Ed Dolan's Econ Blog

Is the Chained CPI the Right Fix for Social Security?

One of the most controversial elements of President Obama’s 2014 budget is the proposal to reduce future cost-of-living adjustments to Social Security benefits by changing the inflation index. The Social Security Administration now bases inflation adjustments to on the consumer price index for urban wage earners and clerical workers (CPI-W), a close cousin of the more widely publicized CPI for all urban consumers (CPI-U). The administration proposal would instead use a relatively new index called the chained CPI, or C-CPI-U, which, in the past, has increased slightly less rapidly. Predictably, deficit hawks love the idea, while seniors and those who defend their interests hate it. Suppose, though, that we set ideology and interest group politics aside to look at the underlying economics of the issue. On those terms, is the switch to the chained CPI the right fix for Social Security?

What exactly are we trying to fix?

Before we start fixing something, we should be sure we know what is broken. Is a flawed method of inflation adjustment really a major problem? Would fixing it, in isolation, really improve the functioning of the Social Security system as a whole? Or is it just an attempt to disguise an unpalatable cut in benefits as a minor technical correction? If what we really want is an across the board cut, why?

It is sometimes argued that we can afford to slow the growth of Social Security benefits because seniors are no longer as economically disadvantaged as they once were. Consider, for example, the dramatic decrease in poverty rates among the elderly over the past half century. As the following chart shows, in the 1960s, when the government first began to publish official poverty statistics, people 65 and older had the highest poverty rates of any age group. Today they have the lowest rate.

Taken at face value, these trends appear be consistent with the notion that seniors have more than kept up with inflation. However, a closer look at the income status of older Americans raises some doubts about that. One difficulty is that the official approach to measuring poverty probably overstates the standard of living of seniors.

The shortcomings of the official poverty measure are well known. In its original form, it simply multiplies the cost of an economy food plan by three. As a result, it fails to take into account the increasing relative prices of budget elements other than food, the impact of taxes, and the value of in-kind government benefits like SNAP (formerly food stamps), Medicare, and Medicaid. Other problems include inadequate attention to regional differences in living costs and an inadequate view of family structure.

Two years ago, the Census Bureau introduced a new Supplementary Poverty Measure (SPM) that tries to address these problems.The SPM begins from a minimum budget that includes not just food, but food, shelter, clothing, and utilities (FCSU). The FCSU budget is then multiplied by 1.2 to allow for other expenditures, and it is further adjusted for family size and regional differences in housing costs. The SPM then compares the resulting minimum family budget to a measure of resources that adjusts the old cash income concept in three ways. First, it adds the value of in-kind benefits that families can use to meet FCSU needs. Second, it subtracts net taxes. Third, it subtracts other necessary expenses, of which out-of-pocket medical expenses are one of the largest. (For more on the SPM, see this earlier post.)

As the next chart shows, the SPM increases the estimated poverty rate for the whole population only modestly, from 15.2 percent to 16 percent for 2010. However, the impact varies widely by age group. In particular, the poverty rate for people aged 65 and older jumps from 9 percent to 15.9 percent, which is close to the average for the population as a whole. A large part of that increase comes from the way it takes into account out-of-pocket medical expenses that reduce household income available to meet FCSU needs.

A poverty rate for seniors no lower than that for the population as a whole already undermines the case for less generous cost-of-living adjustments to Social Security, but there is more. We should look not just at the poverty rate among seniors, but at the entire distribution of income for the elderly population. According to CBO data, presented in the next chart, that distribution is far less equal than for the rest of the population, and, as for other age groups, it is becoming even more unequal over time.

The chart shows Gini indexes for various population groups based on market income, a measure that does not include Social Security or other government benefits. A higher value of the Gini index means more inequality. The picture we get is of an elderly population in which a relatively few wealthy households account for most of the market income, while many of the rest are highly dependent on Social Security benefits.

That picture is confirmed by data from the Social Security Administration, presented in the next chart, that show that a third of the elderly population depend on Social Security for 90 percent of their income, and two-thirds for half or more of their income. For the single elderly, the degree of dependence on Social Security is even greater.

Taken together, these data suggest that an across-the-board benefit reduction, whether by way of a switch to the chained CPI or in any other form, would further aggravate the already unequal distribution of income among seniors. To offset that tendency, the administration budget proposal offers “bump-ups” for retirees older than 75, but the bump-ups may not help low-income retirees as much as is sometimes supposed. The problem is that people with lower incomes are much less likely than those with higher incomes to live long enough to reach the bump-up age. For example, for men reaching retirement age of 67 in 2006, the life expectancy is five and a half years less for those in the lower half of the income distribution than for those in the top half. That means many of the poorest retirees will die before their get their first bump-up. (The same problem also affects proposals to lower Social Security costs by raising the retirement age, as discussed in this earlier post.)

