What does "Chained CPI" Mean?

A popular way to reduce expenses and raise revenue in DC is to pass legislation that isn't felt today, but felt in the future.  It's a convenient way for policy makers to have a meaningful impact on the trajectory of the Federal debt (not the deficit) without having their constituents understand what they have done until it is too late.  One idea that has been around for a long time is changing the way that we measure our Cost of Living Index (COLI) to "chained" price increases and attempting to measure a substitution effect as a result of price changes.  Huh is a perfectly reasonable response.  

There is a very simple way to think about this.  Let's assume that you go to the grocery store one day and the price of four boneless skinless chicken breasts is $10 and the price of four pork chops is $10.  Four weeks later you go back to the same grocery store and the price of the chicken breasts has doubled to $20 but the price of the pork chops has remained the same.  Are you still going to buy the chicken breasts or are you going to double up on the pork chops?  Economists argue that most consumers will double up on the pork chops.  But that isn't the way that the current consumer price index calculates it.  It assumes that you have a fixed basket of goods and you don't change your spending habits no matter what happens.  

The Chained CPI tries to take a different angle.  The Chained CPI takes into account the historical price of a item relative to its current price and substitute items and assumes that consumers will make changes based on the current prices relationship to its historical price and other similar items.  Huh?  It assumes you buy the pork chops rather than the chicken.  In essence, it allows you to change your basket of goods based on prices in the market place.  

In other words, the historical index doesn't allow you to change your spending habits based on higher or lower prices but the Chained CPI does.  

Believe it or not, the Chained CPI (technically referred to as the C-CPI-U) has only been around since 2002 but because it has a two year lag it has been measuring prices since 2000.  Over that time period, the Chained CPI has averaged about 0.2% less than the traditional CPI which doesn't seem like much until we think of the impacts that it could have on the two places it is being talked about: Social Security benefits and tax brackets.

Details:

Social Security benefits 

If you start taking your Social Security benefits at age 65, receive $18,000/year (or $1,500/month) in the first year and live to age 90 a pretty large disparity will show up with "just" a 0.2% reduction in the annual increase.  

Assume two cases.  In one case you will receive a 3% increase every single year and in the other case you will receive a 2.8% increase every year.  At the end of the first year, the difference between a 3% increase and a 2.8% increase is just $36/year.  However, after 25 years that annual difference is now almost $1,800 (10% of your initial annual benefiti) and at the end of 30 years the difference is almost $2,500 per year.  That doesn’t sound that large, but the difference is between receiving $37,688/year and $35,900/year.  For Bill Gates, that isn’t a big difference but for someone who is just receiving Social Security benefits – with no other assets or income to support them - it is a large difference. 

Most politicians understand the impact that this has on those seniors who live an extended life (mostly recognized as living either to age 80 or 85).  Therefore, most proposals that adjust the way we increase Social Security benefits incorporate a one-time large increase in the benefit at 80 or 85 to get the recipient back to or near where they would have been under the current formula. 

Tax brackets 

The other case is in tax bracket adjustments.  If tax brackets are allowed to increase annually for inflation and the way inflation is calculated is held to a lower rate of increase then your future taxes will increase as well.  

If we apply the same 3% increase and 2.8% increase to the top end of the current 15% tax bracket then we come out with a similar result.  For reference point, the top of the 15% tax bracket is represented by taxable income of $72,500.  After one year, the difference is $145 – meaning that the last $145 is taxed at the 25% rate rather than the 15% rate.  This results in an anticipated higher tax bill of just $14.50.  However, at the end of 25 years the difference is $7,200 with a higher tax bill of approximately $720 and at the end of 10 years the difference is approximately $10,000 for a higher tax bill of about $1,000 annually. 

It may sound like a small tax increase and it is.  However, if you start doing the math at higher income levels you are having a much larger increase in the overall tax liability.  Therefore it should be welcomed by those who favor a more progressive tax code as it does have a small impact on lower and middle class families while having a larger impact on those taxpayers earning higher income. 

Applying the Social Security adjustment against millions of future recipients will significantly reduce future government expenses.  In addition, changing the way that the government collects revenue through tax bracket adjustments will raise an enormous amount of new revenue to the table.