moving to a “chained” version of the consumer price index (CPI) for price adjustments in various programs, notably including Social Security and the tax brackets.
As briefly as I can, let me give the what’s and why’s of this. I understand that this change cuts benefits for Social Security recipients, so I don’t go there lightly. Retirement insecurity is a huge concern, and I join others in suggesting an idea below to help mitigate that effect. But I endorse the switch because it’s a more accurate price measure, and, applied to the tax brackets, it raises significant revenue as well.
In order to capture the overall cost of living for a typical household, these price indices track the change in the average price of a “market basket” of goods purchased by a typical family, including food, clothing, shelter, fuels, and other goods and services.
What is it?: Consumer price indexes are built by putting together a “market basket” things consumers purchase. The price of the market basket then depends both on the price of the items in the basket and their shares. For example, according to the CPI, shelter costs make up about 40% of household spending, food about 15%, transportation 17%, and so on.
Over time, both prices and these relative shares of the goods in the market basket will change. The difference between the CPI and the chained CPI is in the way these changes are measured. The CPI only captures the changes in prices, not the changes in shares. The chained index captures both.
For example, if the price of meat goes up, families might adjust by buying less meat and more pasta. Or, it could go the other way. If the price of steak falls relative to chicken, shoppers might buy more steak and less chicken. The CPI misses these substitutions, but the chained index captures it, which is why it grows more slowly: it captures consumers’ shifts toward items that have become relatively less expensive.
Whereas the CPI uses only the consumption shares from period one in measuring the price changes in the market basket in period two, the chain-weighted index “chains” together (averages) the shares from period one and period two, thus allowing for the substitution engendered by relative price changes. Since it captures these actual changes in consumer behavior, the chained index is considered a more accurate measure of changes in the cost of living.
What is its impact?: The BLS has been calculating a chained CPI since 2000, and the figure below plots it against the CPI—not that interesting to look at, I guess, but the fact that the chained version grows 0.3 percentage points per year less quickly than the current index is a big deal over time. That old compounding thing, again.
The figure below takes the annual Social Security benefit for a middle-income retiree in 2011 whose initial annual benefit is around $17,000. It then plots the nominal values of that recipient’s benefits out to their 95th year. At first, the difference is about $50, but should they live so long, by the end of the graph, the difference is in the thousands.
Source: Memo to Xavier Becerra from the Social Security Actuary, June 21, 2011 (hat tip, KR); Actuaries report, intermediate assumptions re inflation.
That’s why numerous budget types who have recommended this switch, like Bowles-Simpson and Rivlin-Domenici have suggested an upward adjustment to the Social Security benefits of the old elderly under this plan, an idea I’d agree is essential. In fact, I wouldn’t make the switch without it.
The other important impact here is on the tax brackets. As your nominal income grows you pass into higher tax brackets. EG, in the Federal income tax schedule, a married couple going from $69K to $70K passes from the 15% to the 25% bracket.
Now, these brackets are adjusted by inflation, so if inflation grows by 3%, a bracket that starts at $100,000 (just keeping the math simple here) becomes $103,000. But if we switch to a slower growing price index that has inflation growing by 2%, that bracket starts at $102,000.
Suppose your income grew that year from $100,000 to $102,500. Under the switch to slower inflation, you pass into the higher bracket, and visa versa.
According to CBO, this impact of switching to the chained CPI raises almost $90 billion over 10 years. The Social Security switch raises about $110 billion, but that doesn’t include the elderly bump up, which would have to be applied against those savings.
So, there you have it. Chain weighting the price index improves its accuracy relative to the current price measure, which means benefits adjusted by a price index will grow less quickly. Some of these benefits, like Soc Sec to the old elderly, would need to be adjusted to protect them from cuts they can’t afford. It also raises significant revenues through the tax code.
One more thing: if anyone tries to apply to this change only to the benefits and not to the tax brackets, tap the secret OTE code into your calculator and I’ll be there in moments to put a stop to that nonsense.