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Taxpayers and Investors – Chained-CPI Affects You Too

chained cpi

chained cpiIf you have been following the news related to the recently released “Budget of the United States Government, Fiscal Year 2014,” you have likely heard about the proposed change in the Consumer Price Index that will be used to calculate cost-of-living adjustments (COLAs) for Social Security recipients.  Regarding this change, page 46 of the budget has this to say:

“In the interest of achieving a bipartisan deficit reduction agreement, beginning in 2015 the Budget would change the measure of inflation used by the Federal Government for most programs and for the Internal Revenue Code from the standard Consumer Price Index (CPI) to the alternative, more accurate chained CPI, which grows slightly more slowly. Unlike the standard CPI, the chained CPI fully accounts for a consumer’s ability to substitute between goods in response to changes in relative prices and also adjusts for small sample bias. Most economists agree that the chained CPI provides a more accurate measure of the average change in the cost of living than the standard CPI.”

Whether most Americans will find the chained-CPI to be “more accurate” is certainly debatable.  It is quite common to hear complaints that the CPI-U understates true inflation.  So switching to the chained-CPI, which, as the budget says, “grows slightly more slowly,” will only fan the flames of those who already dislike the CPI-U.  What exactly is the chained-CPI?  Let’s refer to the Bureau of Labor Statistics’ (BLS) “Note on a New, Supplemental Index of Consumer Price Change” for more details.

Chained-CPI is officially known as the “Chained Consumer Price Index for All Urban Consumers.”  It was first published on August 16, 2002 and is sometimes referred as the C-CPI-U.  According to the BLS, the C-CPI-U “employs a Tornqvist formula and utilize expenditure data in adjacent time periods in order to reflect the effect of any substitution that consumers make across item categories in response to changes in relative prices.”  In other words, if you eat steak but suddenly find it too expensive, you might consider switching to chicken.  The C-CPI-U will reflect the fact that you aren’t spending any additional money on a price increase in steak because you switched to less expensive chicken.  If prices on the products people use keep going up, and everyone continually switches to cheaper products, the C-CPI-U will, over time, not fully reflect the price increases of the original products and will also not accurately reflect the lower quality of living that people may experience when making the adjustments.  But one thing it will do is save the government money.

With COLAs for a variety of programs, including Social Security, tied to the CPI, switching from the CPI-U to the C-CPI-U should result in lower benefits adjustments.  Moreover, on its website, the BLS states the following: “The CPI may not be applicable to all population groups . . . the CPI does not produce official estimates for the rate of inflation experienced by subgroups of the population, such as the elderly or the poor.”  I would be interested to know whether those who proposed the CPI-U to C-CPI-U switch in the budget think the C-CPI-U is a “more accurate” consumer price index for the elderly.  I am not saying everyone has to care whether Social Security recipients are and will be receiving negative real COLAs going forward.  I’m just not a big fan of spin.  And I’m coming across a lot of spin out there in media land.

As I referred to in the title of this article, the elderly aren’t the only ones who will be affected by the budget’s proposed change from CPI-U to C-CPI-U.  Taxpayers will also feel the effects.  That’s because the CPI-U is used to determine changes to tax bracket thresholds as well as personal exemption and standard deduction sizes.  Switching to the C-CPI-U for “the measure of inflation used by the Federal Government for most programs and for the Internal Revenue Code” is an across-the-board tax increase on Americans.  This is because by using a measure of inflation that “grows slightly more slowly,” tax bracket threshold increases as well as increases to the personal exemption and standard deduction will also grow more slowly.  This means Americans will, over time, pay more in taxes than they otherwise would with no change to the current measure of inflation used for the calculations (CPI-U).

Additionally, switching to the C-CPI-U for the Internal Revenue Code will affect investors as well.  The CPI-U is currently used to calculate the limits for contributions to retirement plans.  Using a measure of inflation that is lower than the current measure being used will, over a lifetime of investing, allow for fewer contributions to be made to retirement plans.  When thinking through the potential for lost compounding on investments made in the financial markets, the change to the C-CPI-U could have quite the effect on an investor’s retirement portfolio over a period of many years.  Additionally, I should point out that the principal on Treasury-Inflation Protected Securities (TIPS) is adjusted for inflation using the CPI-U.  I don’t know whether the U.S. Department of the Treasury will eventually make the switch to C-CPI-U for TIPS, but it is something worth paying attention to.  If the change is made, those investors who think they are protecting themselves from inflation may end up discovering they are only protecting themselves from a little less inflation.

To summarize, if you are elderly, a taxpayer, an investor, or supported by someone who falls into one those three categories, the inflation measure change proposed in the fiscal year 2014 federal budget will directly or indirectly affect you.

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