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Sunday, January 31, 2010

Automatic Cost of Living Adjustments: Some Economic and Practical Considerations

Brian W. Cashell
Specialist in Macroeconomic Policy

Public-policy discussions often involve dollar amounts. Because of rising prices, however, the purchasing power of those dollar amounts changes over time. For that reason, policy makers have seen fit in some cases to arrange for those amounts to be increased automatically, as prices rise, to keep their purchasing power unchanged. Without such an arrangement, either the real value of those amounts would fall or policy makers would have to take periodic steps to increase them to offset the effects of inflation. 

Most of the effect on the federal budget of automatic cost-of-living adjustments (COLAs) may be accounted for by three programs: individual income taxes, Social Security, and income support programs tied to the poverty thresholds. 

The consumer price index (CPI) is used to make cost-of-living adjustments. It is based on prices and quantities of goods and services, which can be directly observed. It measures the change in income required to purchase a fixed market basket of goods and services, but that is not a "true" measure of change in the cost of living. A true cost-of-living index would measure the change in income required to maintain a constant level of satisfaction. 

If existing measures of price change exaggerate what increase in income is needed to maintain consumer satisfaction, then increases in benefit payments that are indexed are larger than they need to be to maintain their value to beneficiaries, and income tax brackets shift upward more than necessary to avoid bracket creep. These bracket increases reduce federal revenues. Both effects tend to increase the budget deficit. There are other price indexes that may be superior measures of change in the "true" cost of living, but they have some practical disadvantages. One standard for choosing a price index for automatic COLAs might be which one is most appropriate. In some cases, it might be argued that what is appropriate is not a measure of price change but rather a measure of change in income. 

With respect to public policy in general, it has been argued that indexation may have the effect of inhibiting policy makers from making changes to those programs that are indexed. It may be that indexing a benefit implies a kind of guarantee of future benefits, making any future change likely to be more contentious. It may be that there is a loss of policy discretion and an increase in policy inertia with respect to those programs that are indexed. Indexed benefits rise over time with no regard to changes in underlying economic conditions. However, budget priorities are constantly shifting, and if economic growth is sluggish and revenues are less than expected, that may put additional budgetary pressure on those programs that may be relatively more subject to discretion. 

Date of Report: January 11, 2010
Number of Pages: 13
Order Number: RL34168
Price: $29.95

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