Checks, balances and the CPI

Nation's Business, April, 1997 by James Worsham

A downward revision in the Consumer Price Index could affect retirement payments, taxes, and the federal budget deficit.

The Consumer Price Index, perhaps the best-known government statistic, probably impacts small businesses more than any other number that economists crunch. It affects wages and salaries, rents and leases, tax brackets and exemptions, and, of course, interest rates.

Considered the nation's broadest measure of inflation, the index also has a major effect on Social Security and other government retirement programs, the poverty line, and even other federal statistics that are calculated using some or all of the CPI's components.

Now this important index seems headed for an adjustment--either in how it's calculated or in how it's used.

Influential critics, including Federal Reserve Board Chairman Alan Greenspan, say the CPI has overstated inflation for decades by 1 to 2 percentage points a year. As a result, they say, reports of U.S. economic growth have understated the actual expansion rates, and federal payments to retirees have been larger than were needed to keep pace with inflation.

In a report late last year, a panel of five economists appointed by the Senate Finance Committee claimed a 1.1-percentage-point overstatement, adding that "it is likely that a large bias also occurred looking back over at least the last couple of decades."

"This overstatement will have important unintended consequences, including over-indexing [pushing up] government outlays and tax brackets and increasing the federal deficit and debt," the group stated.

The panel, led by Michael Boskin, a professor of economics at Stanford University, said that under the current method of calculating the CPI, new products, quality improvements to existing products, and consumer shifts to discount stores and cheaper goods are not taken into account quickly enough.

The U.S. Labor Department's Bureau of Labor Statistics (BLS), the agency that calculates the widely used statistic, emphasizes that the CPI is not a "cost-of-living index" but a "price index" that measures a fixed market basket of goods and services.

The BLS says it is always seeking ways to improve the CPI, and next January it will re-weight the various categories within the index to reflect updated consumer spending patterns. But officials acknowledge that the BLS can't fix most of the problems cited with the CPI as it's currently structured.

Impacting The Budget

The CPI debate has interested congressional and administration budget writers because shaving 1.1 percentage points off the index would be a big step toward balancing the federal budget. The Congressional Budget Office has estimated that a 1.1-percentage-point reduction in the index would reduce total federal spending by $133.8 billion over five years, largely by lowering projected increases in entitlement payments.

Another effect of a downward revision of the CPI, according to the congressional Joint Economic Committee, would be tax increases for middle-income families. The revision would dampen the rise of federal income-tax brackets, standard deductions, and personal exemptions, meaning that growing incomes would fall into higher tax brackets sooner than they do now.

Nonetheless, proponents of adjusting the CPI say that increasing the accuracy of government statistics--even if doing so would have widespread and, for some, unwelcome effects--is a laudable goal.

Dean Baker, an economist with the Economic Policy Institute in Washington, D.C., says, however, that the Boskin commission was stacked with economists predisposed to finding fault with the CPI. He says that all five panel members had previously stated that they believed the index contained biases.

Baker says that "a thorough, impartial evaluation" of the index is likely to result in little overall change in the CPI, since there are likely to be biases in both directions. And he warned: "Correcting for [what is mistakenly seen as] a significant CPI over-statement of inflation will change nearly everything we thought about the economy."

A Long Reach

The CPI or its components are deeply embedded in business and government at all levels and in many statistics that guide public and private decision making.

The index is widely used in union and nonunion workplaces alike to set or guide wage increases. It's also commonly included in multiyear rental, lease, and purchase agreements to determine increases in amounts paid by businesses and individuals.

At the federal level alone, the CPI governs the size of benefit increases that go to recipients of Social Security and to military and civilian retirement programs, veterans benefits, and programs whose eligibility standards are tied to the poverty line. Many components of the index are factored into the U.S. Commerce Department's quarterly gross domestic product (GDP) figure, the broadest measure of the nation's output of goods and services and the figure most often cited as the level of economic growth.

As the debate over adjusting the CPI simmers, evidence is growing to support the theory that the index does indeed overstate inflation. The Boskin panel told the Senate Finance Committee that the current CPI overstates inflation by 0.8 to 1.6 percentage points each year. It offered 1.1 percentage points as its "best estimate' of the overstatement.