Revisiting the Chained CPI

Reporting from The Wall Street Journal has indicated that lawmakers from both parties are taking a look at using an alternative measure of inflation, the "chained CPI," in a final deal that would avert the fiscal cliff. As far as possible options, this is one that makes a lot of sense for both technical and budgetary reasons. Today, CRFB's Moment of Truth project has updated its analysis of the chained CPI to include the latest projections of the budgetary impact and a new discussion of the distributional impacts of switching to the chained CPI, in light of current discussions surrounding the fiscal cliff and budget imbalances.

The main reason lawmakers should look to the chained CPI is that it is a more accurate measure of inflation, given that current measures used in spending programs and the tax code overstates inflation by 0.25 to 0.3 percent each year. As CRFB Policy Director Marc Goldwein explained in an op-ed in The Atlantic last year: 

Every year, wages and prices go up. The government wants to measure this inflation to index everything from Social Security checks to tax brackets. The government makes these measurements by focusing on a "basket of goods" to compile its so-called consumer price index, or CPI.

The weakness of regular CPI is that we don't account for when consumers start changing their relative buying habits. If the prices of apples skyrocket, the regular CPI assumes cost-of-living will go way up. But in the real world, most people just buy fewer apples and more oranges.

Moving to the "chained CPI" corrects for this technical flaw by trying to provide an honest assessment of each month's basket and creating a "chain" between them. Moving to a more realistic measure of inflation would save well over $200 billion over the next decade, including from Social Security, other inflation-index programs, and from the tax code.

But the chained CPI isn't just a technical fix. As Goldwein mentioned, it would also be timely in that it would also help control deficits in the future. Specifically, it would save $236 billion over ten years, with $149 billion coming from spending savings, $62 billion coming from revenue, and $26 billion coming from interest savings.

We talk a great deal here at The Bottom Line about how comprehensive plans should address both spending and revenue in debt reduction. Fortunately, switching to the chained CPI would both raise revenue through indexing tax brackets while reducing spending, mainly by having cost-of-living adjustments in retirement programs grow more slowly. Additionally, the effects of the chained CPI would be phased in gradually, so individuals would have plenty of time to prepare for the tax and spending changes and it would avoid a dramatic change during the economic recovery.

Some critics have claimed that the chained CPI is a regressive tax increase, but we've shown in the past that this is false. Tax Policy Center analysis shows that its effect is roughly distributionally neutral, with a roughly 0.2 percent of income increase across each quintile. The move doesn't affect those at the very high incomes because they already are in the highest tax bracket, although it would be more progressive if an additional higher bracket were added at some point. Regardless, there are many other ways to make the tax code more progressive, as many plans have done while switching to the chained CPI.

^{Source: Tax Policy Center}

Meanwhile, other critics have claimed that older retirees would be hit hardest by chained CPI due to its compounding effect. This is true, but it doesn't make sense to overstate inflation for everyone just to protect those older seniors. Instead, many bipartisan plans that included chained CPI also included an old age bump up to protect those seniors that live past their savings, targeting resources where they are most needed. The Simpson-Bowles plan proposed implementing this policy in a particularly progressive way through a flat dollar bump up for all beneficiaries who have been receiving benefits for twenty years, which would provide lower income beneficiaries with a greater percentage increase in benefits.

Others have suggested that certain programs such as Supplemental Security Income should be exempted from chained CPI. However, this would undercut the central rationale for adopting the chained CPI -- more accurately achieving the policy goal of indexing benefits to inflation -- and lead to pressure for further exemptions. Rather than continuing to use an inaccurate measure of inflation to index certain programs, policymakers could include targeted policies to offset the impact of chained CPI on vulnerable populations. For example, the Center on Budget Policy Priorities -- which supports the use of chained CPI as part of a comprehensive deficit reduction plan if low income populations were protected -- has proposed several policies to achieve this goal through changes in the SSI, including indexing the income disregards and asset limits in the program for inflation and applying the twenty year benefit bump-up to SSI as in Social Security.

Policymakers are certainly going to have to make tough choices in a large deal. But including the chained CPI is one of the easier ones. It will more accurately measure inflation and its savings will be both gradual and include a mix of revenue increases and spending cuts. Those negatively affected by the new measure, like older seniors, can easily be helped with additional policies in a bipartisan compromise. We still have a ways to go in the negotiations, but the chained CPI should definitely be considered.

Click here to read the updated "Measuring Up" paper.