Chained CPI Estimated to Reduce Deficit by $340 Billion

We've written extensively on the chained CPI, which represents both a more accurate measure of inflation and a policy change which would result in substantial deficit reduction. We've shown many of the arguments in favor of this idea and demonstrated that many of the criticism are misguided.

Prior to the fiscal cliff deal, we estimated chained CPI would save about $250 billion over ten years, $290 billion including interest. The CBO has updated its estimate, and it now estimates $340 billion in primary savings -- which would be about $390 billion including interest. Specifically, switching to the chained CPI would save $127 billion from Social Security, $38 billion comes from other programs with COLAs, $51 from other spending programs with inflation calculations (especially health programs), and $124 billion from revenue.

CBO's estimates have changed for a number of reasons, but the largest is the the enactment of the American Taxpayer Relief Act (ATRA). To understand why, it is important to understand how switching to the chained CPI generates revenue. The main reason has to do with the fact the threshold of the tax brackets are indexed with inflation, so "real bracket creep" pushes income into higher brackets as people become richer. Measuring inflation more accurately leads to slightly more real bracket creep.

The ATRA permanently indexed the Alternative Minimum Tax (AMT) exemption to inflation -- pulling tens of millions of taxpayers out of the AMT (where the brackets are not indexed and there is no "bracket creep") and also creating a new "AMT creep" which would be affected by the chained CPI. In addition, the ATRA increased the number of brackets from 5 under current law to 7, meaning that income is "creeping" through more brackets. And finally, the ATRA extended a number of provisions in the tax code which rely on inflation indexing.

Regardless of the budgetary impact, switching to the chained CPI should be done in keeping with the government's goal of measuring inflation as accurately as feasible. Most economists agree that the chained CPI is a superior price index compared to the CPI-U or CPI-W because it better accounts for consumer substitution across similar goods. We expanded on this topic in the paper "Measuring Up: The Case for the Chained CPI."

When you combine the fact the chained CPI is more accurate with the $390 billion of deficit reduction from all areas of the budget and tax code which come from utilizing it, the policy becomes almost a no brainer. Policymakers should enact this change, and should do so as soon as possible.