Chained reaction

July 13, 2011

Is one of the proposals to reduce U.S. government spending a long-overdue acknowledgment of reality, a clever way to stick it to seniors or a back-door tax hike?

As part of budget negotiations, lawmakers are considering changing the way Social Security benefits, the tax code, and other cost-of-living gauges are pegged to inflation. The switch to using the so-called chained consumer price index (CPI) rather than the CPI itself could save $255 billion over ten years, $299 billion with interest, according to the Moment of Truth project, the successor organization to the president’s deficit commission.

What’s the difference? The CPI measures the prices of a wide variety of goods and services. Analysts say it overstates inflation because consumers will change their buying pattern rather than simply pay more for a particular purchase.

In fact, the U.S. Federal Reserve prefers to base its monetary policy decisions on a different measure of inflation  – the personal consumption expenditure index — precisely because the PCE takes into account this type of substitution.

Bureau of Labor Statistics economists introduced the chained CPI in 2002 to be a closer approximation of a cost-of-living index than existing measures.

A 1996 commission appointed by the Senate found the conventional CPI overstated inflation by about 1.1 percentage points per year. The chained CPI has been on average 0.25 to 0.3 percentage points lower than the CPI.

However, the proposal is not without concerns, as the Congressional Budget Office notes on page 58 of this report.  For example, Social Security beneficiaries may face a disproportionate level of prices that rise faster than other goods or services, such as medical costs. The National Women’s Law center argues using chained CPI could hit women especially hard.

Also, since it would lower tax deductions linked to inflation and lower adjustments to tax brackets, part of its appeal is that it raises revenues. About one-quarter of its estimated deficit reduction contribution would come from revenues, a third from spending cuts, the Moment of Truth Project estimates.  But analysts at the libertarian American Enterprise Institute say this would constitute a hidden tax.

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