The Real Problem With Chained CPI

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By Josh Barro

My Bloomberg View colleague Ezra Klein notes today that the adoption of the chained consumer price index -- a more accurate and also a lower measure of inflation -- to govern Social Security and the tax code is really a tax-raising and benefit-cutting measure masquerading as a technical change. He’s right.

But the change also highlights a bigger problem: Our income tax and old-age benefit policies are linked, for dubious reasons, to price inflation. They shouldn't be. Instead of tightening our price inflation measure, we should move in the opposite direction: less price indexing, more wage indexing.

Much of the Social Security benefit formula is already linked to wages. Your initial Social Security benefit at retirement is calculated based on how much money you, personally, earned during your career. And the ratio of your lifetime earnings to your monthly benefit is determined in a manner explained by the Urban Institute here; the so-called bend points that are the key to the calculation are adjusted annually to rise with average wages.

But once you’re retired, your Social Security benefit is adjusted for price inflation, not wages. That means that even as the economy grows and average standards of living rise, your personal benefits stay flat in real terms.

It’s hard to see the policy rationale for that; if Social Security is intended to be a program for ensuring that seniors continue to share in national prosperity after they retire, why shouldn't their benefits rise along with national income, and why should older seniors draw smaller benefits than younger ones?

Social Security reform proposals, including the Simpson-Bowles proposal, often contemplate benefit enhancements for the very elderly, in effect to offset the stagnation of benefits that comes from price indexing. An alternative would simply be to annually adjust benefits in line with wage growth, at least for lower-income seniors.

Inflation indexing of the income tax code also makes little sense. Every year, income tax brackets are adjusted upward in line with CPI. So, while the 25 percent federal income tax bracket started at $34,500 of taxable income in 2011, it doesn't start until $35,350 for 2012. But, except in recessions, incomes tend to rise faster than price inflation. That means that, absent changes in tax law, a taxpayer at any given place in the income distribution will face a higher effective tax rate over time.

This effect is called "real bracket creep," and it’s undesirable if we want a tax code that produces stable collections and a stable distribution of the tax burden over time. Indexing tax brackets to national income would cause the bracket thresholds to rise faster, eliminating real bracket creep.

Of course, the crucial problem with my wage indexing proposal is that it would make Social Security more expensive and reduce tax revenue, the opposite of the objective of chained CPI advocates. It’s still a good idea.

Social Security faces a significant funding gap of about 20 percent over the next 75 years. Still, of all the major components of the U.S. retirement savings system, it is in the strongest financial health. As Matt Yglesias notes, the troubles of other retirement saving vehicles are an argument for raising Social Security benefits instead of cutting them.

Look at the alternatives to Social Security. Corporations are abandoning defined benefit pensions for a variety of good reasons. State and local governments are finding their pension promises to public workers to be increasingly unaffordable. Individual retirement savings vehicles, such as 401(k) and IRA accounts, tend to be underfunded and have unattractive cost structures. People who hoped to rely on home equity to finance retirement got burned in the housing bust.

One way to deal with the weakness of these savings vehicles is to enhance Social Security. There are lots of options to consider -- I am a fan of mandatory individual accounts on top of traditional Social Security benefits -- but wage indexing is one appealing option. Such enhancement could be financed with an increase in the payroll tax.

On the tax side, real bracket creep could be thought of as a feature rather than a bug: We have a long-term budget gap, and ongoing stealth tax increases built into the tax code can help address that. But in general, we want a tax code that produces revenue that is flat as a share of the economy, not rising. When we have tax and fiscal reform that puts us back on a path to fiscal sustainability, with sufficient revenue over the long term, one component should be the elimination of real bracket creep.

An obvious question remains: If we don’t cut Social Security, and even expand it, then where should the deficit-closing measures come from? The main answer to that question is "Medicare."

Washington’s fiscal problem is principally a health-care cost problem. Tinkering with Social Security is appealing because adjusting benefit formulas is easier than reforming health-care delivery. But cutting cash benefits to seniors will cause real pain, while bringing the U.S.'s health costs into line with our peers would be close to a free lunch.

(Josh Barro is lead writer for the Ticker. E-mail him and follow him on Twitter.)

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-0- Dec/18/2012 22:06 GMT