Wednesday, December 19, 2012

Is Chained CPI a benefit cut after all?

Whether you think moving the inflation adjustment on Social Security to chained-CPI from regular CPI is a cut or not depends on how you look at it. Remember, the goal is to keep purchasing power equal in order to keep benefit levels the same.  (So the answer is, you have to have a pretty skewed view of it to think that it is). People buy different comparable goods for two reasons: 1) The Income Effect, 2) The Substitution Effect.
The income effect is the change in goods when people's wallets are getting squeezed or expanded. If you have less money, then you buy inferior goods. The plastic bag cereal versus the brand name cereal for instance. Chained CPI does not take this into account. Otherwise, it would clearly be a cut.
The substitution effect is the change in goods caused by the change in price of goods relative to one another. The price of skim milk goes down versus the price of skim milk that stays even, so people buy more of the prior. This is a consumer preference decision. Chained CPI does take this into effect.
Does the consumer get more utility out of 2% milk specifically or does the consumer just want milk generally and therefore is just as happy buying the cheaper good? If you think they are really attached to the 2% milk, then it is a benefit cut. The consumer has lost purchasing power. Some consumers do care, and therefore would pay the extra money (up to a certain point). Economists call this concept elasticity. 
Most people are perfectly happy with skim milk instead of 2%, as long as their cheerios are adequately covered. People, as a whole, change behavior quite a bit on consumer goods due to relative price changes (this is why you see so much competition and advertising on price). If that is the case, then your purchasing power stays equal. 
Let's throw some numbers around in a vast oversimplification. Milk is getting more expensive because of droughts (true story). The price of skim milk goes up only 2 cents a liter, but 2% milk goes up 10 cents a liter. Three fourths of people don't notice and continue using 2%, but 1/4 of people start buying skim instead. Using CPI, you would get an additional 10 cents to cover this cost increase. Using chained-CPI, you would get 8 cents in addition instead since the government does not know which group you are a part of.  That is just one good in a basket of goods, though. Does this sound like the government is trying to cut your benefits or just keep your purchasing power equal (on average)? 
In a single year, it doesn't sound like much - but over 20 years, it becomes a thousand dollar difference per person. Now multiply that by tens of millions of people collecting Social Security, and now you are talking real money.
None of this is to say that this is a good idea or a better idea than some of its alternatives. That is value-subjective. One thing is for sure though, this is not a "secret backroom deal to slash benefits."

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