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AMERICAN.COM

A Magazine of Ideas

Senior Moment: Reduce COLAs and the Social Security Deficit

Thursday, May 19, 2011

Reducing Cost of Living Adjustments by basing them on a more accurate measure of inflation would alleviate the long-term Social Security deficit.

Two prominent deficit reduction plans have proposed reducing the Cost of Living Adjustments (COLAs) paid to Social Security beneficiaries, arguing that COLAs should be based on a “more accurate” —and lower—measure of inflation. The proposal from Erskine Bowles and Alan Simpson, co-chairs of President Obama’s fiscal commission, would “switch to a more accurate measure of inflation for calculating COLAs.” Likewise, Alice Rivlin and Pete Domenici, co-chairs of the Bipartisan Policy Center’s Debt Reduction Task Force, refer to “changing the calculation of cost-of-living adjustments to better reflect inflation.”

Both proposals would reduce annual COLAs by around 0.3 percentage points. While this may seem like a small change, it would have significant effects on benefits for older retirees and on Social Security’s finances. The smaller COLAs these two commissions envision would reduce retirement benefits for an 80-year-old by approximately 5 percent, before any other benefit reductions had been implemented. These lower payouts would fix around one-quarter of Social Security’s long-term funding shortfall.

The obvious solution is to use a Consumer Price Index that accurately measures price changes for retirees. In other words, a chain-weighted version of the CPI-E.

But when proponents of a “diet COLA” speak of making Social Security’s inflation measure “more accurate,” they should first ask, more accurate for whom? Better reflecting inflation for whom?

Most economists do believe that the Consumer Price Index (CPI) used to calculate COLAs—the CPI-W, for Urban Wage Earners and Clerical Workers—overstates the true rate of inflation because it doesn’t fully account for how people alter their buying habits in response to changing prices. For instance, if the price of apples goes up and the price of oranges goes down, in the real world people will buy fewer apples and more oranges. But the CPI-W assumes that everyone continues buying the same amount of each, thereby driving up the measured rate of inflation. Experts call this effect “upper-level substitution bias.”

There is a different CPI—called the Chain-Weighted, or C-CPI-U—that accounts for upper-level substitution bias. According to the Bureau of Labor Statistics, the C-CPI-U “is designed to be a closer approximation to a cost-of-living index than other CPI measures.” From 1999 through 2009, the C-CPI-U reported annual inflation 0.25 percentage points lower than the CPI-W.

This new measure would reduce the long-term Social Security deficit by only around 9 percent, meaning that other revenue increases or benefit reductions would be needed.

But there’s another bias in the CPI, and this one pushes in the other direction. The CPI-W tracks purchases by working-age individuals, which may differ significantly from those of Social Security recipients. Many believe this difference in the population measured causes the CPI-W—and Social Security COLAs—to understate inflation for seniors.

The CPI-E, which stands actually for “experimental” rather than “elderly,” is based upon the purchasing habits of individuals aged 62 and over and helps address age-related bias in the CPI-W. Healthcare, for instance, makes up around 10 percent of spending in the CPI-E versus 5 percent in the CPI-W. Likewise, transportation makes up only 15 percent of the CPI-E versus 20 percent of the CPI-W. Tracking purchases by older Americans from 1999 through 2009, the CPI-E grew around 0.14 percentage points faster each year than the CPI-W.

People who focus on benefit adequacy for seniors favor adopting the CPI-E, forgetting that it overstates inflation for the same reasons as the CPI-W. But those concerned with controlling entitlement costs favor the C-CPI-U, ignoring the fact that it does not account for seniors’ purchasing habits as accurately as the CPI-E.

A new measure would be calculated based on the purchasing habits of seniors, but also would account for how seniors’ purchases adjust in response to changing prices.

The obvious solution is to use a CPI that accurately measures price changes for retirees. In other words, a chain-weighted version of the CPI-E—let’s call it the C-CPI-E. This new measure would be calculated based on the purchasing habits of seniors, but also would account for how seniors’ purchases adjust in response to changing prices. An entirely new C-CPI-E would be costly for the Bureau of Labor Statistics and would take time to construct. In the meantime, however, we could easily adjust the current CPI-W to account for insights from both the C-CPI-U and the CPI-E. The net effect of both adjustments would be a reduction in the CPI—and in COLAs—of around 0.11 percent (0.25 minus 0.14).

This new measure would reduce the long-term Social Security deficit by only around 9 percent, meaning that other revenue increases or benefit reductions would be needed. But it would be a 9 percent that honest reformers from both sides should be able to agree to and one they could defend both to taxpayers and to beneficiaries.

Andrew Biggs is a resident scholar at the American Enterprise Institute.

FURTHER READING: Biggs has also recently written, “Is Social Security Middle-Class Welfare?” “The Protected Class,” and “Why Does Government Grow and Grow and Grow?” He discusses “The Challenges of State and Municipal Debt,” offers “A Primer on Government Pay,” and asks “Entitlement Reform: What Next?”

Image by Rob Green/Bergman Group.