Using a Different Measure of Inflation for Indexing Federal Programs and the Tax Code

Posted on
February 24, 2010

Federal laws try to protect taxpayers and recipients of government benefits from the effects of rising prices by specifying that dollar amounts in many parts of the tax code and in some programs be automatically adjustedor indexedfor inflation. Without such indexing, a rise in the general level of prices would alter the effects of federal policies even in the absence of action by lawmakers. For example, if a Social Security beneficiarys payment remained the same over time (in other words, not indexed for inflation), the value of goods and services that the beneficiary could purchase would go down.

Many federal programs and parts of the tax code are currently indexed to increases in the consumer price index (CPI), a measure of inflation calculated by the Bureau of Labor Statistics (BLS). According to many analysts, however, the CPI overstates increases in the cost of living because it does not fully account for the fact that consumers generally adjust their spending patterns as some prices change relative to other prices. One option for lawmakers, as discussed in a brief released today, would be to link federal benefit programs and tax provisions to another measure of inflationthe chained CPIthat is designed to account fully for changes in spending patterns. (CBO previously discussed the possibility of using the chained CPI in its August 2009 Budget Options volume.) The chained CPI grows more slowly than the traditional CPI does: by an average of 0.3 percentage points per year over the past decade. As a result, using that measure to index benefit programs and tax provisions would reduce federal spending (especially on Social Security and federal pensions) and increase revenues. A separate appendix to the brief explains the methods and calculations that could be used to index the federal tax system, Social Security benefits, and federal pension benefits for the growth in the chained CPI.

Although many analysts consider the chained CPI a more accurate measure of the cost of living, using it for indexing could have disadvantages. Because the values of the chained CPI for a given month are revised over a period of one to two years, the tax code and affected programs would have to be indexed to a preliminary estimate of the chained CPI that is subject to estimation error. Also, the chained CPI may understate growth in the cost of living for some groups, such as older people.

This brief was prepared by Noah Meyerson of CBOs Health and Human Resources Division.