Fixing How We Measure Inflation

Apostolos Pittas contributed to this post.

​ The U.S. government currently loses tens of billions of dollars each year by inaccurately measuring inflation. This continues to occur even though the error is widely acknowledged. As the leading world economy of the 21st century, the U.S. must do better, and that is what both the Bipartisan Policy Center’s Domenici-Rivlin Task Force and the Bowles-Simpson Fiscal Commission recommended. Applying an accurate measure of the consumer price index (CPI) across the federal budget will repair this outdated metric while also reducing the deficit by almost $300 billion over the next decade.

Background

The consumer price index measures the level of inflation in the U.S. economy.  In order to protect individuals from inflation-driven price increases, many federal benefit programs provide annual Cost of Living Adjustments (COLAs) that are tied to the CPI.  Similarly, in order to ensure that taxpayers and income support beneficiaries do not face higher taxes or lower benefits, respectively, as a result of their wages increasing with inflation, the federal tax code’s bracket thresholds and the federal poverty level are indexed to increase with inflation. 

Maintaining purchasing power by accounting for inflation is essential for all of these government functions, but the current CPI metric does so inaccurately.  The Bureau of Labor Statistics (BLS) has found that current calculations of the CPI overstate inflation (e.g., when the prices a consumer faces rise by 2 percent, the CPI will measure roughly a 2.3 percent increase).  When this happens year after year, the error is compounded.

The miscalculation has a simple explanation behind it:  The formula used to calculate the CPI does not account for changes in consumer spending habits because the measurement assumes that consumers will purchase the same categories of goods and services in the same quantities regardless of the prices.  In reality, consumers will lessen the effect of a significant price increase in one good by consuming more of a comparable but cheaper good in its place.  

For example, if average families spend $50 per month on apples, and the price of apples suddenly doubles, the cost of living for those families is unlikely to rise by a full $50.  Rather, the family likely will substitute away from apples, buying fewer of them than before, and more of an alternative fruit instead.  Thus, maintaining a strictly fixed basket of goods and services when evaluating inflation, as the CPI does, poorly reflects actual consumer spending habits. 

In order to correctly measure the price increases that consumers face, an inflation calculation must account for actual consumer buying patterns among goods and services.  A measurement called the “chained CPI” does just that, and therefore, is a more accurate measurement of consumer inflation.  Utilizing this metric throughout the federal government will give all American consumers and taxpayers the actual COLA that they face in the marketplace.

According to the Congressional Budget Office (CBO), instituting the chained CPI for Social Security COLAs will save $112 billion from 2012-2021.  The BPC’s Debt Reduction Task Force additionally recommended increasing Social Security’s minimum benefit, thereby  offsetting the impact of such a change for lower-income beneficiaries.  

Utilizing the chained CPI for other federal programs will save an additional $33 billion over the same period – funds that otherwise would have been erroneously distributed.  It also will cause tax bracket thresholds and other parameters to grow at a slower and more accurate pace than currently projected, thereby recouping $72 billion in revenue over a ten-year period.  Including interest savings, the change adds up to around $300 billion over the ten-year window.

Conclusion

​Returning our budget to a sustainable track will require many tough choices and policy changes, but the technical fix of adopting the chained CPI is not one of them.  This change offers policymakers a rare opportunity to achieve significant deficit reduction simply by making a technical improvement to existing policy.  Moving to the chained CPI deserves bipartisan support.