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By Robert J. Samuelson
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The new interest in the CPI--the consumer price index, the best-known inflation indicator--attests to the power of numbers. The CPI is used to adjust government benefits (mainly social security) and taxes (the personal exemption, standard deduction and tax brackets). Last week, for example, the government announced that social-security benefits will rise 2.6 percent in 1996 because the CPI has increased by 2.6 percent in the past year. The idea is to prevent inflation from invisibly eroding benefits or raising taxes. Good. But suppose the CPI overstates inflation. Then benefits will be too high and taxes too low. Presto: a quick way to cut budget deficits. Just dial back the CPI adjustment.
Comes now a commission of five economists who say the CPI actually does overstate inflation. In a report to the Senate Finance Committee, they conclude that the overstatement is probably about I percentage point a year. After their report, Sen. Daniel Patrick Moynihan, Democrat of New York, enthused on the op-ed page of The Washington Post: "If we were to do no more than declare that henceforth the cost of living adjustment will be CPI minus one percentage point, we would save $634 billion over the next 10 years. . . . Now here is a bipartisan agreement worth having."
Not really. Moynihan's rhetoric may be a reaction to the Clinton administration's unwillingness to do anything about indexing; but his proposal goes too far. I am not arguing that there should be no reduction in the CPI adjustment. There should be; indeed, I have long contended that the CPI exaggerates inflation. Yet once Congress grasps the staggering power of apparently small changes in the index, it may overdo things. The economists' 1-percentage-point figure is only an educated guess. If adopted, the practical effect would be to enact- slowly but surely-a huge benefit reduction and tax increase that falls mostly on those with the lowest incomes.
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Consider first social security. In 1995 the average payment for a married couple is $14,160. Increased 3 percent a year, that becomes $16,416 after five years; increased 2 percent annually, the amount is almost $800 less ($15,655). Social security now provides 40 percent of the income for Americans over 65, but its importance drops as incomes rise. Among the poorest fifth of the elderly, it accounts for about 80 percent of income; among the richest fifth, it's only a fifth.
The tax effects are similar. In 1995, the personal exemption is $2,500 per dependent. If that's raised 3 percent a year, it becomes $2,890 after five years; at 2 percent, it grows only to $2,760. The lower the exemption, the more money is subject to income tax. The difference ($130) means that, for a family of four, taxable income would be $520 greater after five years. Obviously, that matters more for a family with $25,000 of income than for one with $250,000.
Social security and other benefits should not be automatically and silently increased or decreased as a result of inflation or a faulty adjustment for it. Nor should taxes be automatically raised or lowered. Thus, indexing is a good thing; overindexing is not. At present, the best evidence indicates that the CPI overstates inflation by at least 0.5 percentage point a year. That's how much Congress should adjust the index downward. (A 3 percent change in the CPI would become 2.5 percent for spending and taxes.)
This does not mean that the CPI is inept. The error simply reflects the difficulty of the task. In a $7 trillion economy, with hundreds of millions of daily transactions, it is impossible to discover the exact change in average prices. There are constant shifts in products, consumers' tastes and technologies. No statistic can precisely trace the routine frenzy of a dynamic economy.
In fact, the CPI does a pretty good job. Every month the Bureau of Labor Statistics dispatches about 400 data collectors to record roughly 80,000 prices of everything from cereals to college tuition. About 100 new car models are regularly priced. So are cemetery lots and tax-preparation fees. The idea is to duplicate a "market basket" of goods and services actually purchased by typical consumers. Individual prices are weighted in the index according to their importance in people's buying habits.
Among economists, the CPI's flaws are old news. The "market basket" of goods and services is updated only once a decade, based on a huge survey of people's spending. But buying patterns regularly change, in part because consumers buy more of things that become cheaper. If renting videocassettes costs less than going to movies, people will rent more. The CPI understates such changes, because the "market basket" is revised only periodically.
Similar gaps arise from new products. In the early years, their prices tend to drop rapidly. The CPI often misses these, because the products aren't yet in the "market basket." Microwave ovens were included only in 1978, VCRs and personal computers only in 1987. Worse, quality improvements in all products are usually ignored, because they're hard to gauge in relation to price. New drugs may replace costly surgery; the CPI misses that. New refrigerators may use less electricity than the old; the CPI misses that.
But just because these (and other) types of errors are recognized--and can sometimes be estimated after the fact -does not mean that they can all be corrected in the CPI itself. Nor is there unanimity about their full effect. The Congressional Budget Office has put the annual inflation overstatement between 0.2 and 0.8 percent. Federal Reserve chairman Alan Greenspan cites a range between 0.5 and 1.5 percent. The economists convened by the Finance Committee also cited a range, between 0.7 and 2 percent. And all these conclusions draw on the same technical studies.
The president and Congress should have the courage to alter the indexation and the discipline to be cautious. Even a shift of 0.5 percent would produce savings of $320 billion over the next decade, reckons the CBO. Politics is about choice. Proper indexation aims to prevent choices from being made automatically. Once that's done, our political leaders should decide who s e benefits or taxes to change. The job should not be fobbed off on a technical adjustment. Nor should the BLS be pressured to alter the CPI to fit budget politics. Congress and the president are paid to make choices. Let them earn their pay.
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