Any way we look at it, then, it appears that a shift to the chained CPI, with or without bump-ups, would make the already unequal distribution of income among seniors more unequal still. Overcoming that problem would require more far-reaching reforms to the Social Security benefit structure, for example, one that combined a guaranteed minimum benefit at least equaling the poverty level with means testing of benefits for wealthier seniors.

How good is the chained CPI?

Let’s look at the matter from a different perspective now. Regardless of what we do about total Social Security benefit levels, caps, and floors, benefits will, like those of other income support programs, need some kind of inflation adjustment. On purely methodological grounds, what reasons do we have to think that the chained CPI is better than the CPI-W?

What we would really like to have as a basis for inflation adjustment is a true cost of living index (COLI). A COLI would measure the amount of income we need to reach a certain level of consumer satisfaction. If the COLI rose by 3 percent, and your benefits went up from $1,000 a month to $1,030 a month, then we could truly say that you were no better or worse off than before. Unfortunately, though, a true COLI is a purely theoretical construct that we can only approximate in the real world.

The approximations we do have are price indexes–averages of the prices of the various things we consume, weighted by the quantity of each item in our market basket of goods and services. Economists have long argued that price indexes like the CPI in its various forms tend to overstate the rate of increase of the cost of living. Some of the more important sources of upward bias in the CPI are these:

  • A substitution bias, which arises from the fact that changing prices cause consumers to shift, over time, from goods whose prices increase faster than average to those that increase more slowly than average, or fall.
  • A quality bias, which arises from the fact that new models of a good have better performance (like flat-screen TVs) or last longer (like radial-ply tires), and therefore give additional satisfaction that partly or fully offsets price increases. Closely related factors, like the introduction of completely new goods and new, lower-cost methods of retailing add to the quality bias.
  • A small sample bias, which is a purely technical distortion arising from the fact the BLS makes only a few price observations for each good or service each month.

(Note: These three sources of bias and all of the discussion that follows concern the measurement of inflation. In addition, there are strong biases in people’s subjective perceptions of inflation. Many people are skeptical of the idea that published price indexes overstate inflation because they, personally, perceive a much higher rate of inflation than measured by the CPI. The more paranoid among them believe that the government is purposely manipulating the data in a way that understates the true inflation rate. For a detailed discussion of the upward bias in perceived inflation, see this earlier post.)

In the 1990s, Congress appointed a panel of economists, known as the Boskin Commission, to study the accuracy of the CPI. The commission estimated the upward bias of the CPI-U to be about 1.1 percentage points per year and made several recommendations for mitigating it. Since that time, the Bureau of Labor Statistics has implemented a number of those recommendations. For example, it has significantly reduced the substitution bias by updating base-year quantity weights more frequently. Also, it has introduced new methods of correcting for changes in the quality of goods, and it pays more attention to outlet stores and online retailing. As a result, the upward bias of the CPI is almost certainly less than it was in the 1990s, but it may still be as much as one-half to a full percentage point per year. (See here and here for some recent discussions.)

There are strong theoretical reasons for thinking that the chained CPI further reduces the substitution bias. The reason is that it takes into account quantities consumed in the current period, when prices are measured, rather than just quantities consumed in the past. Both theoretical considerations and experience with the C-CPI-U since the BLS began to calculate it in 2000 suggest that the reduction in the substitution bias is in the range of 0.2 to 0.3 percentage points per year. However, that does not automatically make the chained CPI an ideal basis for indexing Social Security benefits. It has problems of its own.

One problem as that the data on current consumption patterns needed to calculate the chained CPI are available only with a lag. The first version of the C-CPI-U released each month is only an estimate based on extrapolations from past data. Social Security benefits would have to be adjusted using a preliminary calculation of the chained CPI rather than the final revision.

A more serious problem is that the quantity weights used for both the CPI-U and the C-CPI-U do not necessarily reflect the consumption patterns of Social Security beneficiaries. Beneficiaries are much older, on average, than the population as a whole; they are likely to drive less, use more medical care, and perhaps differ in other ways as well from the general population.

Conceptually, it would be better to adjust Social Security benefits using a price index specially tailored to the consumption patterns of the people receiving them. With this in mind, the BLS has experimented with a separate consumer price index for the elderly population, known as the CPI-E. Although there are several methodological issues to be resolved before the CPI-E is ready for the big time, preliminary results suggest that it has been rising at a rate about 0.2 percentage points faster than the CPI-W, in large part because of the greater weight it puts on healthcare goods and services.

Arguably, a chained version of the CPI-E would be an even better basis for inflation adjustment of Social Security. The BLS has not yet tried to calculate such an index, but if the substitution bias for the CPI-E is about the same as it is for the CPI-U, a chained CPI-E would probably rise about 0.2 to 0.3 percentage points more slowly than the unchained version. That means that when we take into account the offsetting effects of the substitution bias and the differences in consumption patterns between elderly and younger consumers, it could well turn out that the CPI-W, as now implemented, is a better approximation to a COLI for senior citizens than the C-CPI-U.

