4/11/13 – Chained CPI and Means Testing

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Apr 11, 2013 10:50:24 AM

and tagged Politics and the Economy, Economics Lessons

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We will be hearing quite a bit about the Chained Consumer Price Index (chained CPI) over the next couple days, though most of the details don’t matter. It’s the first of two major takeaways from the president’s proposed budget.

For the sake of completeness, here’s the definition of chained CPI. What matters for the average citizen, however, is one thing: chained CPI increases more slowly than the inflation measures that are currently used, the CPI-U (the CPI for All Urban Workers) and CPI-W (the CPI for All Urban Wage Earners and Clerical Workers). By shifting the measure used, payments for social security will increase more slowly over time.

Not by much. Since the year 2000, the difference has been between 0.25 percent and 0.30 percent per year, but over time this will have big effects. Effectively, this is a benefit cut that gets bigger in both relative percentage terms and dollar terms, as the social security payments grow with boomer retirements. The cuts will be largest just as the payments are needed most.

Shifting the CPI basis has also been proposed—although not in the Obama budget—for other areas, notably the thresholds where tax rates change. By lowering the rate of growth, the amount by which the lower tax rate thresholds increase will also increase more slowly. Put differently, over time, as incomes increase in the higher wage earner CPI (i.e., the CPI-W), the tax thresholds increase in the lower chained CPI, so more and more people will be pushed into higher tax brackets. This effect will be worst on those who are already taxed but not at the higher rates (i.e., the middle class). In effect, by moving to chained CPI for the tax code, over time, we would see an effective tax increase on the middle class.

From a governmental finance perspective, this would be a win-win—lower spending and higher tax receipts over time, brought about by one small technical change that has very little immediate impact. The change even has the added advantage of being technically supported by economists, as well as having broad political backing, at least for the social security component. According to Wikipedia, backers for the social security change include “the Washington Post Editorial Board, the Committee for a Responsible Federal Budget, and the Heritage Foundation, and it is included in various bipartisan commissions designed to reduce the deficit, such as Simpson-Bowles, Domenici-Rivlin and the Gang of Six.” It also has the advantage that it starts to address a real problem that has no easy solutions in a way that phases in over time.

I would be surprised if this move or something very much like it did not make it into a final solution—perhaps not in the next budget, but certainly in any grand bargain. It just makes too much sense not to use it.

A second major takeaway of the president’s budget generates much less consensus, to put it mildly. The Obama budget essentially lays the groundwork for means testing for Medicare by charging more affluent recipients higher premiums. Like social security, Medicare has been an entitlement for decades—a program that everyone got, regardless, and as such has had wide support.

If everyone doesn’t get it, of course, that support becomes less widespread, and moving to charge the more affluent more is a big step in that direction. Once differential benefits become accepted, the program may eventually be seen as a welfare-type program that benefits the poor, rather than something that everyone gets. Once that happens, as we have seen with welfare itself, it becomes much easier to cut.

Of the two takeaways, the chained CPI may end up having the bigger financial impact, but, if something like the means testing is passed, that may end up having the bigger social impact. I have written before about the inevitability of lower benefits and higher taxes, and, although it is no surprise to see higher taxes proposed by a Democrat, it is a real surprise to see lower benefits and means testing so proposed.

This is one more example of the mean reversion of politics. Pragmatism is forcing certain choices on both sides, and the Democrats seem to be ahead at the moment. A great deal will depend on the Republican reaction.

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