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INDEXING WITH
THE CONSUMER
PRICE INDEX:
PROBLEMS AND
ALTERNATIVES
As required by Public Law 96-249

June 1981

INDEXING WITH THE CONSUMER PRICE INDEX:
PROBLEMS AND ALTERNATIVES

The Congress of the United States
Congressional Budget Office

For sale l>y the Superintendent of Documents, U.S. Government Printing Office
Washington. IM\ 20402







PREFACE

For the past several years, the behavior of the Consumer Price
Index (CPI) has differed noticeably from that of other measures of
price changes. This, together with the growing impact of indexation on the federal budget, has raised concern about current
indexing practices.
The Food Stamp Act Amendments of 1980 (P.L.
96-249) instruct the Congressional Budget Office (CBO) to review
the CPI and various alternative price measures, examining the
limitations of each and the reasons why they differ in their
measurement of inflation or the cost of living. The purpose is to
develop information that will assist the Congress in determining
whether the CPI is the most appropriate indexation base for the
Food Stamp Program, or whether alternative measures may better
reflect changes in consumer prices or the cost of living. In
keeping with CBO's mandate to provide objective and impartial
analysis, this study offers no recommendations.
Lawrence E. DeMilner of CBOfs Fiscal Analysis Division wrote
the report. Robert W. Staiger assisted in its preparation and was
primarily responsible for Appendix A. Sandra Christensen of CBO's
Human Resources and Community Development Division prepared Appendix B under the supervison of Nancy M. Gordon. The author gratefully acknowledges helpful comments and information from James E.
Annable, Jr., Stephen Chaikind, Robert A. Dennis, Heywood Fleisig,
and Frederick 0. Ribe of CBO, and G. William Hoagland and Robert D.
Reischauer, formerly of CBO. In addition, information and comments
were provided by Walter Lane and Jack E. Triplett of the Bureau of
Labor Statistics, Vee Burke of the Congressional Research Service,
Joseph J. Minarik of the Brookings Institution, and Robert J.
Gordon of Northwestern University. In accordance with the legislation mandating this study, designated officials of the Departments
of Agriculture, Commerce, and Labor were consulted in its preparation.
In January of this year, a draft was submitted to the
House Agriculture Committee and the Senate Agriculture, Nutrition,
and Forestry Committee. Francis S. Pierce edited the manuscript;
Kathleen M. Quinn, Marsha L. Mottesheard, Debra M. Blagburn,
Dorothy J. Kornegay, and Margalo Ashley-Bennett typed the many
drafts.
Alice M. Rivlin
Director
June 1981




iii




CONTENTS

Page
PREFACE

iii

SUMMARY .

xiii

CHAPTER

I.

CHAPTER

II.

CHAPTER III.

CHAPTER

CHAPTER

CHAPTER

IV.

V.

VI.

CHAPTER VII.




INTRODUCTION

1

PURPOSES OF INDEXATION

5

TYPES OF PRICE CHANGE AND THEIR
IMPLICATIONS FOR INDEXATION
Types of Price Change
The Consequences of Indexation
WHAT FEDERAL PROGRAMS ARE INDEXED,
HOW, AND AT WHAT COST
Federal Programs That Are Indexed
How Programs Are Indexed
The Cost of Indexation

11
11
16

...

21
22
31
37

A SURVEY OF ALTERNATIVE INDEXES
Some Descriptive and Definitional
Issues
The Consumer Price Index
The Producer Price Indexes
The GNP Indexes
Wage Indexes
Possibilities for New Measures
Conclusion

39
39
42
50
51
55
60
61

INDEXATION CHOICES FOR THE FOOD
STAMP PROGRAM
Specialized Indexes
General Consumption Indexes
Policy Choices for Indexation

63
64
66
67

ALTERNATIVES TO THE CPI FOR A GENERAL
CONSUMPTION INDEX

71




CONTENTS (Continued)
Page
APPENDIX A.
APPENDIX B.




A CATALOGUE OF INDEXED FEDERAL
PROGRAMS
ESTIMATED CHANGES IN INCOME FOR RECIPIENTS OF SELECTED BENEFIT PROGRAMS . . . .

vii

79
109




TABLES
Page
TABLE 1.

INDEXED ENTITLEMENT PROGRAMS

23

TABLE 2.

INDEXED PROGRAMS OTHER THAN ENTITLEMENTS, AND
QUASI-INDEXED PROGRAMS

26

COMPARISON OF PERCENT CHANGES IN ALTERNATIVE
PRICE INDEXES

56

COMPARISON OF PERCENT CHANGES IN ALTERNATIVE
WAGE INDEXES

58

TABLE 3.
TABLE 4.

TABLE A-l. INDEXED FEDERAL ENTITLEMENT PROGRAMS, OUTLAYS,
AND COSTS OF INDEXATION, FISCAL YEAR 1981 . . .

80

TABLE A-2. OTHER FEDERAL PROGRAMS CONTAINING INDEXATION
PROVISIONS, AND OUTLAYS IN FISCAL YEAR 1981 . .

90

TABLE B-l.

CHANGE IN AVERAGE FAMILY INCOME COMPONENTS
FOR SELECTED POPULATIONS, FISCAL YEARS 1976
AND 1980

114

TABLE B-2. RELATIVE INCOME CHANGES FOR THE AFDC POPULATION, FISCAL YEARS 1976 AND 1980

117

TABLE B-3. RELATIVE INCOME CHANGES FOR THE SSI POPULATION,
FISCAL YEARS 1976 AND 1980

119

TABLE B-4. RELATIVE INCOME CHANGES FOR THE SS/RR POPULATION, FISCAL YEARS 1976 AND 1980

122




ix




FIGURES
Page
FIGURE 1.

COMPARISON OF ALTERNATIVE INFLATION MEASURES . . .

FIGURE 2.

COMPARISON OF CHANGES IN THE CONSUMER PRICE
INDEX AND IN AVERAGE HOURLY EARNINGS

19

COMPARISON OF CONSUMER PRICE INDEX GROWTH RATES
USING ALTERNATIVE INDEX CHANGE CALCULATIONS . . .

35

COMPARISON OF GROWTH IN BENEFITS WITH ANNUAL
AND SEMIANNUAL ADJUSTMENTS

36

COMPARISON OF ALTERNATIVE CONSUMER PRICE INDEXES .

45

FIGURE 3.
FIGURE 4.

FIGURE 5.




xi

3




SUMMARY

The purpose of this study is to assess the appropriateness of
current indexation practices in the Food Stamp Program.
Many of
the issues discussed here will have relevance for other indexed
federal programs as well.
In particular, the study addresses the
stated concern over the accuracy of the Consumer Price Index (CPI)
and its consistency with other inflation measures.

THE INDEXATION PROBLEM
Considerable growth has occurred in the practice of indexing
federal transfer programs in the last decade and a half. Between
1966 and 1980, the number of individual programs containing indexed
provisions grew from 17 to 90. At present, almost a third of
federal expenditure is directly linked to the CPI or related
price measures, and over half of the federal budget is affected if
indirectly indexed expenditures are added. A one percent increase
in the CPI will automatically trigger nearly $2 billion of additional federal expenditures, at 1981 program levels.
The CPI, the measure most widely used for indexation, has been
criticized for exaggerating increases in the cost of living.
As
the table shows, for the better part of the past decade the CPI
has registered larger increases than has an alternative measure of
consumer prices—the PCE chain index. Most of this discrepancy is
attributable to a difference in the way homeownership costs are
measured.
Because the CPI does not distinguish between a home as
an investment and as a source of shelter services, the rapid rise
in the asset value of homeownership has been treated as an increase
in the cost of living rather than as the increase in wealth that
it has been for anyone already owning a home. In addition, homeownership is given an unrealistically large weight in the index
because mortgage costs are counted along with the full purchase
price. This makes the CPI very sensitive to swings in the mortgage
rate of interest.
Another reason why the CPI has tended to overstate the rise in
the cost of living is to be found in the use of a fixed market
basket of goods and services for tracking price changes. Consumption patterns change over time, particularly in response to changes




xiii

SUMMARY TABLE 1.

COMPARISON OF TWO PRICE INDEXES

PCE Chain Index

Year

CPI

1973

8.3

7.6

0.7

1974

12.2

11.0

2.2

1975

7.4

6.4

1.0

1976

5.1

4.9

0.2

1977

6.7

6.3

0.4

1978

9.0

8.0

1.0

1979

12.7

9.9

2.8

1980

12.5

10.4

2.1

NOTE:

Difference

Figures represent percent changes at annual rates, fourth
quarter to fourth quarter.

in relative prices.
A fixed market basket measure compares the
cost of the market basket in the base year with its cost today.
But this does not provide an accurate measure of the change in the
cost of living between recent years if current consumption patterns
differ from those of the base year.
Reductions in the share of
gasoline in overall consumption since 1973 illustrate the importance of this point.
Although these two features account for most of the discrepancies between the CPI and the alternative measures of consumer
prices, other features of the CPI also bear on its usefulness as an
indexation measure.
First, the importance of individual items in
the market basket is determined by expenditure weights rather than
by population weights. This means that when the expenditures of a
wealthy family are averaged together with those of a poor family,
the buying patterns of the former receive a larger weight. Consequently, luxury goods are given a higher weight and necessities
such as food a lower weight than would be the case if each family
were treated with equal importance.
Second, taxes are treated




xiv

asymmetrically.
Increases in sales taxes show up directly in the
CPI, but increases in income taxes do not. Substitution of one tax
for another could, in principle, change the CPI without any real
change occurring in prices. Third, nonmarket goods such as cleaner
air and water and better safety and health are not included in the
market basket, although their production requires resources and
leads to higher prices for goods whose unregulated production
would create noxious by-products. This suggests that some of the
price increases during the 1970s may have reflected not just a
higher cost of living but also a higher standard of living.
Fourth, the use of an aggregate CPI to index programs that are
targeted at certain demographic groups may not accurately reflect
increases in the prices paid by those groups. Data suggest that
the poor and the elderly may have somewhat different consumption
patterns than the rest of the population.
Finally, the CPI reflects changes in the prices of imported goods; if the intention of
indexation is to redress the internal redistribution of income that
results from inflation and not to cushion the public from a fall in
real income resulting from higher import prices, the CPI is not a
suitable measure.
It should be added that, except for the homeownership and fixed market basket problems, almost all of these
drawbacks are shared by other price measures.

ALTERNATIVES TO INDEXING WITH THE CPI
In considering alternatives to present indexation practices, it is useful to bear in mind the specific purpose of a given
indexing provision—such as to maintain a certain minimum absolute
living standard or to maintain a consumption standard that is
constant in relative terms.
It is also important to bear in
mind the consequences of indexing to different kinds of price
change. Indexing to across-the-board, generalized inflation tends
to preserve the existing income distribution. In contrast, indexing that also includes relative price changes tends to redistribute
income, since those who receive indexed income tend to gain at the
expense of those who do not (see Chapter III).

Other Indexes
The CPI X-l.
The Bureau of Labor Statistics now publishes
a series of experimental price measures that offer alternative
treatments of homeownership costs. While these measures in their
current state contain some shortcomings they are, at least conceptually, improvements over the present CPI. The most intuitively




xv

appealing measure is the X-l, which isolates the investment aspect
of home purchase from the consumption of shelter services by using
the measure of market rent as a proxy for the implicit rent that
the homeowner pays himself or forgoes by living in the house
instead of renting it out.
The PCE Chain Index.
A chain-weighted index for personal
consumption expenditures is produced as a part of the National
Income Accounts. It measures essentially the same market basket as
the CPI but employs different concepts for certain items. The most
important of these is a rental equivalence treatment of homeownership like that employed in the experimental CPI X-l. In addition,
the PCE chain index uses an up-to-date market basket reflecting
relatively current consumption patterns.
The chain index thus
avoids the upward bias associated with fixed-weight indexes and at
the same time does not compound shifts in consumption patterns with
price change as does the better-known implicit deflator form of
PCE.
GNP Measures.
By accepting a price measure that is somewhat
broader than the one confined solely to consumption goods, it is
possible to measure price change with the direct impact of import
prices removed. This can be done with the index of gross national
product prices, which measures all goods and services produced by
the United States. Alternatively, subsets of GNP that are still
free of the direct effect of import prices include GDBP (gross
domestic business product), which subtracts principally the government sector, and PNB (private nonfarm business), which additionally
subtracts the sometimes volatile farm sector. Personal consumption
is the dominant component of each of these, accounting for nearly
four-fifths of PNB. As is the case with the PCE, these series are
available as fixed-weight, chain-weight, and implicit deflator
measures, with the chain-weight being most suitable for measurement
of period-to-period price change using up-to-date consumption
patterns.
Wage Measurements. Wages can be used for indexation, instead
of prices, as in a number of European and South American countries.
Indexation with wages tends to preserve a relative standard of
living in contrast to an absolute standard. As the economy expands
through gains in productivity, these gains are reflected in higher
wages. Wage indexation enables those receiving indexed benefits to
share in this growth. Similarly, declines in wage growth relative
to prices will also be transmitted to indexed benefits.
One
candidate for a wage index is the Hourly Earnings Index (HEI),
which contains adjustments for overtime hours and employment




xvi

shifts between high- and low-wage industries and occupations that
might otherwise affect the measure of wage growth. Another candidate is the Spendable Earnings series that, although lacking the
refinements of the HEI, has the advantage of providing a measure of
after-tax wage income. This is done by subtracting an estimate of
worker payments for Social Security and federal income taxes from
gross weekly earnings.
Indexation with the latter measure would
result in changes in indexed benefits paralleling the spendable
earnings of wage earners.

