Chained CPI and You: A Primer

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As budget negotiations heat up, you're probably going to hear a lot of talk about "correcting the measure of inflation" or "chaining the CPI." Don't let your eyes glaze over, though, because this might be one of the most important proposals in the whole budget. It's also one of the most complicated for non-wonks to understand, and it just might become the most controversial.

The budget that President Obama introduced today calls for "$230 billion in savings from using a chained measure of inflation for cost-of-living adjustments throughout the Budget." Because the measure of inflation is so important when it comes paying Social Security benefits and setting tax rates, a minor technical change could have a huge ripple effect on the economy. But what does it actually mean? First, let's look at what Chained CPI is and then you'll see why switching from the old method will have such a profound impact on Americans.

CPI is the Consumer Price Index, which is the most basic measure of inflation. It's an official, government-approved number produced by the Bureau of Labor Statistics, and all kinds of government and private programs rely on the CPI to make yearly adjustments for the cost of living.

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Early in the last decade, economists began to argue that CPI is not the most accurate measure of inflation, because it merely aggregates prices and doesn't take into account how people spend their money in the real world. Specifically, it doesn't account for consumers' ability to substitute one product for another when prices change. (For example, if the price of butter goes up, people can switch to margarine and save money. Click here for more discussion of the "substitution effect.") So in 2002, the BLS created the Chained CPI, which many experts say is a better measure of the actual "cost of living." (For some people, anyway. We'll get back to that in a bit.) That's why it's also known as Superlative CPI.

Not only is the Chained CPI more accurate, it predicts that inflation grows at a slower rate than regular CPI. In any given year, the difference between the two numbers is minor—only about one-third of one percent—but over time, the effect on budgets can be massive. Because each year's CPI is based off the previous year's number, the effect compounds, meaning a small change now creates a huge difference in the final number 10 or 20 years down the road. Switching from regular to Chained (again, a 0.3-percent difference each year) would save more than $200 billion in inflation-mandated spending over the next decade. (Although that could be redueced over time, as the gap in the two indexes grows even smaller.)

So why would progressives be upset? Because that spending comes mostly out of the pockets of poor people and retirees. Social Security mandates that benefits to seniors increase each year based on the CPI. A lower CPI number means lower benefits increases, which means smaller checks than under the old method.

The other problem is that the people who benefit the most from Social Security—old and unhealthy people—are the ones that Chained CPI does the worst job of measuring. It may be more accurate for average folks, but senior citizens spend most of their income on health care and housing, two areas where the substitution effect has the least impact.

But that's not only thing the government uses CPI for. It's used to adjust income thresholds for government assistance programs, phase-out levels for certain tax credits, the standard deduction you can take on your tax return each year, even the size of the tax brackets themselves. If the amount of money needed to move you into the next highest tax bracket doesn't rise as fast as your income does, you could get bumped into the higher rate faster than you would have under the old CPI. Studies have shown the cost of the switch will be borne almost exclusively by seniors and those making under $100,000 a year. (i.e., the people who can least afford it.)

In a way, switching to Chained CPI is both a spending cut and a tax increase at the same time, with an added benefit for politicians that you don't have to actually get caught voting for either. This original argument for switching said it "should not be regarded as a benefit cut or a tax increase." Supporters of the move prefer to call it a "correction." But if you're the one receiving the checks, it definitely feels like a punishment.

This article is from the archive of our partner The Wire.