INFLATION:
Why the CPI Matters, Big-Time

By Michael J. Boskin

Overstating increases in the cost of living by even small amounts costs the federal government tens of billions of dollars every year. An excerpt from the Boskin commission's report.

The issue posed for fiscal policymakers by an upward bias in the consumer price index (CPI) was stated with admirable clarity in 1994 by the Congressional Budget Office:

The budgetary effect of any overestimate of changes in the cost of living highlights the possibility of a shift in the distribution of wealth. If the CPI has an upward bias, some federal programs would overcompensate for the effect of price changes on living standards, and wealth would be transferred from younger and future generations to current recipients of indexed federal programs-an effect that legislators may not have intended.

Social Security is by far the most important of the federal outlays that are indexed to the CPI. However, Supplemental Security Income, Military Retirement, and Civil Service Retirement are significant programs that are similarly indexed. Other federal retirement programs, Railroad Retirement, veterans' compensation and pensions, and the Federal Employees' Compensation Act also contain provisions for indexing. The Economic Recovery Tax Act of 1981 indexed individual income tax brackets and the personal exemption to the CPI.

How important have the budgetary consequences of upward bias in the CPI been historically? Obviously, a precise answer to this question would require extended study, taking into account the timing of the bias, the parallel development of indexing provisions in specific federal outlays and revenues, and interest on the accumulation of debt that has resulted. Yet an indication of the potential size of these effects can be inferred from one important historical example of one clearly identified source of bias. A careful study of this type, which focuses on the most important federal program affected by indexing, namely, Social Security benefits, has been conducted by the Office of Economic Policy (OEP) of the Department of the Treasury.

A Case Study of Damage Already Done

On February 25, 1983, the Bureau of Labor Statistics (BLS) introduced an important technical modification in the consumer price index for all urban consumers (CPI-U). This altered the treatment of housing costs by shifting the costs for homeowners to a rental equivalent basis. The new treatment of housing costs was incorporated into the consumer price index for urban wage earners and clerical workers (CPI-W), used to index Social Security benefits, in 1985.

The rental equivalent measure of housing costs was a conceptual improvement and has been retained in subsequent official publications. Housing costs in preceding years, however, employed a "homeownership" measure "based on house prices, mortgage interest rates, property taxes and insurance, and maintenance costs." The treatment of housing costs before 1983 was not modified in publishing the revised CPI-U, so that the new treatment of housing introduced a discrepancy in the conceptual basis for the CPI-U before and after 1983. Similarly, housing costs in the CPI-W before 1985 have not been modified.

BLS developed an "experimental" price index, CPI-U X1, based on a rental equivalent treatment of housing extending back to 1967. This provides the basis for the OEP assessment of bias in the CPI-W. The bias for 1975, the first year that Social Security was indexed to the CPI-W, was 1.1 percent. This bias mounted over subsequent years, reaching 6.5 percent by 1982 and then declining to 4.7 percent in 1984.

Overpayments of Social Security benefits resulting from the bias in the CPI-W mounted through 1983, reaching a total of $8.76 billion, or 5.55 percent of benefits paid in that year. These overpayments have resulted in a lower balance in the Old Age Survivors Insurance (OASI) trust fund and a larger federal deficit and debt. OEP estimates interest costs associated with these deficits at the rate of interest paid or projected to be paid on the OASI trust fund. Beginning in 1984 interest costs predominate in the total. In the current fiscal year the total cost is $21.79 billion, of which $17.64 billion is interest. Thus the cumulative effect of just this one source of bias in the CPI-W via this one program on the federal debt amounts to $271.0 billion, as of 1996.

The increases in federal outlays resulting from the bias in the CPI-W cannot be justified as cost-of-living adjustments. These increases are the consequence of an inappropriate treatment of housing costs before 1985 and have resulted in large transfers to beneficiaries of the OASI program that are devoid of any economic rationale. The overpayments have continued up to the present but are declining in importance. The resulting decline in the OASI trust fund, however, continues to mount due to rising interest costs and now contributes more than two hundred billion dollars to the federal debt.

Of course, nobody would suggest retroactively undoing the overindexing due to this or any other source of bias. The point of this discussion is to demonstrate how important it is to correct biases in the CPI as quickly and fully as possible before their consequences mount, indeed compound.

The Damage Still to Come

What would be the effect of an upward bias in the CPI on future budget deficits? If the change in the CPI overstated the change in the cost of living by an average of 1 percentage point a year, this bias alone would contribute almost $135 billion to the deficit in the year 2006. That is one-third the projected baseline deficit (which assumes no policy changes such as the current balanced budget proposals). More remarkably, the upward bias by itself would constitute the fourth-largest federal outlay program, behind only Social Security, health care and defense. By 2008, the increased deficit would be $180 billion and the national debt, $1 trillion.

An upward bias in the CPI would result in substantial overpayments to the beneficiaries of federal entitlements and mandatory spending programs. In addition, such a bias would reduce federal revenues by overindexing the individual income tax. In short, the upward bias programs into the federal budget every year an automatic, real increase in indexed benefits and a real tax cut. Correction of biases in the CPI, while designed to adjust benefits and taxes for true changes in the cost of living more accurately, would also contribute importantly to reductions in future federal budget deficits and the national debt. These reductions can be attributed to higher revenues, lower outlays, and less debt service. Lower outlays-cuts in indexed federal spending programs and reduced interest payments-account for over two-thirds of the long-run deficit reduction, while higher revenues account for the rest.

Available from the Hoover Press is Frontiers of Tax Reform, edited by Michael J. Boskin; the book documents the proceedings of the Hoover Institution's conference "Frontiers of Tax Reform" held in May 1995 in Washington, D.C. To order a copy of the book, call 800-935-2882.

Michael J. Boskin is a senior fellow at the Hoover Institution and the T. M. Friedman Professor of Economics at Stanford University. He is also a research associate at the National Bureau of Economic Research, serves on several federal advisory panels, and advises heads of state, finance ministries, and central banks around the world. Among other posts, he served as chairman of the President's Council of Economic Advisers from 1989 to 1993.