The Switching Proposal
A much-discussed proposal is to use either a wage or a price
index, whichever has increased the least.
The argument for
this proposal is that it is unfair to give more inflation protection to federal beneficiaries than wage earners can obtain, particularly since the benefits are financed largely through payroll and
income taxes on wage earners.
One consequence of this proposal,
however, would be to reduce progressively the real level of indexed
federal benefits. Benefits would be reduced when real wages fell,
but not restored when real wages rose.
This difficulty could be
overcome through a modification of the switching proposal that
would reduce benefit levels when real wages fell but would make
this reduction only temporary until real wages resumed their former
level.
When real wages resumed growing,
the switch back to a
price index would be delayed until benefits had reached their
previous level in real terms.

Other Approaches to Indexing
Other approaches to indexing include putting a cap on benefit
increases. Two variants have been proposed. One would cap benefit
increases at some fraction of the CPI increase, say at 75 or 85
percent.
The drawback of this formula is that it is arbitrary
and automatic.
Another approach would use a discretionary cap,
similar to the manner in which federal pay is adjusted. Beneficiaries could receive the full index change unless the President
proposed a lesser amount and the Congress did not override his
proposal. This would have the advantage of being flexible so that
it could be adapted to changing economic circumstances and different types of price behavior.

xvii
O-i+OO

0 - 8 1 - 2




THE FOOD STAMP PROGRAM
At present, three provisions
indexed:

of the Food Stamp Program are

o

The level of the standard allotment
prices of the Thrifty Food Plan;

is indexed to the

o

Applicants1 income, for purposes of determining eligibility
and benefits, is adjusted by a standard deduction that is
indexed to changes in the CPI less food, and by itemized
deductions the limit on which is indexed to a specific
index developed from CPI data;

o

Eligibility criteria are based on the poverty level defined
by the Office of Management and Budget, which is adjusted
by year-to-year changes in the CPI.

Policy Options for Indexing the Food Stamp Program
Thrifty Food Plan.
The prices of the Thrifty Food Plan
resemble the CPI food-at-home category except that some items are
excluded and the remainder reweighted to reflect adequate nutritional standards and the consuming habits of low-income households.
This method of indexing the level of food stamp allotments is
tailored to maintaining the value of the specific benefits provided
by the program.
It suffers the shortcomings of a fixed, baseweighted index in not allowing for substitution or changing consumption patterns, and this may be more important within the food
category where relative price changes are sometimes larger than in
an overall consumption measure like the CPI. But these food price
changes are often transient, and to capture their effects would
require frequent updating of the market basket.
Currently there is no alternative index that would provide
greater advantages in indexation, assuming that the purpose of
indexation is to hold constant the absolute purchasing power of the
food stamp benefits.
Standard Deduction Adjustment. Prior to the Food Stamp Act of
1977, low-income households were allowed to deduct a number of
specific expenditures from their gross incomes for determining both
eligibility and benefits.
The 1977 legislation replaced these
itemized deductions for expenditures with a standard deduction in
order to simplify program administration.
Since the specific




xviii

expenditures and, therefore, the itemized deductions would have
increased automatically over time with price inflation, indexation of the new standard deduction was proposed to maintain real
benefits.
The CPI less food was chosen to index the standard deduction
since the indexation of food was explicitly reflected in the
Thrifty Food Plan index.
The shortcomings of this index are
essentially the same as those of the overall CPI—a tendency to
overestimate because of the fixed market basket and because of the
treatment of homeownership.
An alternative measure without these
shortcomings would be the PCE chain index with the food portion
subtracted.
Itemized Deductions. The limit on the deduction for dependent
care and for excess shelter costs is indexed to the shelter,
fuel, and other utilities component of the CPI. The relationship,
however, between dependent care expenses—which presumably would be
spent on babysitting, day care, or perhaps home nursing—and this
component of the CPI is questionable.
Variation in the level of
these costs might be better approximated by the behavior of wage
rates or some magnitude such as the minimum wage, which is how
babysitting prices are currently measured for the CPI.
In the case of excess shelter costs, the CPI shelter component
has the shortcomings with regard to homeownership discussed earlier, but here the effect is intensified because the subcomponent
measure is undiluted by the other 80 percent of the CPI. It
is, furthermore, doubtful that food stamp recipients are numbered
among current home buyers. A USDA survey indicates that 80 percent
of beneficiaries rent their dwellings.
Of the remainder, it is
unlikely that a significant number are currently buying houses. In
any case the CPI measure of rent would be a more representative
index for this purpose.
Indexing the Poverty Level. The alternatives to the CPI as a
general consumption price measure have been discussed above. Among
currently available measures, the index that corrects the chief
shortcomings of the CPI is the PCE chain index.
But more is
involved here than choosing the most appropriate price index.
Articulation of the programs1 objectives might include consideration of a relative standard that would adjust the poverty level
according to changes either in a general wage index such as the HEI
or in a Spendable Earnings series. Alternatively, if a demographic-specific CPI that reflected consumption habits of the lowincome population were to become available at some time in the




xix

future, it might be a suitable means of indexing the poverty level,
particularly if changes were made in the CPI to correct the homeownership problem and to update the market basket more frequently.
Finally, a more flexible approach to indexing might be adopted that
would permit adjustments for exceptional circumstances, such as
falling real wages or large relative price changes, while permitting increases in benefit levels when productivity gains raised
real per capita incomes.




xx

CHAPTER I.

INTRODUCTION

The Food Stamp Act Amendments of 1980 (P.L. 96-249) require
the Congressional Budget Office to review the Consumer Price Index
(CPI) and various alternative consumer price or cost-of-living
measures such as the Personal Consumption Expenditure deflator.
The review is to examine the limitations of each alternative and
the reason why the indexes differ in their measure of inflation or
the cost of living. The purpose is to determine whether the CPI is
the most appropriate index for the Food Stamp Program or whether
alternative measures may better reflect changes in consumer prices
or the cost of living.
The concern over indexation procedures in the Food Stamp
Program and in other federal programs arises from questions as to:
o

The growing impact of indexed programs on the federal
budget;

o

Accuracy in the CPI—the most widely used index measure;

o

The adequacy of an aggregate measure like the CPI as a
gauge of the cost of living of groups such as the poor and
the elderly; and

o

The fairness of allowing beneficiaries of federal programs
to keep up with inflation when wage earners are falling
behind.

Impact on the Budget
The circumstances leading to this study derive primarily from
the impact of inflation on federal benefit programs during the
19 70s. One response to inflation was to index provisions that were
specified in current dollar amounts. From 1966 to 1980 the number
of programs containing indexed provisions grew from 17 to 90.
In most of these programs, an increase in the Consumer Price
Index will automatically lead to an upward adjustment of program
benefits (or, in some cases, of eligibility criteria specified




in current dollar terms). At 1981 levels of expenditure, a 1
percent change in the CPI or related indexes causes federal spending to increase by about $2 billion.
An alternative to indexing would have been for the Congress to
continue legislating changes from time to time on an ad hoc basis.
Indexing was felt by some to be preferable because ad hoc adjustments risk repeated reopening of debate on other aspects of the
programs involved, arouse uncertainty on the part of beneficiaries
as to future benefits, and create a temptation to raise real
benefits during election years.
With time and continued high rates of price increase, however,
it has become apparent that a significant portion of the budget is,
in effect, on automatic pilot.
In fiscal year 1980 nearly onethird of federal outlays were for indexed entitlement programs.
These automatic increases of expenditure make it increasingly
difficult to reduce the size of the federal budget. Moreover, when
inflation is combined with a stagnating economy, these programs
consume an increasing share of national output.

Accuracy of the CPI
Perhaps the most critical development in the growing unease
over indexed spending has been the criticism that the CPI—the most
widely used measure for indexation—exaggerates the rise in the
cost of living.
If estimates of the distortion in the CPI are
correct, many billions of dollars have been unnecessarily spent
over the last several years.
Concern as to the behavior of the CPI gained the most attention
over the last year or two, when its rate of increase significantly
exceeded those of alternative price measures.
Figure 1 compares
the performance of the CPI with that of a broad measure of prices
in the economy—the gross national product (GNP) deflator—and with
that of a close substitute for measuring consumer p r i c e s — t h e
personal consumption expenditure (PCE) deflator. \J
The three
measures show very little divergence until the mid-1970s, but in
the years after that the CPI departs radically from the other two.

1/




The GNP and PCE deflators are not without shortcomings as
measures of the cost of living. These are discussed in Chapter
V.

Figure 1 .

Comparison of Alternative Inflation Measures
14
Consumer Price Index for all
Urban Consumers

12

12.7

12.5

Implicit Price Deflator for
Gross National Product
Implicit Price Deflator for
Personal Consumption
Expenditures

10

9.5

9.0

9.8

10.1

8.1
6.5

I

6.2

m
m
m
m

5.9

JZ

o

m

c

s
2.5

2.7

2.4

59:4-69:4

m

im

69:4-76:4

1
76:4-77:4

77:4-78:4

78:4-79:4

•
1
79:4-80:4

Representativeness of the CPI
In addition to the criticism that the CPI has been distorting
the aggregate measure of consumer price change, there have also
been complaints that it is an inaccurate measure of prices paid by
certain demographic groups. The consumption habits of the poor and
the elderly differ from the market baskets used in the CPI-U or
CPI-W—the two consumer price measures currently produced by the
Bureau of Labor Statistics. The budgets of the poor are dominated
by expenditures on necessities, while the elderly spend relatively
more on medical expenses. If the prices of such items rise faster
than other prices measured by the CPI, then current indexation
practices may not adequately compensate these groups for changes in
their cost of living.




Fairness
An additional concern about current indexation practices is
that of fairness. In the struggle to keep up with rising prices,
some groups have been more successful than others.
The less
successful groups have seen their real wages and purchasing power
fall. Meanwhile, federal beneficiaries on the whole appear to have
been fully compensated for rising prices.
This disparity in the
treatment of wage earners and federal beneficiaries has been
aggravated by the recent increases in Social Security payroll
taxes.

Organization of the Study
Chapter II outlines some of the primary, but not always
explicit, objectives of indexation, explaining how they affect
the actual practice of indexing.
Chapter III describes the environment of price changes in which indexing is done, and the
implications of indexing to different kinds of price change.
Chapter IV briefly surveys the scope of indexation provisions in
federal progams.
(Appendix A lists federal programs that employ
explicit indexation features.)
Chapter V examines in detail the
shortcomings of the CPI and presents some alternative measures that
overcome certain of the CPI's deficiencies. The indexed provisions
of the Food Stamp Program and possible improvements to existing
practices are discussed in Chapter VI. Finally, the alternatives
for a general consumption index and their budgetary implications
are treated in Chapter VII.




CHAPTER II.

PURPOSES OF INDEXATION

Indexation is a response to a persistent rise in the level of
prices, or—put another w a y — a persistent fall in the purchasing
power of the dollar.
The fall in the value of the dollar erodes
the value of payments called for by contracts or by federal laws.
Indexation is an effort to protect real benefits over time through
escalators, cost-of-living adjustments, and similar provisions.
The task is complicated, however, by the fact that other things
are changing at the same time, such as the pattern of employment,
the composition of consumption, asset values, and demographic
patterns.

Alternatives to Indexation
Indexation is not the only solution to the problem of maintaining the real level of benefits in the face of rising prices.
In the private sector, contracts can be made of shorter duration.
In government programs, benefit levels can be readjusted more
frequently.
Several objections may be made to such alternatives.
The
necessity of readjusting benefit levels at more frequent intervals
requires time and effort; moreover, it may reopen debate on other
provisions of a program. There is, also, a cost to recipients in
the form of uncertainty about whether benefit levels will be
maintained in the future.
Finally, under a regime of repetitive
one-time adjustments pressure may develop, particularly during
election years, to overcompensate for price increases. This was
one of the reasons cited for the adoption of indexation in the
Social Security program.
Given the difficulties of frequent decisions about benefit
levels, indexation has a certain appeal. Yet indexation may create
other problems.
First, it makes changes in expenditure levels
automatic, and the larger the proportion of expenditures that are
indexed the more difficult it becomes to control the federal
budget. Second, indexing is not a straightforward m a t t e r — a
point that is developed at some length in this report.




Provisions That May Be Indexed
Indexation is applied to many provisions of federal programs.
Benefit levels are usually specified in dollars, and must be
readjusted if their real value is to be preserved when prices
increase.
Many federal programs are targeted at certain demographic g r o u p s — f o r example, welfare programs for the p o o r —
and employ indexed eligibility provisions to ensure continued
service to those targeted groups. Other programs are designed to
operate only under certain circumstances—such as farm support
programs when agricultural prices are low—and employ indexation to
ensure that trigger mechanisms will continue to operate correctly.
Still other programs contain provisions that limit the amount of
benefits paid—such as on Medicare claims—and employ indexation as
a way to maintain benefit ceilings at a constant real level.
Without indexation, eligibility requirements would become increasingly restrictive, trigger mechanisms would cease to operate, and
ceilings would begin to reduce real benefit levels.

