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Using a Different Measure of Inflation for Indexing Federal Programs and the Tax Code 1 (February 2010)

handle is hein.congrec/cbo07046 and id is 1 raw text is: A series of issue summaries from the Congressional Budget Office FEBRUARY 24, 2010 Using a Different Measure of Inflation for Indexing Federal Programs and the Tax Code 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 adjusted- or indexed-for inflation. Without such indexing, a rise in the general level of prices would alter the effects of fed- eral policies even in the absence of action by lawmakers. For example, if the dollar amounts that delineate the dif- ferent tax brackets in the individual income tax were not indexed, inflation would push many people's income into higher brackets and boost average tax rates over time, even if income did not grow faster than prices. Many federal programs and parts of the tax code are cur- rently indexed to increases in the consumer price index (CPI), a measure of inflation calculated by the Bureau of Labor Statistics (BLS).1 According to many analysts, however, the CPI overstates increases in the cost of living because it does not fully account for the fact that con- sumers generally adjust their spending patterns as some prices change relative to other prices. One option for law- makers would be to link federal benefit programs and tax provisions to another measure of inflation-the chained CPI-that is designed to account fully for changes in spending patterns. The chained CPI grows more slowly than the traditional CPI does: by an average of 0.3 per- centage 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 1. For more information about the CP, see Congressional Budget Office, x)z ai: g the Conmer Prie, Index, Issue Brief (June 20, 2007); and Bureau of Labor Statistics, Consumer Price Index: Frequently Asked Questions (January 14, 2010), available at wwwwbl.gov/cpi/cpi iq.htm. For technical details about how the CPI is calculated, see Bureau of Labor Statistics, BLS Handbook of Methods, Chapter 17 (June 2007), available at ww-w.bs gov/op ub/ hom/pdflhonch 7.pdf. on Social Security and federal pensions) and increase revenues. Although many analysts consider the chained CPI a more accurate measure of the cost of living, using it for index- ing could have disadvantages. Because the values of the chained CPI are revised over a period of several 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. Inflation and Changes in the Cost of Living Inflation-a general increase in the prices of goods and services-can be measured in various ways. Traditionally, the rate of inflation has been computed by multiplying the percentage price change for each item that people purchase by that item's share of consumer spending in a period before the prices changed and then summing those changes for all items. In a simplified example, imag- ine that people bought only two things last year, cars and cauliflower, and that they divided their spending evenly between the two. If the price of cars rose by 4 percent this year and the price of cauliflower rose by 7 percent, annual inflation would be measured as (0.04 x 0.50) + (0.07 x 0.50) = 0.055, or 5.5 percent. Such increases would reduce consumers' purchasing power (unless their income and wealth rose accordingly). In reality, however, inflation as measured that way is generally higher than the annual growth in the cost of living-that is, than the amount of additional resources someone would need to maintain the same standard of living this year as last year in the face of rising prices. The reason for the difference is that many people can soften CBO

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