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Better Inflation Measure Would Reduce Deficit

December 18, 2012

The Bureau of Labor Statistics calculates two versions of the Consumer Price Index (CPI) to measure inflation. These measures work by assuming that a consumer purchases a certain “basket” of goods, and they track the total cost of this basket.

  • The “CPI-U” is the headline measure and it includes all urban consumers. This measure is used to index the tax brackets for inflation.
  • The “CPI-W” includes urban wage earners and clerical workers -- so it excludes the unemployed, self-employed, and certain occupations. This measure is used to index federal benefits, including Social Security, for inflation.

Chained CPI – A Deficit Reduction Option

These two measures have several problems that overestimate inflation. First, they assume that consumers purchase the same basket of goods, regardless of what happens to prices. So if the price of muffins increases, they don’t consider that some consumers will switch to toast. Second, they can’t easily deal with the introduction of new products. Third, they can’t measure product quality. A product may cost the same as it did five years ago, but it could be of a much higher quality. 

To address the problems with the traditional CPI measures, BLS in 2002 introduced “chained-CPI,” which is a modified version of CPI-U. Chained-CPI is meant to more closely measure cost of living. By switching to chained-CPI in calculating both federal benefits and tax brackets, we could reduce the deficit by $200 billion over the next 10 years.


For Social Security, Chained CPI is a Middle Road

Some are lobbying against chained-CPI because of its impact on Social Security. But it is actually the middle road and should be an easy compromise. There is a proposal known as “progressive indexing” that would slow the growth of Social Security even more. It would change the way initial benefits are calculated. Currently, initial benefits are calculated by adjusting a worker’s wages for every year of their career by the average wage increase. Thus, this adjusts their lifetime earnings by “wage inflation” rather than price inflation. Progressive indexing would lower higher income retirees’ initial benefits by linking their lifetime earnings to price inflation rather than wage inflation.

In contrast, instituting chained-CPI as a compromise would not affect the calculation of initial benefits. Chained-CPI simply recognizes the fact that consumers change the type and quantity of the products they buy when prices change. Economists say that the traditional CPI overestimates inflation, and a move to chained-CPI was endorsed by President Obama’s Fiscal Commission. Chained-CPI is not radical – it is the middle road.