The bottom line

When all is said and done, the economic arguments for switching from the CPI-W to the chained CPI for inflation adjustment of Social Security benefits is a good deal weaker than it is often represented to be. We cannot really be confident that the chained CPI is a better approximation to changes in the cost of living of the elderly population than the CPI-W. In addition, switching to the C-CPI-U without adjusting benefit floors and caps could very well increase the inequality of income distribution among the elderly, which is already greater than for the population as a whole.

The fact is, the proposal to switch Social Security to the chained CPI has much more to do with politics than with economics. In the current phase of the budget debate, the White House appears eager to assume the role of the reasonable party by offering to cut entitlements, in order to set up a contrast with a conservative opposition that is unwilling to consider even small increases in revenue. The administration apparently hopes that it can minimize the backlash from its core supporters by passing off the C-CPI-U a purely technical adjustment.

It is not likely to work. My advice would be to forget about changing inflation adjustments for Social Security until the political climate allows consideration of a more comprehensive set of entitlement reforms. Use of the C-CPI-U or some similar chained price index might eventually make sense as part of broader reform package, but as a stand-alone measure, it offers little to love.

11 Responses to “Is the Chained CPI the Right Fix for Social Security?”

daveApril 29th, 2013 at 9:07 pm

its all good if obama just keeps extending programs to illegal aliens we can starve the elderly americans.after all the old people wont do the jobs americans wont do .and the illegals let the old eat cake!just through another party with Jay-z and beyonce at the white house! maybe Beyonce can dance around in her camel toe pants ,in the lincoln room .

benleetApril 30th, 2013 at 12:22 am

Ron Baiman at CPEG said this, "falling incomes that cause consumers to shift over time to less expensive quantities will cause the chain link index to increase less rapidly than a corresponding fixed weight index. Conversely rising incomes that cause consumers to shift to more expensive quantities will cause the chain link index to increase more rapidly than a fixed weight index." Ed Dolan's point about the SPM poverty rate for seniors rising from 9% to 15.9% increases the pool of poverty seniors by 76%, huge jump. I looked at the CBO paper, it states that the inequality Gini for seniors was reduced by 25% to 35% because of transfers, mostly SS payments (Fig. 16, page 23). I cannot understand how the average worker's contribution to total GDP can be $109,000 per year (S.F. Federal Reserve Bank chart), and therefore each average worker contributes around $88,000 per year to total personal income with total personal income over $13 trillion per year, yet the SSA report on wages and income states that half of all workers receive less than $26,965 annual income for 2011. Perforce retirement income will reflect this enormous income inequality. Half of all households own 1.1% of all wealth, and many are seniors. I don't need to state my point.

Ed Dolan EdDolanApril 30th, 2013 at 10:21 am

1. "falling incomes that cause consumers to shift over time to less expensive quantities will cause the chain link index to increase less rapidly than a corresponding fixed weight index." (From Baiman, CPEG)." This depends not just on changes in quantity weights but on whether prices of staple goods are rising faster or slower than prices of luxury goods. Does anyone have a link to some good data on that?

2. Baiman's characterization of the C-CPI-U in his 'technical appendix' is not quite right. He makes it look like a chained index is just a Laspeyres index with more frequent updating of base quantities. Instead, it is probably more accurate to describe it as an average of a Laspeyres index with a Paasche index (the latter using current quantity weights.) However, in practice, the two-stage procedure for the C-CPI-U makes it a little more complicated than that.

3. You are right to point to Fig 16 in the CBO paper. Unfortunately, the text is not completely clear whether it refers to a percentage change or a percentage-point change. It looks to me like the CBO data still show income inequality greater after transfers. I'll have to look into that.

John PetersonMay 8th, 2013 at 10:37 pm

The shorter life-span of the poorer half of SS recipients is not a strong argument against the chained measure, because use of the chained measure would have little effect on benefits for the first 5 or 10 years. It would mainly reduce (relative to current law) the benefits of recipients who live a long time–a category that may be dominated by women in the upper half of the income distribution (I haven’t fact-checked this). Longer-lived people are the ‘winners’ in the SS system, and the use of the chained CPI would reduce their ‘winnings.’

Of course, one important rationale for SS is to provide efficient insurance against ‘longevity risk,’ and adopting the chained CPI would reduce that insurance benefit.

Ed Dolan EdDolanMay 9th, 2013 at 1:47 am

You make a good point. What I had in mind was the fact that the "bump-up" offered by the administration seems disproportionately to protect the long-lived, who are disproportionately more affluent. It would be nice to see a full actuarial analysis, probably not an easy problem.