Complications
In a dynamic economy indexing is complicated by the fact that
many things are changing besides the level of prices. Changes in
employment, output, value of assets, and demographic patterns
affect the welfare of various groups in the economy. Some of
the nonprice changes are triggered by price movements, while
others may occur independently.
This means that the statistical
measures used for indexation may reflect more than simply inflation.
For example, the CPI will be affected by an increase in
sales taxes or by a rise in values of durable assets like houses,
or by changes in the quality of goods not fully adjusted for in the
CPI.
Straightforward indexation in these cases may not reflect
actual changes in the cost of living.
Because both price and nonprice changes affect the standard
of living, and because of the limitations of available statistical
measures in providing the desired information, it becomes necessary
to examine the purpose of indexation more carefully in order to
evaluate the performance of existing indexation measures.




Purposes of Indexation
A number of different possible objectives for indexing have
been either stated or implied in the public discussion of this
topic.
o

Holding constant the ability of beneficiaries to purchase
a fixed basket of goods

This is the approach that underlies current indexation practices. Its advantage is that of being easy to understand and
relatively straightforward to m e a s u r e — f o r example, with the
CPI.
It would be most suitable if the only changes taking place
were those of prices. In an environment of more complex changes,
some shortcomings become clear. The index will reflect increases
in sales, excise, o r — t o some extent—payroll taxes. If the same
revenue is raised through income taxes it will not appear directly
in the CPI and may not register to any significant extent, even
indirectly.
This raises the question whether indexation ought
to protect against tax changes as well as price changes.
Another difficulty with this approach is that over time
consumers will not stick to a fixed basket of goods; they will
substitute new products for old ones, and cheaper items for
those that become more expensive. An index based on a fixed basket
of goods will tend to rise faster than one based on a consumption
mix that preserves a fixed level of satisfaction or well-being.
A third difficulty with the fixed-basket approach is that it
ignores other conditions in the economy bearing on the equity of
such indexation, and on the ability of the economy to pay its
costs. For example, if wages are rising less rapidly than prices,
beneficiaries of indexed federal programs will improve their living
standard relative to that of the working population. Under these
conditions, the burden of financing the benefits will tend to grow
as a share of total economic output.
o

It

Holding constant a standard of living obtainable with the
program's benefits

This approach would recognize changes in consumption habits.
thus requires that the market basket be updated frequently.




When treated rigorously, it also requires that factors other than
market consumption be taken into account. Changes in the provision
of public goods—such as better safety and health, cleaner air and
water, more secure national defense—will raise the standard of
living.
Moreover, since the provision of such items is usually
reflected in either higher prices or higher taxes, counting
their costs without considering their benefits would lead to
overindexation.
In addition, overindexation will occur if one
ignores the fact that the rising real values of durable goods such
as houses or silverware represent increases in wealth for their
owners. Whereas the CPI would register this as a loss in purchasing power, in reality it means the possibility of an improved
standard of living for the owners if they alter their savings
habits or liquidate some of their increase in wealth.
The drawbacks to this approach are that it is more abstract
and harder to understand; requires much more
information; and in
many instances is difficult to quantify. Nevertheless, it is
useful as a concept to which other approaches can be compared.
o

Holding constant a relative standard of living that is
gauged to the income levels of the working population

This approach abandons the attempt to preserve the value of
benefits in real or absolute terms. Instead, it ties benefit
levels to the performance of the economy. In place of the goal of
an absolute level of benefits it substitutes a relative notion—
something closer to a constant share of an economic pie whose size
may be changing. 1/ One way of approximating such a standard is by
indexing to wage changes instead of to price changes. This puts
beneficiaries in the position of sharing with wage earners the
burden of economic setbacks. Moreover, it tends to keep the costs
of indexation more in line with the ability of the economy to bear
those costs.
The other side of this coin is that beneficiaries
would share with wage earners the dividends of productivity growth.
This is because productivity growth enables wages to rise faster
than prices in the long run.

1/

Qualification must be made when demographic changes cause a
shift in the ratio of the beneficiary population to the working
population, thus changing the relative burden of indexation in
the economy.




o

Holding constant the benefits 1 purchasing power over a
basket of goods excluding certain goods that may be
subject to wide and uncontrollable price swings

This approach is suggested by the current difficulty of
adjusting to relatively large changes in certain prices—notably
the price of imported oil. These changes have had a large effect
on the CPI, and thus on the costs of indexation, at a time when net
income growth is slow.
The unavoidable consequences of the oil
price increases are that the nation must either reduce its level of
oil consumption or else cut back on other consumption. Indexation
has the effect of insulating beneficiaries from these consequences.
By raising their benefits in line with all price increases, it
gives them enough purchasing power to continue consuming the same
basket of goods. Thus a larger share of the burden must be borne
by those whose incomes are not indexed. While operationally it is
possible, at the cost of redistributing income shares, to carry out
such indexation for a portion of the population, it should be
apparent that it is impossible to do so for everyone.
Excluding imports from the indexed basket of goods would mean
that everyone, including the beneficiaries of federal programs,
would share in the burden of adapting to the new economic circumstances resulting from the rise in oil prices.

Other Considerations
It may be that a single standard or approach to indexing will
not suffice for all federal programs.
The goals of a particular
program may determine its indexing requirements. Programs that seek
to provide some minimum standard of living may require indexing to
a market basket; the Congress may desire to exempt persons covered
by these programs from the burdens borne by active wage earners.
On the other hand, some federal benefits may be amenable to other
indexing approaches.
Another consideration in designing an indexing formula is the
burden it will impose on the economy, particularly in times of slow
growth. Certain of the approaches mentioned above accommodate
themselves to changing conditions—but even the most flexible may
sometimes be more than a nation can afford. Accordingly, proposals
have been made to discount the index measure by an arbitrary
amount, say by limiting increases to only 85 percent of the increase in the CPI. If this were continued over a period of years,
however, it would mean a cumulative decline in real benefits.




Another proposal is to switch back and forth between a price
index and a wage index, using whichever rises the least. This proposal would reduce the real value of federal benefits whenever real
wages fell, in line with the lower capacity of the economy to
finance such benefits. The difficulty with this proposal is that
benefits once reduced would never regain their initial position
even if economic stagnation was replaced with rapid economic
growth.
The implications of the proposal, and some alternative
formulations, are discussed further in the next chapter.
Other considerations in setting the goals of indexation
include the types of price behavior that are likely to be encountered.
It may make a difference if all prices are rising or if
only some prices are rising; and if only some prices are rising, it
may make a difference if they are the prices of necessities such as
food, of luxuries such as gold and silver, of investments such as
houses, of imports such as oil, or of taxes that are included in
retail prices (even if those tax increases are offset by cuts in
other kinds of taxes). Because price changes occur as a result of
a variety of forces, it will be useful to examine the implications
of indexing to different kinds of price changes.




10

CHAPTER III.

TYPES OF PRICE CHANGE AND THEIR IMPLICATIONS FOR
INDEXATION

Indexation is an effort to adjust benefit levels so as to
neutralize the effects of price change. Can indexation succeed in
preserving living standards from change stemming from price movements?
The answer depends on the types of price change encountered, and on whose standard is to be protected. This can be most
usefully illustrated by defining two special cases of price behavior.

TYPES OF PRICE CHANGE
A distinction may be made between two types of price movement.
One is an upward movement of all prices at about the same rate, or
generalized inflation, and the other is an increase in the price of
one or several goods relative to all others.

Generalized Inflation
Generalized inflation is characterized by a persistent and
widespread rise in prices.
It is synonymous with a fall in the
value or purchasing power of money. Although economists differ as
to the details of causality, the fall in the value of the dollar is
generally associated with a rise in the money supply in excess
of the growth in real activity. The most important feature of this
kind of price behavior is that all prices are rising at about the
same rate, including the price of labor—wages. 1/ If wages keep
up with prices, then both the level and composition of consumption
will likely be little affected.
At first glance it would appear that generalized inflation is
merely a change in the numbers used to carry out economic activity.
In actuality, even the most general movement of prices would not

1/

For the sake of simplicity, productivity growth—which tends to
cause wages to increase faster than prices—is not discussed.




11

have an equal impact on everyone.
In the short run, unexpected
inflation, or unexpected changes in the rate of inflation, can
redistribute income between borrowers and lenders.
Second, some
wage earners in the economy may have less market power than others,
and not be able to get increases that keep up with the full change
in prices. Third, persons receiving fixed non-wage income such as
pensions, transfer payments, or interest on bonds will see the real
value of these payments fall, and, in addition, those holding cash
will be penalized. Finally, if the income tax system is progressive, generalized inflation will lead to an increasing tax burden
as people move into higher tax brackets.

Relative Price Change
The other special case is that of relative price change. This
is a change in the price of one or several goods relative to the
prices of all other goods—as would occur if the price of butter
were were to go up 50 percent while that for margarine rose
only 10 percent, or if electricity doubled in cost while natural
gas stayed the same.
The most important feature of a relative
price change is that it disturbs the relationship among prices of
different goods. It is a signal that supply or demand conditions
for a particular good have changed, and that there must be changes
in consumption as well as in production. This is the sort of
adjustment that takes place if a frost reduces Brazil's output of
coffee, or if an oil embargo reduces the available supply of oil.
Where possible, consumers substitute cheaper goods for those that
have become more expensive; if substitution is difficult, consumption has to be cut back—either that of the more expensive good or
that of other goods. It should be added that these consequences of
a relative price change apply in the aggregate and not necessarily
for each individual.
To the extent they apply in the aggregate,
however, they are real changes rather than nominal changes.
Indexation cannot undo aggregate real effects but only redistribute
them.
Relative price changes play an important role in the economic
system.
They are responsible for the reallocation of consumption
patterns and the redirection of productive activity in response to
changes in economic circumstances. To suppress the signals being
sent by relative price changes is to risk increasing resource
misallocation, leading to a standard of living far below the
nation's potential.




12

Actual Price Behavior
Actual price change has been a mixture of both kinds:
The
relationship among prices has been changing, while at the same time
the aggregate level of prices has risen.
There are a number of
reasons why this is so. One reason is that the forces that produce
each special type of price behavior can be present at the same
time.
Another reason is that, through the working of economic
institutions, relative price changes have tended to cause increases
in the aggregate price level. The conventional description of this
latter process is that prices in the economy move upward more
readily than downward.
If one or several prices rise, and other
prices fail to decline, the result will be a rise in aggregate
expenditure and an increase in the demand for money. If the money
supply does not expand, demand will be constrained by the relatively tighter money supply and economic activity will slacken
until prices adjust.
Unfortunately, postwar experience suggests
that this adjustment has tended to be somewhat slow and that it
imposes a cost in the form of unemployment and lost output.
Attempts to restore the trend rate of economic growth through
accommodative increases in the money supply lead to a new, higher
absolute level of prices. The process can be a gradual one,
with the initial relative price change diminished by the partial
catching up of the prices of other goods in the economy, followed
by a reestablishment of the relative price change.
For example,
the real price increase of OPEC oil in 1974 was diminished by
inflation in the ensuing four years, and was not fully reestablished until the oil price increases of 1979.
Thus government policy can be a partner in the transformation
of a relative price change into a rise in the aggregate price
level.
In the past the government affected the process chiefly
through its commitment to high levels of employment and output.
Its attempts to stimulate economic growth led to increases in the
money supply.
But government policy can create relative price
changes as well. This is done in two ways. The first of these is
associated with the provision of social goods.
Social goods are
goods and services that everyone consumes in some sense but that
are not bought and sold in the marketplace. The clearest examples
are cleaner air, cleaner water, safer working and living conditions, and better levels of support for the poor and unemployed.
The provision of these goods through antipollution and safety
regulations ultimately leads to higher prices for chemicals, steel,
electric power, paper, and other final products.
Similarly,
increased levels of unemployment compensation impose costs on

13
80-400

0 - 8 1 - 3




producers that show up in higher prices. It is through these
higher prices that society pays the cost of the social goods.
The question as far as indexation is concerned is whether recipients of government benefits should be protected from or excused
from paying these costs.
Another way in which government policy has created relative
price changes is through efforts to regulate the working of private
markets for the benefit of particular groups.
A change in the
rules that affects the economic circumstances of a particular group
can bring substantial economic benefits to that group. Unless the
change in the rules itself increases economic output or wealth,
however, the economic benefits will be achieved at the expense of
other groups in the economy. When the government guarantees milk
support prices to dairy farmers, when it protects the steel industry from the competition of cheaper imports, when it regulates
competition in transportation, and when it requires that teenagers
be paid the minimum wage, the benefits provided to the target
groups are funded by higher prices paid by consumers.
Actual price behavior, then, has been a composite of inflation
and relative price changes.
To some extent the large relative
price increases of recent years for commodities such as oil have
contributed to successive increases in the overall level of prices.
In addition, relative price increases have originated not only from
shocks to the economic system but also from the efforts of government policymakers to redistribute income through intervention in
the marketplace.

Meaning of "Cost of Living"
Rising prices and inflation are associated with changes in the
cost of living, and frequently the terms are used interchangeably.
But the cost of living is a broader concept than the others.
Because it is often mentioned as a basis for indexation, the cost
of living concept requires closer examination. An effort is made
below to provide a general understanding of the notion and how
it is applied. 2/

2J




For a fuller discussion, see Jack E. Triplett "Cost of Living
Questions and Cost of Living Indexes," U.S. Department of
Labor, Bureau of Labor Statistics (processed), and its bibliography.

