Base Social Security Cost-of-Living Adjustments on an Alternative Measure of Inflation

As specified by law, the Social Security Administration increases recipients' monthly benefits in most years. For example, the 5.8 percent cost-of-living adjustment (COLA) that went into effect in January 2009 was based on the increase in the consumer price index for urban wage earners and clerical workers (CPI-W) between the third quarters of 2007 and 2008. That index is calculated by the Bureau of Labor Statistics, or BLS. Although declines in overall consumer prices between the third quarters of 2008 and 2010 meant no COLAs were provided in 2010 or 2011, the Congressional Budget Office projects that there will be one in 2012.

The CPI-W, however, tends to overstate inflation because it does not fully account for changes in patterns of spending. This option would set the COLA equal to the growth in the chained consumer price index for all urban consumers (chained CPI-U). The chained CPI-U is an alternative measure of inflation, also calculated by BLS, that more fully incorporates the effects of changes in patterns of spending. CBO estimates that, on average, the chained CPI-U is likely to grow 0.25 percentage points per year more slowly than the CPI-W over the next 10 years. Using the chained CPI-U to set Social Security COLAs would reduce federal outlays by about $27 billion over five years and by $112 billion through 2021, CBO estimates. By 2050, such action would have reduced Social Security outlays by 3 percent--from 5.9 percent to 5.7 percent of gross domestic product. Some other policy changes that would reduce Social Security outlays--by constraining the increase in initial benefits, for example, or by raising the full retirement age (Mandatory Spending--Options 28 and 30, respectively)-- would affect future beneficiaries only. This option, by contrast, would reduce benefits to current beneficiaries so that current and future generations would bear the reductions more equally.

The chained CPI-U is initially published as a preliminary value and then revised over the following two years. As a result, implementing this option would require the use of preliminary data. CBO discussed the details of the approach in a Web-only technical appendix released with its February 2010 issue brief, Using a Different Measure of Inflation for Indexing Federal Programs and the Tax Code.

A rationale for this option is that the CPI-W overstates increases in the cost of living. Specifically, the CPI-W measures inflation on the basis of price changes for a fixed basket of goods and services that is periodically updated, whereas the chained CPI-U more quickly captures the extent to which households adjust their consumption when relative prices change. (Technically, the chained CPI-U avoids the so-called "substitution bias" that arises from the use of a fixed basket of goods in computing the CPI-W. Some analysts also conclude that neither the CPI-W nor the chained CPI-U fully accounts for increases in the quality of existing products or the value of new products.) Therefore, using the chained CPI-U would reduce federal outlays but ensure that, after adjusting for overall inflation, benefits remain at the same level as they are when a recipient becomes eligible for benefits.

An argument against reducing the COLA is that the prices faced by Social Security beneficiaries could rise faster than prices faced by the population at large. For example, beneficiaries are likely to spend more than younger people do for medical care, the price of which generally outpaces the prices of many other goods and services. BLS computes an experimental consumer price index for the elderly (the CPI-E) that aims to track inflation for the population ages 62 and older. From December 1982 through December 2010, the CPI-E grew faster than the CPI-W by an average of 0.27 percentage points per year. Another potential drawback of this option is that a reduction in the COLA would generally have larger effects on the oldest beneficiaries and on those who initially became eligible for Social Security on the basis of a disability. For example, if benefits were adjusted every tect vulnerable populations, lawmakers might choose to year by 0.25 percentage points less than the increase in reduce the COLA only for beneficiaries whose income or the CPI-W, beneficiaries would face a reduction in retire-benefits were greater than specified amounts. Doing so, ment benefits at age 75 of about 3 percent compared with however, would reduce the budgetary savings from the what they would receive under current law; at age 95, option. they would face a reduction of about 8 percent. To pro-