Jill LivingstoneMay 12th, 2013 at 9:41 pm

I'm 69, collecting SS and very happy to have a minimum wage 32-hour a week job. Were it not for working, I would be eating less well. I'm very healthy and don't take meds. I also opted for the BEST supplemental medicare plan (F) I could find. It t means I can go to the doctor anytime I please and not have to pay anything — or very little if one procedure or another is not covered at all under medicare.

With that said, the elegance of Social Security is that everyone receives it. FDR knew that if wealthy people were excluded or that somehow their benefits were much less than others while they paid more into the fund, the program would go the way of (now you can fill in the blank with every single program that was created to fight poverty and has now been dropped because 1) it doesn't work; 2) we don't have the money; 3) we have a couple of wars to fight off the books; 4) "they're" (recipients) all cheating; 5) malingerers are in the program; 6) government is your enemy, problem; 7) everyone but (name your favorite conservative) is a liar and a cheat; 8) democrats use these programs to keep people voting for democrats.

No suggestion to means test SS should go anywhere at all otherwise the whole program will be at risk and go the way of the dodo bird.

Ed Dolan EdDolanMay 13th, 2013 at 9:32 am

What you say makes sense, but somewhat the same thing as means testing could be accomplished by removing the earnings cap on contributions. Also, what you say is not true of all programs. For example, we don't give wealthy people food stamps, but the food stamp program is alive and well.

llisa2u2May 19th, 2013 at 4:43 pm

It seems so basic to just raise the top annual earnings limit/threshold that is presently being used to determine SS withholding. WHY NOT? It's easy and only affects those earners that have seen a large increase in their annual earnings. Why continue to penalize the low-end earners????

OldNerdGuyMay 21st, 2013 at 4:05 am

Chained CPI means that if tuna goes from $4 to $5, and cat food goes from $3 to $4, then there is no inflation because you can switch to cat food.

By that thinking, we can say that retirees on a fixed income never experience inflation, because their costs always stay under the fixed amount of their income. Their costs never go up and inflation no longer exists. That's right, kids: we can eliminate inflation by declaring it not to exist. Hooray!

I don't know why we're even talking about this. Seems like an "Emperors New Clothes" moment in the social discourse. Those moments seem to be happening more often (like when we were led like sheep to accept the notions of WMDs, the Atkins diet, unlimited money printing, and Facebook as a life necessity). Where's that kid ("but he has nothing on!") when we need him?

Chained CPI: "Let them eat cat food."

Ed Dolan EdDolanMay 21st, 2013 at 10:01 am

No, you are flat wrong about tuna and catfood. That is just an urban myth. The BLS categories for goods and services are much narrower than that.

If tuna increases by 20%, the tuna sub-index goes up by 20%. If it has a 1% weight in the CPI, then the CPI-U as a whole increases by .2% (assuming no other prices change), regardless of whether people switch to cat food or not.

It is true that the effect you describe does occur within categories, for example, if Star-Kist tuna goes up and people switch to Bumble Bee brand, which does not change, then yes, your are right, the CPI would not show inflation because these goods are in one narrow category. The BLS considers them equivalent. But the categories are not as wide as tuna/cat food or sirloin steak/hamburger, as many people think.

It is also true that if something were to go up in price so much that people no longer consumed any of it at all, then it would disappear from the CPI and no inflation would be recorded. For example, if tuna went up to $100 a can, probably no one would buy it and it would eventually be dropped as a category. The inflation would at first be recorded, while the price was going up and while consumers phased it out, but after the quantity dropped to zero, a further increase to $200 would not show up.

It is also true that the C-CPI-U shows the effects of quantity changes sooner. However, remember that applies both to increases and decreases in prices.

OldNerdGuyMay 21st, 2013 at 1:56 pm

Thanks for your response. If I may respond to your comments:

"if something were to go up in price so much that people no longer consumed any of it at all", "For example, if tuna went up to $100 a can", "a further increase to $200". I don't see how tuna can fetch a price of $100, and then $200, in the situation you describe ("people no longer consumed any of it at all").

Even if the catfood argument doesn't work (until they change the categories, which I presume they could do without Congressional approval), it still appears to be one more ploy in an avalanche of policies that are designed to benefit bankers and borrowers at the expense of savers and retirees. The real issue is, when will the people in the latter category get tired of that. Then, I suppose the people in the former category will hope they are too tired to complain. This seems to be where we are headed.

I might add that in your Bumble Bee example, the lower price may be due to a quality difference. I suppose people on fixed incomes can just keep switching to lower quality choices within categories. In that situation, I think my earlier point stands: just because retirees costs didn't go up doesn't mean there's no inflation. It just means they are on a fixed income.

In any case, I do appreciate that your article is not entirely positive on Chained CPI.