14

The concept of a measure of the cost of living (COL) is
usually expressed as an answer to a question such as, "What is the
change in cost of maintaining a given level of living (satisfaction) between two periods with different prices?"
The question
can be phrased in a number of ways in order to give it specific
content. The key to understanding the various ways of phrasing the
question is that it is an attempt to measure a constant or fixed
level of living in the sense of well-being or satisfaction.
Depending on the kinds of economic forces bearing on this level of
living, the question may have to be more probing or comprehensive
in order to measure the cost of a constant or fixed level of
satisfaction. For example, the CPI, which is an attempt to approximate the COL, is based on the question, "What is the expenditure
necessary at today's prices to maintain the living standard of the
ase period?" An alternative but related concept is embodied in
the question, "What would have been the cost in the base period of
consuming a basket of goods representing today f s standard of
living?"
This concept underlies the construction of the implicit
price deflators employed in the GNP accounts.
Both concepts
compare prices of two different periods, but they use different
baskets of goods for that purpose. While they can yield very
similar results, they tend to diverge the further apart in time are
the two periods and the larger have been changes in relative
prices.
A different approach to the COL concept is to ask "What is
the income required at today's prices to maintain the standard of
living of the base period?" This measure will yield the same
result as the expenditure approach unless there has been a change
in income taxes. The expenditure approach is insensitive to such a
change while the income approach is not. On the other hand, even
if such a measure were available, it is not clear that it should be
substituted for the CPI in all uses.
For example, a change in
income taxes would cause the income-based COL to rise even if all
prices in the economy remained unchanged.
In other words, such a
measure might be misleading when used for some analytical purposes.
If the objective of indexation is to maintain a given standard of living, then still more comprehensive COL questions need to
be devised, questions in which the standard of living is affected
by changes in wealth—as with the rise in value of a portfolio of
stocks or an increase in the value of a house—or questions in
which changes in the level of nonmarket consumption occur.
For
example, in the latter case, a statistical measure like the CPI
will register higher product prices resulting from pollution and




15

safety requirements but will not reflect the benefits received, and
is thus a distorted measure of the cost of living.
The more sophisticated COL approaches are not practical to use
because they require too much information and are difficult to
construct.
But they throw light on the limitations of presently
available measures.
And periods may actually occur in which
the only essential changes are price changes, so that an expenditure COL such as the CPI may be quite adequate for indexation
purposes.

THE CONSEQUENCES OF INDEXATION
The consequences of indexation vary according to the kinds
of price change taking place and the kinds of statistical measures
used. The major consequences can be described with a few examples.

Indexation to Generalized Inflation
When prices are rising across the board, indexation has the
fewest complications.
Its application to those in the economy
whose incomes are fixed in nominal terms merely restores their
initial condition and keeps them at relative parity with everyone
else.
Living standards are preserved in both an absolute and a
relative sense. Indexation thus corrects or neutralizes one of the
few real consequences of generalized inflation.
It does not, of
itself, cause government expenditures to rise as a share of GNP.
Moreover, the choice of a statistical measure for indexation is
greatly simplified under these conditions. As a result of the more
or less uniform rate of price increase throughout the economy, any
statistical measure should yield the same results. Different
demographic groups, even if they have different consumption patterns, will experience the same nominal changes in consumption
costs.

Indexation to Relative Price Changes
The consequences of indexing to a relative price change are
quite different.
A rise in the price of a single good will have
two effects: people will consume less of it by substituting more of
other goods; and because of the drop in their purchasing power,
they will tend to consume a little less of all goods. Indexation




16

restores the lost purchasing power so that they are capable of
continuing to consume the same basket of goods. 3_/ If the cause of
the relative price change was a drop in supply, it should be clear
that indexation cannot restore that supply. If everyone's income
is indexed, then attempts to purchase the original amount of the
scarce good will only drive the price higher, until the burden of
reduced consumption is somehow allocated. And if only part of the
population has indexed incomes, the burden of reducing consumption
falls on the rest of the population. Thus, while indexing to
generalized inflation tends to preserve the initial income distribution, indexing to relative price changes redistributes income.
The reason, of course, is that one of the most common causes of
relative price changes is a drop in real o u t p u t — a s with the
increase in food prices in the second half of 1980.
The signal that is given by a relative price change of the
need to modify consumption patterns and resource allocation can be
muted by indexation if indexation is very widespread.
Indexation
is already well established—and growing. It affects one-third of
the federal budget formally and as much as one-half of it if
indirect or quasi-indexation is counted.
In the private sector,
the number of wage earners with formal cost-of-living escalators
has been estimated to be as high as 9 million, with many others
receiving wages that are implicitly indexed.
In such a setting,
when the CPI rises in response to a relative price change, a
significant portion of the population will be compensated for
that price change. This means that the remainder of the population
must bear the burden of reducing consumption. If they resist this
burden and attempt—through the use of market or political power—
to bargain for higher nominal incomes, then the general price level
will begin to rise.
The demand for the particular good will not
have been reduced to match the supply, and relative prices must

2J

In fact, consumers will be better off than before by consuming
less of the higher priced good even if they have an adequately
compensated income.
The reason is that a unit of the more
expensive good can now be traded off for more of other goods
than before.
This is why a fixed-weight index that uses the
original market basket and ignores substitution tends to
overestimate the cost of restoring consumers to the same level
of satisfaction.




17

again readjust. This process will continue until it has allocated
the reduced consumption among the population. Given the lags that
occur between the various steps in the process, a considerable
time may be required for large relative price changes to work
through the system. Thus, the amount of generalized inflation that
accompanies a relative price change, and the length of time required to reach a new stable level of prices, may be directly
affected by the scope or extent of indexation.

Indexation to Wage Changes
The consequences of using a wage measure for indexation would
depend on the behavior of prices. In the case of generalized
inflation, the consequences would be the same as with the CPI or
some other price measure assuming that wages rise at the same rate
as other prices. If the level of wages is rising more rapidly than
prices (as happens when there are gains in productivity), then
wage indexation leads to a rise in real benefits. Indexed benefits
will tend to be a constant share of total economic output, however,
unless the ratio of beneficiaries to the labor force changes.
In the case of a relative price increase, wage indexation
should lead to a somewhat slower rate of benefit increase than with
price indexation.
The extent of the difference will depend upon
how wages respond to a relative price increase. Wages for workers
covered by cost-of-living escalators will rise, of course, to
compensate for at least part of the increase.
Many other wage
earners, both unionized and nonunionized, will have enough market
power to obtain similar compensation.
But others will not.
Thus, the aggregate wage may rise in response to a relative price
change, but by less than the increase in aggregate prices.
The
increase in wages will, however, trigger another round of price
increases, and these will be much more widespread than the initial
relative price increase. There will then likely be a readjustment
of the initial relative price change in order to restore its
relationship to other prices.
This process will repeat itself
until it finally damps out. The more widespread is indexation in
the economy, and the greater the extent of full versus partial
indexation, the longer the process will persist.

The Switching Proposal
A proposal that has received considerable attention in recent
months is to index to either wage change or price change, whichever




18

Figure 2.

Comparison of Changes in the Consumer Price Index and in
Average Hourly Earnings
14

L
1
1—

12
^

s 10 —

A

* 6» 4
£ 2
0

\

Average Hourly Earnings

1

i

J/f

V 'iy\i

\
1 1 \ \/
\
1
1)

- v

-2 1 1 1 1 1 1111
1950
1945

/
^
. /

\

if

1f \
/ \

4

I 8 I-

\

V

1

\L

—

V

Consumer Price Index Urban

^1
1 i i 1 1

1955

—
—

i i

1 1 1 1 1 1 1 1 1 i

1960

1965

1970

i

i

i i
1975

1 1 1

|
1980

is lower over a given period•
The advantage of doing so would be
to lower the cost of indexation when price increases exceed wage
i n c r e a s e s — t h a t is, when real wages fall. The lower cost m a y be a
significant consideration by itself, but it is of particular
importance when falling real wages make it more difficult to
finance the indexed benefits through tax revenues.
Advocates of
the proposal also argue its fairness. Unlike the present system,
which in a period of falling real wages offers more purchasing
power to federal beneficiaries than those in the labor force can
provide for themselves, the switching proposal would require the
beneficiaries to share in the burden felt by wage earners.
The appeal of this proposal is offset by three additional
considerations. First, as shown in Figure 2, there have been
relatively few instances in the postwar period when wages have
risen less rapidly than prices. For most of the period the switching proposal would have given the same results as current procedures.
Second, there were two rather pronounced episodes of
falling real wages in the 1970s.
Such episodes could, if they
occurred repeatedly, lead to progressive reductions in real benefit




19

levels through the switching proposal.
Not only can a relative
price shock cause a drop in real wages, but temporary episodes of
falling real wages could occur merely because wage changes tend to
lag changes in prices.
With low levels of productivity growth,
even cyclical movements in prices could temporarily outrun wage
increases.
If repeated episodes of falling real wages were to
occur, the principal implication of indexation with this technique
would be progressive reductions in real benefit levels of government programs.
This would happen because the switching proposal
is, in effect, a ratchet mechanism. When real wages fall benefits
will also fall, but when wages catch up benefits will not.
The
third consideration concerns the fairness criterion.
Some may
question whether beneficiaries should share in the economic losses
but never in the economic gains. Moreover, depending on the actual
goals of indexation, the switching mechanism, if it were applied to
programs that attempt to insure some minimum welfare level, might
one day render them incapable of doing so.
The switching proposal could, of course, be modified to
include a catch-up mechanism that would delay the switch back to a
price index until real benefits had been restored to their former
level.
Alternatively, benefits could be adjusted by changes in
whichever index was lower relative to a base period. This would
mean that real benefit levels would be reduced only when the level
of real wages fell below the level of a given base period. Under
both of these modifications, in a growing economy temporary economic setbacks would at most lead only to a temporary reduction in
real benefits.




20

CHAPTER IV.

WHAT FEDERAL PROGRAMS ARE INDEXED, HOW, AND AT WHAT
COST

A Brief History
Precedents for indexing federal programs go back more than
a century to 1870, when increases in military retirement benefits
were first adjusted to reflect increases in active-duty pay in a
procedure known as "recomputation."
This discretionary procedure
was made into an automatic one by the Joint Service Pay Act of
1922, This form of indexation to wages was replaced temporarily in
1958 by an annual 6 percent cost-of-living payment adjustment for
military retirees.
In 1962 the Congress undertook to index the Civil Service
Retirement System.
Initially it favored institution of a wagelinked index.
The Civil Service Commission, while agreeing on
the need for a long-term alternative to the time-consuming and
difficult task of repeated one-time adjustments, argued for an
index linked to prices. Wage changes, they contended, were needed
to attract and retain active employees and had no necessary bearing
on the needs of retirees. As a result, CPI indexation was adopted
for civil service retirement benefits in 1962 and for military
retirement benefits the following year. Price indexation had been
applied to several smaller programs during the 1940s and 1950s—
including construction programs, agricultural support programs, and
compensation for overseas employees—but civil service retirement
represented the first major federal program to be formally linked
to a price index, setting a powerful precedent for indexation
activity in the future.
During the 1960s several other workers 1 compensation and
retirement programs were formally indexed but it was not until the
1970s that more widespread indexing of federal programs took
place. An upsurge in indexation came after 1972 when Social Security benefits—the largest of all indexed federal programs—were
linked to changes in the CPI. Along with the ensuing indexation of
other major retirement and workers' compensation programs, the
expansion of indexation to include transfer programs began to take
place.
The Food Stamp Program had already been indexed in 1 9 7 1 —
the only major income transfer program to be indexed before the
indexation of Social Security in 1972.




21

FEDERAL PROGRAMS THAT ARE INDEXED
Indexed programs may be divided into indexed entitlement
programs, indexed programs other than entitlements, and quasiindexed programs.

Entitlement Programs
The programs listed in Table 1 have in common the fact that
their benefit levels are indexed. This, together with their status
as entitlement programs, means that under current law a change in
the appropriate index will automatically trigger a predictable rise
in the level of per capita nominal benefits. 1/ For the programs
in Table 1, the estimated level of total expenditures in fiscal
year 1981 is $195 billion. A 1 percent change in the appropriate
price index would, at this level of expenditure, trigger approximately $1.9 billion of additional federal outlays. 2/ This estimate assumes that everything else, particularly participation
rates, remains the same.
In fact, however, if indexed benefits
increase faster than the other income of the group participating in
a program, it is likely that the rate of participation among those
eligible will also increase, raising total outlays still further.

Other Indexed Programs
Another group of indexed programs i s made up of programs that
are not entitlements, and/or of what might be called quasi-indexed
programs.
They differ from the group of indexed entitlement
programs in Table 1 in that either:

\J

Entitlements are benefits prescribed by law for a l l persons
meeting a program's e l i g i b i l i t y requirements.
The t o t a l
outlays are not determined by an annual appropriations decision of the Congress.

2/

The sensitivity is slightly less than proportional because of
instances where indexation is not applied uniformly to the
t o t a l benefit payment, such as in the Railroad Retirement
Program.




