Social Security's COLA increase Is based on an outdated inflation measure

Social Security just announced the biggest increase in beneficiaries' cost‐of‐living adjustment (COLA) in 40 years: 8.7%. The trouble is, Social Security is using an outdated measure that's driving up benefit costs. The so‐called chained CPI would protect seniors' purchasing power while extending Social Security's ability to provide benefits.

Social Security benefits are indexed for inflation to protect beneficiaries from a decline in purchasing power when the prices of goods and services rise. That's generally a good thing. The 8.7 percent COLA increase, announced today, is a direct result of the 40‐year inflation high, that's plaguing the post‐pandemic nation. Without this increase in nominal benefits, more seniors would likely experience poverty at older ages.

However, the index used to calculate Social Security's cost‐of‐living adjustment needs an upgrade. CPI‑W was the name of the game back in 1975 (10 years before this author was born) when Social Security adopted automatic inflation adjustments. Since then, the measure has become outdated and riddled with measurement errors.

As a result, CPI‑W overstates the rise in the cost of living by about a quarter percentage point (0.26 from 2013–2022).

This contributes to the growth in Social Security benefit payouts, raising program costs beyond what's necessary to keep beneficiaries whole.

Back in 1975, when Congress first adopted automatic inflation adjustments for Social Security benefits, the Bureau of Labor Statistics published only one Consumer Price Index – also known now as the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI‑W).

CPI‑W tracks the prices paid by urban wage and clerical workers, reflecting the purchasing behavior of about 3 in 10 U.S. individuals. There is a broader Consumer Price Index for All Urban Consumers (CPI‑U), that covers 8 out of 10 individuals in the U.S. This broader measure—by considering the prices paid by a larger number of individuals—improves inflation measurement accuracy.

There's yet another important facet to this issue. As prices change, consumers change what they buy. For example, if the price of apples rises more rapidly than the price of bananas, households will reduce their purchases of apples and buy more bananas instead. That's called the substitution effect. You can probably think of a thing or two you've bought less of (and what you've purchased instead) since inflation took hold in America's grocery stores, gas stations, and elsewhere.

Beginning in 1999, the Bureau of Labor Statistics began reporting a yet more accurate measure of inflation, the chained CPI. The chained CPI incorporates the broader CPI‑U and adjusts for the substitution effect.

Lawmakers should index Social Security's COLA to the chained consumer price index (CPI), which acknowledges that people choose less expensive and different goods and services in response to changes in prices. According to the Social Security Administration, this reform would eliminate about one‐fifth of Social Security's long‐term fiscal imbalance. And it would more accurately protect the value of benefits from the impact of inflation on beneficiaries' cost of living.

The Congressional Budget Office last projected that adopting chained CPI would save Social Security about $150 billion over 10 years (or about 15% of the projected 10‐year growth in benefits). And that was before the 2022 spike in inflation.

What about adopting chained CPI for other social welfare programs? Because the chained CPI is a more accurate measure of changes in the cost of living, it should be adopted across all federal benefit programs that are currently using the CPI‑W or the CPI‑U to make benefit adjustments. Opponents of moving to this measure, argue that it would grow welfare beneficiaries' benefits more slowly, leaving them with fewer resources over the long run. If proponents believe that welfare benefits are too low, they should address this issue directly; not perpetuate use of a less accurate inflation measure to achieve their ends.

What about adopting the Consumer Price Index for the Elderly (CPI‑E) instead? Proponents of the experimental Consumer Price Index for the Elderly (CPI‑E) argue that the current COLA adjustment doesn't keep up with the more specific inflation that seniors face because they spend more than other Americans on out‐of‐pocket health care costs and those costs rise faster than average inflation. They have a point. However, there are at least three reasons why Social Security should not adopt the CPI‑E:

* One‐third of Social Security beneficiaries are not elderly. Social Security also pays benefits to eligible disabled individuals and so‐called survivors of Social Security beneficiaries, including children.

* The CPI‑E includes persons age 62 and older, many of whom participate in the workforce. The purchasing behavior of working seniors differs from the retired elderly.

* The sample size for the CPI‑E is only one‐quarter that of the CPI‑U sample. Using a smaller sampling size increases the probability of sampling error, reducing the measure's overall accuracy.

What about adopting chained CPI in the U.S. tax code? Moving to chained CPI in the tax code would push taxpayers into higher tax brackets sooner, resulting in tax increases for U.S. households. Opponents of shifting to chained CPI for the tax code acknowledge that it represents a more accurate measure, but they take issue with the indirect tax increase this change represents. My colleague Chris Edwards has argued that shifting to chained CPI would worsen an existing "bias that pushes families into higher tax brackets over time, which is called "real bracket creep." Real growth in the economy steadily moves taxpayers into higher rate brackets since the tax code is indexed for inflation but not real growth." Chris instead proposes that federal lawmakers use an entirely different index for the U.S. tax code: nominal GDP growth.

With Social Security running a cash‐flow deficit of $126.5 billion in 2021 and trust fund exhaustion projected by 2034, reform is long overdue. Using chained CPI to determine future Social Security cost‐of‐living adjustments would extend benefits for longer without raising taxes on working Americans, while protecting beneficiaries from a real loss in purchasing power based on inflation.