Using a Different Measure of Inflation for Indexing Federal Programs and the Tax Code

Report
February 24, 2010

Economic and Budget Issue Brief

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 federal policies even in the absence of action by lawmakers. For example, if the dollar amounts that delineate the different 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 currently indexed to increases in the consumer price index (CPI), a measure of inflation calculated by the Bureau of Labor Statistics (BLS). According to many analysts, however, the CPI overstates increases in the cost of living because it does not fully account for the fact that consumers generally adjust their spending patterns as some prices change relative to other prices. One option for lawmakers 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 percentage 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 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 indexing 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.