22

TABLE 1.

INDEXED ENTITLEMENT PROGRAMS

Date of
Indexation

Estimated
1981 Outlays
(billions of dollars)

Federal Judiciary Survivors
Benefits

1956

0.002

2.

U.S. Coast Guard Retirement Pay

1958

0.232

3.

Civil Service Retirement System

1962

17.326

4.

Military Retired Pay

1963

13.781

5.

U.S. Presidents1 Pensions

6.

Public Health Service Commissioned Officers Retirement

1965

0.077

Federal Reserve Board Employees
Retirement

1965

0.004

Program

1.

7.

8.

9.

10.

11.

12.

13.

14.

1963 (effective 1964)

CIA Retirement and Disability
System
1964 (effective 1966)
Federal Employment
Act

0.0002

Classified

Compensation
1966

0.376

Special Benefits for
Disabled Coal Miners (HHS)

1969

1.057

Guaranteed Student Loan Program
(Special Allowances)

1976

0.401

Federal Old Age Survivors and
Disability Insurance (OASDI)
Child Nutrition Programs
National School Lunch
Program (Commodity
Subsidy)
National School Lunch
Program (Cash Subsidy)




1972: (effective 1975)
Benefits:
1973,1975,1978
Eligibility:
1971,1977

140.117
3.790

(Continued)

TABLE 1.

(Continued)

Program

15.
16.
17.
18.

Estimated
1981 Outlays
(billions of dollars)

1974

0.922

School Breakfast Program
(Cash Subsidy)
Summer Food Service
(Cash Subsidy)
Child Care Feeding
(Commodity Subsidy)
Child Care Feeding
(Cash Subsidy)

19.

Special Benefits for
Disabled Coal Miners
(Department of Labor)

20.

Railroad Retirement
Benefits

21.

Supplemental Security
Income

22.

Date of
Indexation

Foreign Service Retirement
and Disability Fund

1974 (effective 1975)

5.296

1974 (effective 1975)

7.438

1976

0.174
0.322

25.

1972,1974,1978
Department of Defense
Survivor Benefit Plan
Retired Serviceman's
Family Protection Plan
Guaranteed Minimum Incorporated

26.

Veterans1 Pensions

3.844

23.
24.

Total Outlays




1979

195.159

o

they are appropriations subject to discretionary review by
Congress,

o

the benefit level is not one of their indexed provisions,

o

the indexed provision
circumstances, or

o

the indexed provision may operate as a ceiling or floor and
thus be binding on only a fraction of total outlays.

may

be

inoperative

under

certain

The list of these programs is shown in Table 2.
Their expenditures in fiscal year 1981 are projected at more than $177
billion. The sensitivity of their expenditures to changes in an
index level varies widely among these programs. The most sensitive, based on past experience, are programs with benefit levels
tied to an index and tending to behave as entitlements even though
subject to an appropriation by Congress. Although there is no
guarantee that they will continue to behave in the same way
in the future, past expenditure levels have kept in step with the
relevant index.
The most important of these is the Food Stamp
Program.
Next in importance are the programs in which benefit payments
or claim reimbursements are subject to a floor or ceiling that is
indexed, as in Medicare and Medicaid. The ceilings or floors may
not always be binding on all of the claims paid, so movements in
the index do not necessarily affect the total of program expenditures in a predictable way.
Because of the size of the outlays
involved in these programs and the degree to which the ceilings and
floors have been binding in recent years, however, their indexation
has a significant impact on government expenditures.
An area in which indexation may at times play an important
role is that of agricultural price supports.
In these programs
the government purchases certain farm commodities in sufficient
quantities to maintain the market price at a target level. The
expenditures are triggered whenever forces of changing supply or
demand cause the market price to fall below the support level. The
support level is determined by a parity formula that in turn is
based on the ratio of an index of prices paid by farmers to an
index of prices received by farmers.
Another set of programs involving substantial levels of
expenditures includes federal civilian and military pay and the




25

TABLE 2.

INDEXED PROGRAMS OTHER THAN ENTITLEMENTS, AND QUASI-INDEXED PROGRAMS

Program

1.
2.
3.
4.
5.
6.

Price Support Loans:
Rice
Honey
Tobacco
Upland Cotton
Wool
Mohair

7. Dairy Price Supports
8. Medicare (Part A)
9. Medicare (Part B)
10. Medicaid
11.

Special Milk Program

12. Food Donations

Estimated
1981 Outlays
(billions of dollars)

Classification

Date of
Indexation

Quasi-indexed
Entitlement

1949, 1954
1977, 1978

0.068

Quasi-indexed
Entitlement

1949

0.925

Quasi-indexed
Entitlement

1965
(effective 1966)

27.625

Quasi-indexed
Entitlement

1972
(effective 1973)

12.650

Quasi-indexed
Entitlement
Quasi-indexed
Entitlement

1974
Benefits: 1974
Eligibility : 1973

16.026

0.163

Quasi-indexed
Entitlement

1975

0.085

13. Commodity Export Sus- Quasi-indexed

1977

0.0

1979

0.753

Elderly Feeding
Program

pension Protection

14.
15.
16.
17.

Entitlement

Deficiency and Disaster
Payments (Target Price
Programs):
Quasi-indexed
Wheat
Entitlement
Feedgrains
Cotton
Rice




(Continued)

TABLE 2.

(Continued)

Date of
Indexation

Estimated
1981 Outlays
(billions of dollars)

Program

Classification

18. Grants to States for

Quasi-indexed
Entitlement

1979

3.283

Quasi-indexed
Appropriation

1949

0.486
(obligation)

Quasi-indexed
Appropriation

1949

0.011
(obligation)

Quasi-indexed
Appropriation

1949

0.120

Quasi-indexed
Appropriation

1954

0.590
(obligation)

Quasi-indexed
Appropriation

1968

0.228

24. Military Pay

Quasi-indexed
Appropriation

1968

33.588

25. Federal Civilian Pay

Quasi-indexed
Appropriation

1970
(effective 1971)

38.969

Quasi-indexed
Appropriation

1968
(effective 1972)

10.368

Social Services
19.

20.

Overseas Station
Allowances (Dept.
of Defense)
Overseas Station
Allowances (Dept.
of State)

21. 0PM Cost-of-Living
Allowance Program

22. Dept. of Interior
Water & Power
Resources Service
Construction Program

23. Military Barracks and
Officer Quarters
Construction Program

(General Schedule)

26. Federal Civilian Pay
(Blue Collar)

27. Food Stamp Program

Indexed
Appropriation

1971

10.954

28. Legal Services

Quasi-indexed
Appropriation

1972

0.317




(Continued)

TABLE 2.

(Continued)

Program

29.
30.
31.
32.
33.
34.

Community Services
Administration, Community Action Operations:
Local Initiative
Senior Opportunities
State Economic
Opportunity
Community Food and
Nutrition
Energy Conservation
Services
Youth Sports Program

Health Scholarships:
National Health
Service Corps
Scholarships
36. Indian Health
Scholarships
37. Foster Grandparents

35.

Classification

Date of
Indexation

Estimated
1981 Outlays
(billions of dollars)

Quasi-indexed
Appropriation

1972

0.488

Indexed
Appropriation

1976

0.038

Quasi-indexed
Appropriation

1973
(effective 1974)

0.048

1973
(effective 1974)

0.013

38.

Senior Companions

Quasi-indexed
Appropriation

39.

Basic Education
Opportunity Grants

Indexed
Appropriation

1974

2.353

40.

Supplemental Education Opportunity
Grants

Indexed
Appropriation

1974

0.370

41.

Senior Community Service Employment and
Training Service

Quasi-indexed
Appropriation

1974

0.265

Lower Income Housing
Assistance (Sec. 8)

Indexed
Appropriation

1974

3.070

42.




(Continued)

TABLE 2.

(Continued)

Date of
Indexation

Estimated
1981 Outlays
(billions of dollars)

Program

Classification

43•

Community Services
Administration Energy
Crisis Intervention
Service

Quasi-indexed
Appropriation

1975

44.

Territorial & International A f f a i r s —
Grants for the
Northern Mariana
Islands

Quasi-indexed
Appropriation

1976

0.024
(obligation)

45.

Territorial & International A f f a i r s —
Guam and Virgin
Islands Construction
Project

Quasi-indexed
Appropriation

1976

0.032
(obligation)

46.

Bureau of Indian
Quasi-indexed
Affairs, Navajo Indian Appropriation
Irrigation Project

1976

0.495
(authorization)

47.

Department of Energy
Weatherization Aid

Quasi-indexed
Appropriation

1976

0.193

48.

Follow Through

Quasi-indexed
Appropriation

1976

0.044

49.

Head Start

Quasi-indexed
Appropriation

1976

0.870

Indexed
Appropriation

1976,1977

0.372

HSA Grants for
Community Health
Services:
50.
Community Health
Centers
51.
Migrant Health
Services
52.
Home Health
Services

a/

(Continued)

80-400

0 - 8 1 - 4




TABLE 2.

(Continued)

Program

53.
54.
55.
56.
57.
58.

Classification

Indexed
Comprehens ive
Appropriation
Employment & Training
Program (CETA):
Comprehensive
Employment and
Training (Title II)
Youth Employment
and Training Program (Title IV-A)
Job Corps (Title IV-B)
Summer Youth Employment
Service (Title IV-C)
Countercyclical Public
Service Employment
Program (Title VI)
Private Sector Incentive Program (Title VII)

Date of
Indexation

Estimated
1981 Outlays
(billions of dollars)

1978
(effective 1979)

7.194

59.

Special Supplemental
Food Program for
Women, Infants, &
Children (WIC)

Quasi-indexed
Appropriation

1978
(effective 1979)

0.862

60.

Vocational Rehabilitation Program

Quas i -i nde xe d
Appropriation

1978
(effective 1979)

0.956

61.

Health Profession
Scholarship Program

Indexed
Appropriation

1979

0.025

62.

Low Income Energy
Assistance Program
(HHS)

Quasi-indexed
Appropriation

1979

1.850

63.

College Work Study

Indexed
Appropriation

1980

0.550

64.

National Direct
Student Loans

Indexed
Appropriation

1980

0.201

Total Outlays
a/

177.522

Budget authority for the CSA Energy Crisis Intervention Program beginning
in 1981 is transferred to the HHS Low Income Energy Assistance Program.




Comprehensive Employment and Training Act (CETA). These programs
are called quasi-indexed because, while they contain certain
indexed provisions, other factors influence the actual levels of
expenditure.
A special group of programs are those construction programs
containing explicit indexed provisions in the authorization language but whose outlays are nonetheless subject to appropriations.
The authorization for the appropriation of funds for a
given construction project is explicitly indexed, and acts as an
indexed entitlement for those funds over the life of the project.
The changing composition of projects within each program, however,
makes it difficult to estimate the "costs" of indexation.
Another special group of programs are military and foreign
service station allowances, for which outlays depend both on the
level of costs in the United States or a given city, and on the
level of costs in a foreign country or noncontiguous state. The
difference in movements of the two price indexes drives the level
of expenditures for a given level of coverage, and not the change
in any one index.
Detailed information on the indexing provisions of these
programs is contained in Appendix A.
The effect of indexation on programs in this category is to
put upward pressure on expenditure levels. In some cases the
pressure is all but automatic, while in others it is indirect and
perhaps muted by other influences. Consequently, it is not practicable to estimate the sensitivity of expenditures to a change in
the level of the relevant index.

HOW PROGRAMS ARE INDEXED
The preceding discussion has shown that indexation practices
among federal programs are far from uniform. Important differences
exist in the types of provisions indexed and in the statistical
measures employed. There are also differences in the formulas used
for adjusting benefit levels. The differences are summarized
below.




31

Provisions Indexed and Measures Used
Major indexed provisions in federal programs are:
o
o
o
o

benefit levels,
eligibility criteria,
ceilings or floors on benefits payable, and
agricultural parity formulas.

