Use an Alternative Measure of Inflation to Index Social Security and Other Mandatory Programs

Cost-of-living adjustments (COLAs) for Social Security and many other parameters of federal programs are currently indexed to increases in the consumer price index (CPI), a measure of overall inflation calculated by the Bureau of Labor Statistics (BLS). That agency computes another measure of inflation—the chained CPI—that is designed to account fully for changes in spending patterns and that effectively eliminates a statistical bias that exists in the traditional CPI.

This option would use the chained CPI for indexing COLAs for Social Security and parameters of other programs beginning in 2015. The chained CPI has grown an average of about 0.25 percentage points more slowly per year over the past decade than the traditional CPI has, and the Congressional Budget Office expects that gap to persist. Therefore, the option would reduce federal spending, and savings would grow each year as the effects of the change compounded. Outlays would be reduced by $162 billion through 2023, CBO estimates, and the net effect on the deficit would be about the same. (This option would not change the measure of inflation used for indexing parameters of the tax code, as would be done in the related option cited below; the small revenue effects estimated here stem from changes in the revenue portion of refundable tax credits for health insurance purchased through exchanges, as well as other effects on revenues of the Affordable Care Act’s provisions related to insurance coverage.)

COLAs for Social Security and the pensions that the government pays to retired federal civilian employees and military personnel are linked to the CPI, as are outlays for veterans’ pensions and veterans’ disability compensation. In most of those programs, the policy change would not alter people’s benefits when they are first eligible to receive them, either now or in the future, but it would reduce their benefits in subsequent years because the annual COLAs would be smaller, on average. The impact would be greater the longer people received benefits (that is, the more of the reduced COLAs they experienced). Therefore, the impact would ultimately be especially large for the oldest beneficiaries as well as for some disabled beneficiaries and military retirees, who generally become eligible for annuities before age 62 and thus can receive COLAs for a longer period.

Growth in the CPI also affects spending for Supplemental Security Income, Medicare, Medicaid, the health insurance exchanges established under the Affordable Care Act, Pell grants, student loans, the Supplemental Nutrition Assistance Program (SNAP), child nutrition programs, and other programs. The index is used to calculate various eligibility thresholds, payment rates, and other factors that affect the number of people eligible for those programs and the benefits they receive. Therefore, switching to the chained CPI would reduce spending by both decreasing the number of people who are eligible for certain programs and reducing the average benefits that eligible people receive.

One argument for switching to the chained CPI in Social Security and other federal programs is that that index is generally viewed as a more accurate measure of overall inflation than the traditional CPI, for two main reasons. First, the chained CPI more fully accounts for the way that people tend to respond to price changes. Consumers often lessen the impact of inflation on their standard of living by purchasing fewer goods or services that have risen in price and more goods or services that have not risen in price or have risen less. Measures of inflation that do not account for such substitution overstate growth in the cost of living—a problem known as substitution bias. BLS’s current procedures for calculating the traditional CPI account for some types of substitution, but the chained CPI fully incorporates the effects of changing buying patterns.

A second reason to believe that the chained CPI is a better measure of inflation is that it is largely free of an error known as small sample bias. That bias, which is significant in the traditional CPI, occurs when certain statistical methods are applied to price data for only a small portion of the items in the economy.

One argument against using the chained CPI, and thereby reducing COLAs in Social Security and other federal retirement programs, is that the prices faced by Social Security beneficiaries and other retirees generally rise faster than prices faced by the population at large. That issue may be of particular concern because Social Security and pension benefits are the main source of income for many older people. BLS computes an unofficial price index that reflects the purchasing patterns of older people, called the experimental CPI for Americans 62 years of age and older (CPI-E). Since 1982 (the earliest date for which that index has been computed), annual inflation as measured by the CPI-E has been 0.2 percentage points higher, on average, than inflation as measured by the traditional CPI. That difference mainly reflects the fact that a larger percentage of spending by the elderly is for items whose prices tend to rise especially quickly, such as medical care. However, whether the cost of living actually grows at a faster rate for the elderly than for younger people is unclear, because measuring the prices that individuals actually pay for health care and accurately accounting for changes in the quality of that care are difficult.

Another potential drawback of this option is that a reduction in COLAs would ultimately have larger effects on the oldest beneficiaries and on those who initially become eligible for Social Security on the basis of a disability. For example, if benefits were adjusted every year by 0.25 percentage points less than the increase in the traditional CPI, Social Security beneficiaries would face a reduction in retirement benefits at age 75 of about 3 percent compared with what they would receive under current law, and a reduction at age 95 of about 8 percent. To protect vulnerable people, lawmakers might choose to reduce COLAs only for beneficiaries whose income or benefits were greater than specified amounts. Doing so, however, would reduce the budgetary savings from the option.

Finally, policymakers might prefer to maintain current law because they want benefits to grow faster than the cost of living, so that beneficiaries would share some of the benefits of economic growth. An alternative option would be to link benefits to wages or gross domestic product. Because those measures generally grow faster than inflation, such a change would increase outlays.