How Statistics Can Lower Your Standard of Living

What you don't know can hurt you.

Nothing glazes over as many eyes as economic statistics. And with good reason, since most of them, even if accurate (a big assumption) don't mean much of anything by themselves. At best, even the most important economic statistics are meaningful only when considered in light of numerous other statistics and the big picture revealed thereby.

But there are a few statistics that really matter: the ones used to figure out how much we are paid and taxed. The ongoing debate over Social Security and tax reform revolves around three of them. Pay attention, because money talks and these statistics are talking loudly.

Social Security benefits and federal pension payments are adjusted by an inflation index called the CPI-W, or the Consumer Price Index for Urban Wage Earners and Clerical Workers. Federal income tax brackets are adjusted by the the CPI-U, or the Consumer Price index for All Urban Consumers. The CPI-W and CPI-U are not identical. But they both gather information about the prices and amounts of goods and services people buy, put the information in a giant mixing bowl, swirl things around vigorously, dump the contents in a large blender, and churn out a value that reflects a composite price value, weighted by the relative amounts of goods and services people buy. Changes in prices over time increase or decrease (usually increase) the value of the composite. These changes are treated as the measured inflation rate. The CPI-W and CPI-U also take account of changing consumption patterns of consumers--i.e., as consumers buy less iceberg lettuce and more arugula (or vice versa, which may be the case in times of recession), the weights assigned to the prices of iceberg versus arugula are adjusted. These adjustments are made once every few years.

The debt ceiling/budget deficit debate has included a proposal to use the Personal Consumption Expenditures Index (or Chained CPI) in place of the CPI-W and CPI-U as the measure of inflation for adjusting Social Security, federal pensions and tax brackets. The Chained CPI takes account of substitution of goods as prices rise. For example, if the price of beef rises, consumers may eat less beef and more chicken, thus lowering their overall spending on meat. The Chained CPI doesn't increase as much as the CPI-W and CPI-U because overall meat expenditures don't rise as fast when chicken is substituted for beef. If consumers substitute beans for beef and chicken, then the Chained CPI would rise even less. The Chained CPI may, over time, rise about one-third more slowly than the CPI-W or the CPI-U. (Actually, the CPI-W and CPI-U also incorporate the substitution effect but reflect those changes only once every few years, while the Chained CPI accounts for the substitution effect much more quickly.)

Using the Chained CPI, instead of the CPI-W, to increase various federal payments will be less costly to the federal government. But that's only part of the story. The Chained CPI, as an index for increasing Social Security and pension payments, punishes people for economizing, because it treats substitution solely as a matter of price, without taking account of the loss of perceived quality. Given a more miserly inflation adjustment, people might economize some more, only to be further punished through next year's use of the Chained CPI to get a lower inflation adjustment. That in turn would continue the cycle of skimping, followed by punishment, followed by more skimping, resulting in more punishment, until people are eating sawdust instead of bread. At a time when we need to sustain and support consumer spending in order to have a foundation for economic recovery, using the Chained CPI lessens the potential for recovery.

The use of the CPI-W as an index for adjusting payments to retirees has been criticized for not fully reflecting the rising costs of health care, which are more burdensome for retirees than younger, healthier people. But the Chained CPI would only make things worse, and if people turn to alternative medicine because they can't afford mainstream care, their cost of living adjustments will be further limited by the Chained CPI. Witch doctors will rejoice.

As if retirees and other Americans receiving Social Security haven't been penalized enough, look at what happens when the Chained CPI is applied to the tax code. By law, the CPI-U is applied to increase the level at which higher tax rates are imposed. In other words, the more inflation there is, the lighter taxes become at a given income level because inflation has effectively lowered the value of that amount of income.

The inflation adjustment was enacted in the 1980s as a matter of fairness and to take away an incentive for the federal government to inflate the dollar, slyly obtaining tax increases without legislating them. If the Chained CPI is substituted for the CPI-U, the effect will be to weaken that policy by raising tax brackets less quickly when there's inflation. The Chained CPI would, in effect, to raise taxes from what current law provides. That, in turn, would squeeze consumers, forcing them to cut back on their standard of living.

The combined effect of substituting the Chained CPI for the CPI-W and CPI-U would be that retirees and others receiving federal payments would be hammered harder by inflation, and their taxes would increase in real terms to reward them for having to live with lower standards of living. As they tried to cope with their reduced circumstances, their inflation adjustments would be even less, while their taxes would effectively rise some more. Catch-22, only this isn't fiction. Even if you're not receiving Social Security yet, don't think this doesn't affect you. Your taxes will be higher than otherwise because the brackets will adjust slower.

The Chained CPI provides useful information to economists and others trying to understand consumer behavior. But if it becomes the legal basis for deciding how much the government pays to retirees and other people (recall that many receiving Social Security are disabled), and also for how much government will tax its citizens, then it may end up automatically lowering standards of living. Why this beggar the citizens policy in a time of economic stagnation is a good idea hasn't been explained. Yes, it would tend to reduce the federal deficit, but only by making the electorate poorer.

The times are beginning to hark back to the pinched, self-flagellating malaise of the late 1970s, when it seemed we could do little about OPEC oil price hikes except turn down the heat and wear sweaters. The Chained CPI proposal takes advantage of the unfamiliarity of most citizens with the complexities of economic statistics. It would lower standards of living for tens of millions of Americans while raising taxes on all, and encourages the federal government to foster inflation. Why is this a good thing? The federal deficit needs to be addressed. But surreptitiously eroding the prosperity of citizens, most of whom aren't prosperous anyway, is the wrong approach.