Benefit Levels.
Indexation of benefit levels produces the
greatest sensitivity of outlays to changes in the statistical
measure used for indexation.
In most cases, the provision calls
for a proportional escalation of benefit levels with changes in the
measure used for indexing. The CPI is the index most commonly used
for this purpose, but there is inconsistency in the choice between
the available versions: the index for all urban consumers (CPI-U)
and an index for urban wage earners and clerical workers (CPI-W).
Until now the two measures have diverged only slightly.
This
cannot be guaranteed, however, for the future.
In a number of cases, where the benefits are to be used only
for certain types of purchases, special indexes are used that
reflect more directly the cost of the goods on which benefits are
to be s p e n t — t h e Food Stamp Program being the most prominent
example.
Eligibility Criteria.
Eligiblity criteria are employed in
programs targeted at low-income recipients. Since changing prices
alter the significance of a particular income eligibility level,
it is necessary to readjust the nominal terms of this provision
from time to time.
The sensitivity of outlays to changes in the
eligibility criteria is not always easy to predict.
If wages are
rising more rapidly than prices, upward changes in the eligible
income provision may actually be accompanied by a drop in the
number of eligible participants.
On the other hand, even at a
moderate rise in the price level, if wages are rising more slowly,
or if joblessness has increased, there may well occur a sharp rise
in the number of people eligible. Also, the sensitivity of outlays
to changes in the eligibility criteria will depend on the distribution of incomes among those close to the defined poverty or
eligible income level.
One of the major issues involved in the choice of a measure
for indexing eligibility criteria is whether the CPI accurately
represents the consumption habits of the target population. To




32

the extent that the buying patterns of low-income consumers differ
from those of the average population, the CPI may be less than
ideal as the basis for indexing the poverty income level.
Ceilings*
Indexation of ceilings on benefits payable is a
prominent feature in the Medicare and Medicaid programs. The
ceilings are designed to prevent excessive claims. The statistical
measure used to adjust ceilings is an index of prices of input
costs for the services covered by the program. One of the weaknesses of indexing the ceilings is that it reduces the incentive of
doctors, hospitals, nursing homes, and other health care providers
to control or minimize the costs, because the ceiling on reimbursements will rise automatically as costs rise. Moreover, physicians
are in a position to influence directly the movement of the ceiling
index through increases in their own fees.
The sensitivity of outlays to movements in the ceiling depends
on the variation in the range of prices charged for medical services.
The ceiling may be binding on only a fraction of the
claims, but if inflation is rapid the time lag in adjusting the
ceiling may conceivably cause it to become binding on an increasing
number of claims. In this case, its upward adjustment could affect
a sizable portion of program expenditures.
Agricultural Parity.
The agricultural parity formula is a
measure of the relative prices of the goods that farmers buy
compared to the prices of the goods they sell. The formula, which
is used as a reference for determining the degree of support for
farm incomes, is based on a ratio of two indexes. The numerator is
an index of prices paid by farmers scaled so that the years 19101914 equal 100.
The denominator is a similarly based index of
prices received by farmers for their products, currently a sample
of 44 commodities. The parity price for a particular crop or
product is determined by multiplying this ratio times the average
price of the product. If the support target is, say, 85 percent of
the parity price, then whenever the market price falls below the
designated level farmers can, in effect, count on the federal
government to purchase the crop at the support price. If market
forces keep the product price above the designated parity level,
the support program becomes inactive.
The numerator in the parity ratio—prices paid by farmers—
is made up of the CPI plus the costs of production inputs, interest
costs, taxes, and wages for farm labor.
The weighting of these
components is periodically revised.




33

Several criticisms have been made of the parity formula.
First, the reference base is completely outdated. Neither consumption habits nor production techniques today are what they were in
1910-14. Second, the formula has no explicit means of taking into
account the rather large productivity gains that have occurred over
this period, and thus greatly overstates the price levels necessary
to provide a purchasing power comparable to that of 1910-1914.
Finally, it contains a feedback mechanism that tends to inflate
agricultural prices. If, for example, the support price for milk
is raised to a certain level, this will eventually be reflected in
the CPI through higher milk prices. The higher CPI then leads to a
readjustment of support prices via the parity formula.

Formulas for Indexing
Indexes can be calculated and applied in a number of ways.
They differ mainly in the type of interval used for measurement,
the frequency of adjustment, and the length of the lag between the
time they are calculated and the time they are applied.
The interval of measurement and the frequency of adjustment
correspond in the major indexed programs. Annual adjustments
implement annual changes; semiannual adjustments implement sixmonth changes.
Type of Interval.
The measurement of index change over a
given interval can be computed in different ways.
For yearly
intervals there are three possibilities.
The first is a pointto-point measure, as from December of one year to December of
the following year. The second compares a quarter—using a threemonth average—to the same quarter a year earlier.
Finally, one
can compare the average index level for an entire year with the
average level of the previous year.
In the long run these three
methods will produce virtually the same results.
In the short
run, however, rather large differences may occur if the index is
accelerating or decelerating. The year-over-year average—and, to
a lesser extent, the quarter-over-quarter average—produces a
smoother, less volatile series of changes than point-to-point
measurement. This can be seen in Figure 3, which plots the three
variants for the CPI for the past ten years.
The accompanying
figures showing rates of change show how large the differences can
be for a given year. Besides smoothness, another feature of the
different methods of calculation is the implicit lag.
The yearover-year calculation gives equal weight to all months of the years
being compared.
If the rate of change is a constant one, this




34

Figure 3.

Comparison of Consumer Price Index Growth Rates
Using Alternative Index Change Calculations
14
12 -

E 10

a.
o

ANNUAL
AVERAGES

4TH QUARTER
TO 4TH QUARTER

1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979

DEC.

5.4

5.7

6.0

5.9
4.2
3.3
6.2
11.0
9.1

5.7
3.5
3.4
8.3
12.2
7.4

5.6
3.4
3.4
8.8
12.3
7.1

5.7
6.5
7.7

5.1
6.7
9.0

4.9
6.7
9.1

11.3

12.7

13.3

8-

6-

December >
to December

DEC.

TO

A

/A

if// '/ /

11

// 1
I I I

II1
j/

Annual
/
Averages ^ ^ 7

V1V \
1

/ /

4th Quarter .
to 4th Q u a r t e r ^

/

/

V\

/

4-

I

1969

I
1970

I
1971

1972

I

_L
1973

1974

1975

I

1976

T

J_
1977 1978

1979

amounts to comparing the mid-points of the two years. In contrast,
the point-to-point measure from December to December reflects
annual change over a period more recent by six months. In other
words, averaging lengthens the lag between the underlying change
and its full incorporation into readjusted indexed provisions.
The primary advantage of semiannual indexation is its shorter
lag.
Usually employing a point-to-point measure, semiannual
indexation reduces the amount of purchasing power lost as prices
rise more or less continuously while adjustment of benefits is
done only at discrete intervals.
The difference can be seen in
Figure 4.
Time Lag.
In most indexed programs, there is a lag between
the time when the index change is calculated and the time when it
is reflected in program benefits. The longer this lag, the more
purchasing power is lost during a period of rising prices.
To
give one example, Social Security benefits are adjusted by the




35

Figure 4.

Comparison of Growth in Benefits with Annual
and Semiannual Adjustments
1,050
1050

1,000 -

950 --

Growth in Cost
of Hypothetical
DdSKcl OT

I

I

1

UUUU3

900
\

Q

850 -

Growth in Benefits with
Annual Adjustments
Growth in Benei its
with Semiannual
Adjustments

800 S
750 s

1

1
Yeari

1

1

YearZ

1

1
)rear3

i
Year4

amount of change of the first-quarter average of the CPI of the
current year from that of the previous year, but the adjustment is
not implemented until the following July.
This means that beneficiaries may never quite catch up to where they once were in
purchasing power if prices have increased between the interval for
which they were measured and the time of the benefit adjustment
several months later. 3/

3/

The loss of purchasing power between the interval used for the
index calculation and its time of implementation was of concern
to those who framed the indexing provisions of the federal
civilian and military retirement programs. To make up for the
loss an additional percentage point was added to the calculated
change every time an adjustment was made.
The problem with
this solution was that the 1 percent "kicker" was permanent but
the purchasing power loss was temporary, so that the provision
resulted in overindexation.
For this reason it was discontinued in 1976.




36

Asymmetry*
Finally, another notable feature of many indexing
formulas is that they adjust benefits only when prices increase.
However unlikely the prospect of falling prices may seem—it has
occurred in only two years since World War II—such a development
would lead to a decrease in nominal benefits for some programs but
not for others. Among those that would not be adjusted downward if
prices fell are Social Security benefits.

THE COST OF INDEXATION
Indexing provisions vary so widely in their formulas that it
is difficult to estimate their overall effects on outlays. A rough
estimate can be made, however, by calculating the effect of an
index change on those programs for which funding is fairly predictable, and then adding the effect of other program outlays calculated under some simplifying but arbitrary assumptions.
The group of entitlement programs with indexed benefit levels
account for $195 billion or about 30 percent of estimated 1981
federal outlays. A 1 percent change in the relevant indexes would
raise expenditures by $1.9 billion—not counting possible changes
in participation rates. If it is assumed that other programs
that have in the past behaved like entitlements continue to do
so—principally the Food Stamp Program—the cost sensitivity rises
to about $2.0 billion. If it is further assumed that the Medicare
and Medicaid programs are affected by only one-fifth of the rise in
the relevant index, the sensitivity figure rises to $2.1 billion.
If federal civilian and military pay rise by one-half of the rise
in measured comparability pay, this increases the sensitivity
figure to $2.4 billion. Very modest assumptions as to the sensitivity of CETA funds to rising index levels, and the effects of
higher benefits on participation rates in entitlement programs,
raise the sensitivity figure to over $2.5 billion at the 1981
level of federal outlays.
To put the sensitivity figure in perspective several comments
should be added. First, it is not a measure of the full effect of
inflation or rising prices on federal outlays.
The full effect
would be larger because of the existence of implicit or informal
indexation, which has not been discussed in this report. The
sensitivity figure calculated here refers to the effect of formal,
explicit indexation alone. Second, the $2.5 billion in added
cost can be broken down into two sums: Slightly under $2 billion of
it represents the amount of additional cost that cannot be avoided




37

without a change in existing law.
The other $0.5 billion is a
conservative estimate of the cost of continuing past practices with
regard to the indexing of nonentitlement programs.




38

CHAPTER V.

A SURVEY OF ALTERNATIVE INDEXES

This chapter is a guided tour of a number of statistical
measures that may be of interest for purposes of indexation.
The CPI—the most widely used measure for indexation—receives
initial attention as a standard against which other measures are
compared. These include indexes based on the national income
accounts and indexes based on wages and earnings. First, however,
some issues in the construction and definition of index numbers are
discussed.

SOME DESCRIPTIVE AND DEFINITIONAL ISSUES
An index number is a constructed measure whose variations
are designed to reflect the increase or decrease of a variable that
is impossible to measure directly—such as the aggregate change in
the prices of consumer goods. The function of the index is not to
measure the absolute level of this variable but only to indicate
changes in its level from a base period, usually set equal to 100.
Indexes can be constructed in many ways, but three types of
construction are used for the indexes surveyed below. These are:
o

Base-period
indexes);

fixed-weight

indexes

(known as

Laspeyres

o

Current-period weighted-indexes (known as Paasche indexes);
and

o

Chain indexes.

The feature that distinguishes these three ways of constructing indexes is the weighting procedure.
Since an index measures
an aggregation of many items—in this case, prices of goods and
services—some way must be chosen to combine them.
Simply adding
them together and dividing by the number of items will yield
an arithmetic average that gives equal weight to each item. But in
measuring the cost of a basket of goods it is preferable to weight
items according to their importance in the actual market basket.




39

Fixed-Base-Weighted Indexes (Laspeyres)
In the Laspeyres index—which is the formula used for the
CPI—current prices are compared with prices in a base period by
using the shares of the items in expenditures during the base
period as weights for aggregation.
Thus the same basket of
goods is priced throughout the time period in question.
In contrast to the other index types discussed below, the fixed market
basket insures that changes in the index represent pure price
movements throughout the period, making it possible to compare
price behavior over different intervals on a consistent basis. The
disadvantage of a Laspeyres index is that over time the base-period
market basket may become increasingly unrepresentative of actual
consumption patterns.
Changes in the consumption mix can result
from changing levels of income, changing tastes, and, most importantly, from substitution between commodities in response to
relative price changes. For example, a rapid increase in the price
of an item—say, gasoline—will lead consumers to reduce their
purchases of the item.
A fixed base-weighted index takes no
account of this change; subsequent changes in gasoline prices
continue to receive the same weight as they did in the base period.

Current-Period-Weighted Indexes (Paasche)
The Paasche index—which is the formula used for calculating
the implicit price deflators for components of gross national
product—uses the current-period consumption pattern for weighting
purposes. Whereas the Laspeyres index compares todayfs prices with
yesterday's using yesterday's consumption pattern, the Paasche
index makes the same price comparison using today's consumption
pattern. While the Laspeyres index, because of substitution, has a
tendency to overestimate the true change in the cost of living, the
Paasche index, using end-period weights after substitution has
occurred, will tend to underestimate the true change.
Like the
Laspeyres index, however, its degree of bias is influenced by the
size and extent of substitution.
Another contrast between the Paasche and Laspeyres indexes is
that the latter uses a single market basket for comparing each
period's prices to those of a base year, whereas the Paasche
formula requires that the market basket be updated each period in
order to compare that period's prices with the base year. Using
the Laspeyres formula, interperiod comparisons elsewhere in the
series can be made on a comparable, consistent basis. In the




40

Paasche formula, however, each pairing of a different current year
with the base year uses a new set of weights, so that interperiod
comparisons are not consistent.
If an implicit deflator is used to compare this year's prices
with last year's prices—assuming that last year was not the base
year—it will not measure pure price change. Since the comparison
is being made with two different sets of weights, it will reflect
composition change as well as price change.
It is possible, in
principle, for an implicit deflator to rise or fall even when no
actual price change occurs, because of a change in weights from one
period to the next.

