It has become a familiar refrain in recent months. Federal Reserve Chairman Alan Greenspan and other economists have argued that the consumer price index should be lowered because it overstates inflation--a position that delights budget-whacking politicians on Capitol Hill. Because Social Security benefits and tax thresholds rise with the CPI, lowering the index would therefore cut automatic increases in government spending and raise taxes. Indeed, a new budget proposal by House Republicans contains $52 billion in spending cuts and tax hikes over four years on the assumption that the Bureau of Labor Statistics will reduce the index.
An easy fix, yes--but a bad idea. The reason: The CPI understates inflation as well as overstates it, other economists say. And no one is yet sure of the net result.
HIDDEN HIKE. Arcane as this debate may seem, it has a huge effect on all sorts of Americans. The CPI is used to set federal tax-bracket thresholds, personal exemptions, and the earned-income tax credit. A lower index would reduce exemptions, push more taxpayers into higher brackets, and make others ineligible for the credit--creating a hidden tax hike. Social Security, food stamps, and pensions for federal workers also would be pinched. A 0.5% CPI cut would cost the average Social Security recipient a total of $2,700 over 10 years, figures David Certner, an economist at the American Association of Retired Persons.
Economists have struggled with CPI distortions for decades. Every month, the BLS surveys 25,000 retail outlets to collect prices for some 95,000 goods and services. Measuring the posted price is easy. But the BLS also tries to discount portions of price hikes that reflect improved quality. Drawing that line is no easy task. Critics say the CPI undervalues many quality gains, such as drugs with fewer side effects or cars that need less repair work. Overall, inflation may be exaggerated by 0.5% to 1.5% a year, say Greenspan and some private economists.
But many mismeasurement problems run the other way, too. For instance, the BLS considers federally mandated smog-control devices for autos a consumer benefit, so their cost isn't counted in the CPI. But the CPI is designed to measure what individuals buy, not social benefits such as cleaner air. The index would have climbed nearly 0.1% a year faster since 1967 if it included what auto buyers spent on smog control, the BLS says. "If people scrutinized the CPI for downward biases with the same intensity that they do for upward ones, I'm sure you'd find the same size biases," says Daniel J.B. Mitchell, a labor economist at the University of California at Los Angeles. "The political incentives are to find only the upward ones."
QUICK FIX. Changing the CPI would just sow confusion. Companies and unions use it in private contracts, which might then have to be changed. And the markets--as well as the Federal Reserve--make decisions about the economy based on CPI-adjusted wages, productivity, and gross domestic product growth. If the CPI truly does overstate inflation, a good argument can then be made that Greenspan probably has pushed interest rates higher than is necessary to meet an overstated threat.
Given what's at stake, the best response is to keep politics out of the debate and let BLS economists deal with the issue. They've already responded to complaints of inaccuracy. In January, the bureau changed the way items surveyed for the index are sampled to adjust for a weighting bias it had found.
The BLS is engaged in a long-term review of the CPI that likely will bring more changes. That may not satisfy Washington politicians hungry for a quick budget remedy. But it sure beats turning a statistical battle into a political one.