Chain Indexes
The chain index—which, in addition to the Paasche and Laspeyres formulas, is one of the three forms in which GNP price
information is published—includes features of both fixed-weight
and current-weight indexes. To understand the operation of a chain
index it is useful to examine an analogous construction in the
long-run history of the CPI.
The fixed market basket of the CPI
has been revised at about ten-year intervals because of the growing
obsolescence of a given consumption pattern over time.
When a
new index base is constructed, a continuous historical series is
maintained by linking together the last period measured using the
old base with the first period using the new base. Each ten-year
segment of the historical series is thus like a link in a chain.
The point at which they are connected is where the switch is made
from one base to the next.
Comparisons of price change across
links are complicated by changes in the weights used in each
segment, while comparisons within a segment represent pure price
change.
The chain index is, then, like a Laspeyres index that changes
bases each period rather than at ten-year intervals.
Prices are
compared between last period and this period using the former's
consumption pattern as weights. Between such adjacent periods the
index reflects pure price change as does a Laspeyres index.
Comparisons of price change between nonadjacent periods are,
however, compounded with nonprice changes because of the differences in weights. The implicit deflator has this problem for all
comparisons except those using the base period. If, however, one
needs a measure of recent price change, say between last year
and this year, the chain index offers significant advantages:




41

first, it measures only pure price change, an advantage over
an implicit deflator; second, it employs a very current (last
period's) consumption pattern as weights, an improvement over the
Laspeyres index. These advantages are reduced if the chain index
is used to compare nonadjacent periods.

THE CONSUMER PRICE INDEX
The CPI-W, which currently is the most widely used index for
escalation of federal programs, attempts to measure the prices of a
fixed basket of goods and services representing the consumption
patterns of urban wage earners and clerical workers (less than 40
percent of the U.S. population). A second CPI, designated CPI-U,
was added in 1978 to extend the population coverage to include the
salaried, unemployed, self-employed, and retired (about 80 percent
of the population).
Both of these monthly indexes are based on a
1972-1973 Bureau of Labor Statistics survey of consumer expenditures, of points of purchase, and of the pattern of specific items
sold by retail outlet.
The two indexes have deviated very little from each other at
the all-items level, although this is not true of some of the
component groups. There is no guarantee that the all-items indexes
may not diverge in the future, however; if they should diverge,
there is little basis for predicting which might move more rapidly.
A choice between them might be based simply on their reference
bases. The broader-based CPI-U, although it adds the salaried and
the self-employed to the population reference base, has a lower
average income level because it also includes the retired and the
unemployed.
The CPI is an attempt to
cost-of-living (COL) measure but
that attempt.
In addition, it
that are characteristic of this
areas are discussed below:




approximate an expenditure-based
it is not without shortcomings in
shares some of the disadvantages
type of COL measure. Six problem

o

The treatment of homeownership;

o

The fixed market basket;

o

The aggregation of family budgets by expenditure weights
instead of population weights;

42

o

The treatment of taxes;

o

The treatment of nonmarket consumption; and

o

The use of an aggregate or average consumption pattern for
escalation of income to a specific demographic group.

The first three are shortcomings of the CPI itself; the next two
are shortcomings of the expenditure-based COL concept; and the last
is a problem resulting from the use of a single index for a variety
of applications.

The Treatment of Homeownership
The most substantial shortcoming is the treatment of homeownership.
The current treatment has by one method of estimation exaggerated the rise in overall consumer prices by as much
as 1.1 percentage points in 1978, by 2.4 percentage points in 1979,
and by 1.6 points in 1980. \J
Currently, each percentage-point
change in the CPI will directly trigger an additional $2 billion in
federal expenditures alone.
The distortion in the measure of homeownership stems from
the durable nature of housing. Since the services of a house are
consumed over a long period of time, its treatment as just another
commodity means that it receives a tremendously large weight
compared to other consumption expenditures. 2/ Moreover, a house

1/

This method compares the current CPI-U with the BLS's experimental X-l rental equivalence measure of the CPI. Comparison
of annual changes covers up the extraordinary measurement
discrepancy of 3.6 percentage points (at an annual rate) during
the first half of 1980, followed by a difference of -0.1 point
(at an annual rate) in the second half of the year, as shown in
Figure 5.

2/

The large weight is also influenced in some part by the high
level of house construction activity in the base-period survey
of consumer expenditures.
In general, the treatment of durables in the CPI shows the extent to which an index of prices
of items purchased can differ from a true cost-of-living
index.




43

can be resold, and the resale possibility means that changes in
the supply or demand for housing not envisioned at the time of
initial purchase can bring significant capital gains to the owner.
Such capital gains, represented by increases in the price of
housing, are increases in wealth. If such an increase in wealth is
made liquid by refinancing or by the lowering of other forms of
saving, higher levels of current consumption are possible. Therefore, higher house prices, for the more than 90 percent of homeowners who do not buy a house in a given year, are more like a fall
in the cost of living than an increase—as suggested by the CPI.
Another difficulty in the current treatment of homeownership
is the very large weight given to mortgage interest costs. These
are weighted both by the purchase price of the house and by the
total undiscounted mortgage interest payments over the expected
life of the mortgage. For example, the current relative importance
of mortgage interest costs in the CPI is about 9.8 percent. If the
mortgage rate were to change from 10 percent to 11 percent in a
given month, this alone would cause the overall CPI to rise by
almost 1.0 percent, or at an annual rate of more than 12 percent.
Another approach to the measurement of homeownership costs is
to think of a house, because of its durable nature, as having two
functions, one as a source of shelter services and the other as an
investment that provides a return and can be resold for a possible
capital gain.
The price of the house represents both of these
functions. While we wish to record the cost of the first function
in our cost-of-living index, we do not wish to include investment
goods—any more than we would wish to include the Dow Jones average
or changes in bond prices. One way to separate the two functions
is to treat the owner of a house as an investor who has bought it
for income p u r p o s e s — b o t h current income and capital g a i n s —
and then rented it out to himself. This is the approach taken in
the national income accounts.
The value of a house to a renter
is only that of the shelter services it provides. A measure of the
value of shelter services can be obtained by measuring market
rental rates. House price changes in excess of rental rate changes
can be assumed to represent changes in the investment value of the
house.
Such a rental equivalence concept is now being employed by the
Bureau of Labor Statistics as a proxy in one of a series of
experimental homeownership concepts.
The effect of substituting
this measure—called CPI X-l—results in the large reductions in
the CPI changes mentioned above and shown in Figure 5. There is
not, however, a complete consensus on which of the experimental




44

Figure 5.

Comparison of Alternative Consumer Price Indexes
Percent Change December to December
16
Consumer Price Index Urban
14

13.3

CPIU-X1

12.4

12.3
12

11.1

10.9

10

8.0

8

7.1
6.0
5.2

6.6

5.6

3I

4.8

4.5

4
2

i

9.1

£.5
6

10.8

1969

14^3

1970

1971

1972

1973

1974

1975

s

6.7

6.3

5.1

1976

1977

I

1978

Difference in Percentage Points
4.5,

1979

1980

4.0
3.4
3.0
2.4
2.0
1.6
1.2

1.1

1.1

1.0 -0.8
0.5

0.4

0.1
-0.1

-0.1
-1.0

I
1969

-0.3

I

1970 1971 1972 1973

I
19741975

I

J
1976

1977

I
1978

I
1979

1980

I
80:6* 80:12*

* These are not seasonally adjusted, since seasonal adjustment processes for CPI-U and CPIU-X1 are not comparable.

80-400

0 - 8 1 - 5




BLS alternatives is the most suitable, and further work may have to
be undertaken before an acceptable solution is found. 3/

The Problem of the Fixed Market Basket
A Laspeyres index holds the base-period quantity weights
constant over the run of the index.
This permits the index to
reflect only pure price changes. Over time, however, an increasingly out-of-date consumption pattern is used for measuring today's
cost of living.
The index continues to answer the question,
"What is the cost of the base-period consumption basket at today's
prices?" but does not tell how much the cost of current consumption patterns has changed since the last or more recent period.
The consequences of using an out-of-date market basket are that the
index tends to overstate actual period-to-period changes in the
cost of living.
This is because people generally reduce their
consumption of items whose prices increase, and substitute consumption of items whose prices have decreased or at least increased at
a less rapid rate.
Thus the share of gasoline in total personal
consumption fell from 3.5 percent in 1972 to 2.8 percent in 1980,
or by a fifth. In the CPI, however, gasoline continues to have the
same weight as it had in the days prior to the rapid increase in
world oil prices. Given the rapid changes in gasoline prices over
the past seven years, this overweighting has driven the overall CPI
up faster than actual living costs.

3/

The current CPI rent data are collected from a renter-occupied
housing sample. Some objections have been raised to the use of
this as a proxy for homeownership costs.
The criticisms are
based on the difference in characteristics between rental
housing and owner-occupied housing such as size, neighborhood,
and physical condition.
While these factors are assumed to
account for a difference in the level of rent between the two
types of housing, it is not known whether their rates of change
differ from each other. This problem could be reduced by
redesigning and reweighting the sample of rental units.
Fuller information on the problem of measuring the cost of
owner-occupied housing can be obtained from the lengthy
series of technical working papers by Robert Gillingham and
others of the Bureau of Labor Statistics, and from the General
Accounting Office report Measurement of Homeownership Costs in
the Consumer Price Index Should Be Changed,
PAD-81-12
(April
1981).




46

The magnitude of this substitution bias in the CPI is somewhat
cumbersome to estimate, kj One recent attempt concluded that for
the 15 years ending in 1973 the bias was about 3 percent of the
total rise in prices. 5J One would expect, however, that the bias
would be larger, the greater is the change in relative prices and
the greater is the responsiveness or elasticity of purchases to
changes in prices. The most dramatic relative price changes have
occurred since 1973.
Also, one would expect substitution to be
greater in the long run, as adaptation takes place, than in the
short run. This suggests that the substitution bias in the CPI may
have become substantially larger in the different price environment
of the years since 1973.
One approach to this problem is to update the market basket
at more frequent intervals.
This is what is done with the chain
index, and BLS will have the opportunity to update more frequently
in the future with data from the continuing expenditure survey now
under way.

Aggregation of Family Budgets
The BLS bases its market basket on data from surveys of
consumer buying habits.
It aggregates the expenditure data over
the sample of families surveyed.
This means that when a highincome family is averaged with a low-income family the consumption
pattern of the wealthier family receives a greater weight because
of its larger expenditures than the consumption pattern of the
low-income family. While in some uses such a weighting is desirable, the practical effect on the CPI is to make it less representative of average consumption behavior. Consumption goods that
are income-elastic—that is, which assume larger proportions of
total expenditures as income grows—receive a greater weight.
Consumption items that are thought to fall in this category are
housing, entertainment, and education.
Conversely, necessities

_4/

A quick approximation of the distortion due to an out-of-date
market basket can be gleaned from the comparisons of the
fixed-weight and chain versions of the Personal Consumption
Expenditure indexes discussed later in this study.

5/

Steven D. Braithwait, "The Substitution Bias of the Laspeyres
Price Index: An Analysis Using Estimated Cost-of-Living
Indexes," American Economic Review (March 1980), pp. 64-77.




47

such as food are underweighted. An alternative method would be to
calculate the budget share of each item by family and then aggregate or average these shares using equal population weights. This
would correct the overweighting of luxury goods and underweighting
of necessities.

Tax Treatment
The CPI includes sales and excise taxes in its market basket,
and, to the extent that they are passed on by producers, the CPI
will also pick up payroll taxes and other indirect business taxes.
Income taxes, however, do not enter directly into the CPI. Even
though there is no reason to think that one type of tax affects the
standard of living any differently than another (provided it cannot
be evaded) the CPI will rise more or less immediately in response
to some kinds of taxes, but not apparently to an income tax. 6J
This is a characteristic shared by other price indexes as well, and
stems from their relationship to the expenditure-based COL concept.
Along with the inconsistency that this treatment of taxes
lends to a COL measure, it has another drawback. Because the CPI
is a widely watched economic barometer, it may tend to bias legislators against tax increases that directly affect the CPI as
opposed to income tax increases that do not. This bias could exist
in the absence of any evidence that one tax affects the standard of
living any differently than another.
It may also obscure from
consideration the fact that one type of tax (a consumption tax)
will have different allocative effects over time than an income
tax.
In other words, the asymmetric treatment of taxes in the
CPI may strongly influence the choice of tax policy to the detriment of efficiency and other considerations, such as growth.

The Treatment of Nonmarket Goods
The benefits of cleaner air, cleaner water, and better
worker safety and health require resources for their production and

This insensitivity to income taxes presumes that increases in
income taxes are not passed on by workers to the prices of the
goods they produce—that is, that workers bargain with employers over pretax earnings instead of take-home earnings. This
seems to be borne out in the U.S. experience to date, although
it does not appear to be true in, for example, Britain.




48

improve the standard of living. Yet these goods are not counted in
the consumption basket of any statistical measure. But the higher
product prices that result from the cost of producing these benefits push up the CPI as though the same quality of living had
become more expensive. Again, this shortcoming is shared by other
price indexes. The fact that considerable progress was made in the
1970s toward better air, water, and safety standards suggests that
this may have been a source of upward bias in the CPI.

The Problem of Representativeness
The accuracy of the aggregate CPI in measuring changes in the
cost of living for any particular person or group depends on the
degree to which people's consumption habits are the same.
For
example, older people consume more medical services than others,
and hence it has been argued that when these costs are rising
r a p i d l y — t o the extent they are not covered by M e d i c a r e — t h e
retirees1 real cost of living is underestimated by the aggregate
CPI. But it is also argued that homeownership cost is a relatively
smaller portion of the budgets of the elderly, so that they have
benefited from the overweighting of this fast-rising item in the
CPI.
Examination of individual's budgets reveals statistically
significant differences when persons are grouped by age, income
level, and certain other demographic variables, but it also reveals
a large amount of variation within these groups after those factors
are taken into account. 7/ Furthermore, the influences of age and
income on consumption patterns do not appear to be stable over
time. To determine whether these demographic groups actually
experience a consistent and statistically significant difference in
cost of living from that measured by the current CPI would require
a study of survey-based samples of the items purchased and points
of purchase of these demographic groups. Given that the majority
of indexed federal programs are targeted at the elderly or poor,

7/

R. Michael, "Variation Across Households in the Rate of Inflation, tf Journal of Money, Credit, and Banking (February 1979),
pp. 32-46; and Hagemann, R.P., Inflation and Household Characteristics: An Analysis of Group Specific Price Indexes, U.S.
Department of Labor, Bureau of Labor Statistics, Working Paper
No. 110 (December 1980).




49

such demographic indexes would have ready application.
With
present information, however, it is guesswork as to whether such
indexes would show a faster rate of change or whether any differences would be consistent ones.
Other CPI Issues
The CPI reflects changes in prices of imported goods such as
automobiles, televisions, and oil. Price increases in these items
can take place for reasons having nothing to do with the domestic
economy.
They may be relative price movements or changes in the
terms of international trade that require an increased share of
U.S. economic output to pay for them. &_/ Indexation exempts
certain groups from sharing in this burden, an income transfer that
may or may not be desired depending on the purposes of indexation.
If it is not desired, the inability of the CPI to render a measure
of only domestic price change constitutes a drawback of this
index.
Finally, despite many improvements over the years^ certain
technical measurement problems continue in the CPI. One of these
is the difficulty of distinguishing pure price change from price
movements associated with change in the quality of the goods in the
market basket.
Although the BLS makes some effort to adjust for
these changes, a number of criticisms remain. Another problem is
that the samples used in collecting house price and rental rate
information are not as representative as would be desired.

THE PRODUCER PRICE INDEXES (PPI)
There are three separate indexes of producer goods prices at
different levels of processing—for crude materials, intermediate
goods, and finished goods. (Simple aggregation of these into one
index would result in double counting, as a price rise in a crude
material is reflected in prices of goods using that material. ) The
indexes cover a limited universe of goods, principally in the
mining, manufacturing, and agricultural sectors. They do not
include construction, transportation, and other services.
Prices
are collected from a variety of sources including questionnaires,

<&J Higher import prices
exchange value of the
rate system, is what
generalized domestic




could also result from a fall in the
dollar which, under a flexible exchange
would occur in
the presence of the
inflation described in Chapter III.

50

industry publications, and government agencies.
Normally, these
are prices quoted by sellers rather than buyers, and while an
effort is made to obtain actual transaction prices, in practice
this cannot always be done. Similarly, the collected data reflect
a mixture of order prices for future shipments and the shipping
prices of finished output. For goods with a considerable time lag
between order and delivery, such inconsistency can create ambiguity
about the timing of price changes.
Weighting of price changes within the three PPIs is based
on the value of shipments of each category of goods in 1972.
Thus the PPIs are Laspeyres indexes with 1972 weights, although,
like the CPI, they have a reference base of 1967.
The PPI measures would not be very appropriate for general
indexation purposes because of the limited universe they cover and
because they measure the prices only of certain inputs into the
creation of consumer goods and services.
The prices of this
limited universe of goods may rise at a different rate from other
sectors of the economy, thus yielding an inaccurate measure of
changes in the cost of living. Similarly, the costs of some inputs
may change at different rates than the prices of final goods and
services because the particular inputs are a small portion of total
value added—for example, the value of the wheat contained in a
loaf of bread. The PPI indexes may, however, be used for specialized purposes such as escalating purchase contracts and deflating
inventory measures. As they tend to be rather sensitive to supply
and demand changes, one of their major uses is as an analytical
tool for observing in detail the effects of changing economic
conditions.
Another major use is for deflating portions of the
national income accounts.

THE GNP INDEXES
The gross national product is the total value of goods and
services produced in the economy.
It includes consumption,
investment, and government services, with exports added and
imports subtracted.
It is the broadest concept for which a price
measure exists.
GNP price measures are available in all three
index forms—Laspeyres, Paasche, and chain-weighted.
The Paasche
form of the GNP index is created by detailed deflation (adjustment
of nominal value to remove the effect of price change) of each item
category in the national output.
When these items are reaggregated, the resulting series is called constant-dollar or real GNP.
When nominal GNP is divided by real GNP, the result is an implicit




51

price deflator. As mentioned before, one
measure is that it does not measure pure
to period but is contaminated by changes
It has a tendency because of these shifts
mate the true change.

characteristic of such a
price change from period
in the quantity weights.
in weights to underesti-

In addition, a fixed-weight version of the GNP price index is
produced using 1972 expenditure weights. These are drawn not from
a statistical sample as in the CPI, but from the aggregate data
collected for the national income accounts. The GNP index is also
produced in a chain-weighted version that uses weights from the
previous period's expenditure pattern.
The usefulness of the three GNP price measures stems from
several features.
First, they are indicators of domestic rather
than foreign prices. This is a consequence of the GNP accounting
framework that adds export prices but subtracts import prices.
Thus indexes are obtained with the direct effect of foreign price
changes removed. While it is true that U.S. consumption includes
imported goods, and also true that someone else consumes U.S.
exports, attempts to index to import price changes will, as discussed earlier, lead to successive rounds of price increases (see
Chapter III). The advantage of using a GNP index to adjust federal
benefits is that it would require beneficiaries to share in the
burden of adjusting to foreign price changes.
Second, the GNP measures are useful because they are so
broad, including all sectors of the economy, and thus give a better
measure of the value of the dollar in all its uses.
Third, the existence of three different GNP index forms
provides better insight into problems of determining the true
change in the cost of living.
Comparison of the chain-weighted
form with the fixed-weight form reveals the differences created by
substitution in the market basket.
Fourth, the GNP measures can be decomposed into various
subindexes that may be more appropriate for certain tasks of
indexation.
Some of the more important of these are discussed
below.

Gross Domestic Business Product (GDBP)
This subset of GNP covers the private business portion of the
economy and accounts for about 85 percent of GNP. It is created




52

by subtracting government purchases from GNP and by making minor
adjustments to the consumption and net export sectors (to remove
household and nonprofit activity from the former, and to remove
payments to U.S.-owned factors of production abroad from the
latter).
GDBP indexes have some of the advantages of the GNP indexes,
notably that import prices are removed. They are also available in
the three index forms.
Their advantage over the GNP indexes is
that they concentrate on the private sector, reflecting the
activity of market forces.

Private Nonfarm Business (PNB)
This measure is a subset of GDBP, created by excluding the
output of the farm sector. Economic activity in the farm sector is
sometimes rather volatile and subject to random forces such as the
weather, pests, and diseases. Furthermore, government agricultural
policy may also strongly influence the level of activity as well as
prices in this sector.
By excluding this sector, one obtains a
measure that is to a much greater extent reflective of market
forces on private business activity.
Use of such a measure
would, for example, make it easier to conduct farm policy without
adverse effects on cost-of-living escalators.
If such a price
measure were used in computing the parity concept underlying crop
support programs, it would also reduce the feedback of boosts in
crop support levels on parity.
Like the other GNP-based indexes
mentioned above, the PNB indexes exclude import prices. And, like
the other measures, the trade-off for this advantage is that the
measure is not strictly confined to consumption goods. 9/

Personal Consumption Expenditure (PCE)
The coverage of this subset of GNP is the closest of all the
GNP subsets to that of the CPI.
It includes the economywide
purchase of goods and services for consumption by individuals. In
addition, it contains the smaller components of the operating
expenses of nonprofit institutions, and some of the value of goods

9/

Since the benchmark revision of December 1980, the chain and
fixed-weight versions of this price measure are available only
on an annual basis, in contrast to the quarterly publication
of other GNP-based indexes.




53

and services received in kind by individuals.
Thus, while the
concept of the PCE indexes is quite similar to that of the CPI,
both the scope and population coverage are somewhat broader. PCE
accounts for nearly two-thirds of total GNP.
Although the PCE indexes are very similar to the CPI in
concept, there are both major and minor differences in coverage,
weighting, and concepts of measurement. 10J
The most important
difference is in the treatment of housing.
Homeownership in the
PCE indexes is treated in a manner similar to that of the experimental X-l CPI measure, as a rental equivalence.
In the national
income accounts, home purchase is treated as an investment purchase, not as consumption.
The flow of shelter services consumed
by those who own their houses is measured by the proxy of rental
rates. This practice treats homeowners as investors who have
rented out the use of the home to themselves. It gives housing a
significantly lower weight in the PCE, which, when combined with
the slower rate of increase of rental rates as opposed to house
prices, explains the larger part of the difference between the
recent behavior of the CPI and of the PCE measure.
Another item treated differently in the PCE indexes is the
purchase of used cars.
Since the national income accounts are
concerned with the measurement of currently produced goods and
services used for consumption, they endeavor to measure only the
current value added in a used car transaction—such as the markup
by the used car dealer—and the net value of used cars sold from
nonconsumption sectors of the economy to the consumption sector.
In contrast, the CPI treatment is essentially that of a gross
concept, resulting in a weight in the CPI for this often volatile
price series that is very large (equal to about three-fourths of
the relative importance of new cars).

10/

Published documentation on the construction of PCE indexes is
somewhat limited.
A standard reference is Readings in Concepts and Methods of National Income Statistics, U.S. Department of Commerce. For a comparison with the CPI, see "Reconciliation of Quarterly Changes in Measures of Prices Paid by
Consumers" Survey of Current Business (March 1978) and J.E.
Triplett and S.M. Merchant, "The CPI and the PCE Deflator: An
Econometric Analysis of Two Price Measures," Annals of Economic and Social Measurement (February 3, 1973).




54

The PCE deflator has tended to be more stable than the CPI and
to rise at a less rapid rate.
These differences can be seen in
Table 3.
Like the CPI, the PCE indexes include the cost of imported
goods.
These enter directly as consumption of finished imported
goods, indirectly as consumption of goods fabricated with imported
inputs, and more indirectly as these affect the prices of competing
domestic goods.
Like the other GNP measures, the PCE is available as a deflator and as a chain index as well as in a fixed-weight form. As
shown in Table 3, the chain and deflator forms have risen less than
the fixed-weight version because of the difference in market
baskets.
The effect of substitution can be seen most clearly by
comparing the change in the PCE fixed-weight index with the change
in the PCE chain index for a given year.
Like other GNP account measures, the PCE is published quarterly.
A preliminary figure is reported one month after the
end of the quarter and may be revised in each of the two succeeding months as more data become available.
In addition, the
accounts for the three preceding years are revised in July of each
year.
Such revisions will affect the index levels in those
previous periods as well as the current index level.
If a GNP
component price measure is to be used for indexation, then the
escalation formula should take into account the revision process,
so that the current level of indexed payments remains consistent
with the current price index level.
The Department of Commerce recently has begun publishing a PCE
deflator on a monthly basis. At present the fixed-weight and chain
index forms are not available on a monthly basis. Monthly indexes
are not, however, a necessity for escalation purposes unless
very recent changes must be taken into account or unless it is
necessary to index over very short intervals.

WAGE INDEXES
As mentioned in Chapter III, the rationale for using a wage
index is based on two related concerns. The first concern is that
of fairness—of avoiding rates of increase in benefit programs that
outstrip the rate of wage increase of the working population. It
is their taxes that fund these payments, and when benefits increase




55

TABLE 3.

COMPARISON OF PERCENT CHANGES IN ALTERNATIVE PRICE INDEXES

CPI-U

CPI X-l

PPI
Finished
Goods

GNP
Deflator

GDBP
Deflator

PNB
Deflator

PCE
Deflator

PCE Fixed
Weight

PCE
Chain

1971

3.5

3.7

2.9

4.7

4.0

3.7

3.9

3.7

3.8

1972

3.4

3.3

3.5

4.3

3.5

3.0

3.6

3.6

3.7

1973

8.3

8.0

11.6

7.0

7.0

5.3

7.3

7.8

7.6

1974

12.2

11.1

18.7

10.1

10.5

11.8

11.0

11.3

11.0

1975

7.4

6.8

7.0

7.7

7.5

7.5

6.1

6.5

6.4

1976

5.1

5.2

3.2

4.7

4.3

4.9

4.9

4.9

4.9

1977

6.7

6.3

7.1

6.1

5.9

5.7

5.9

6.4

6.3

1978

9.0

7.8

8.8

8.5

8.7

8.3

7.8

8.2

8.0

1979

12.7

10.6

12.7

8.1

8.2

8.3

9.5

10.3

9.9

1980

12.5

10.9

12.3

9.8

9.9

10.1

10.0

10.7

10.4

116.6

103.0

130.2

97.6

95.3

93.3

96.5

102.3

99.8

70-80 1/
NOTE:
_1/

Percent changes, annual rates, fourth quarter to fourth quarter.

Percent change over ten-year period, 1970:4 to 1980:4.




faster than wages this represents a redistribution of income.
Second, the wage measure is more closely keyed than other measures
to the ability of society to shoulder the burden of benefit payments.
A relative slowdown in wage growth either because of
reduced productivity growth or a shift in the cost of imports
relative to the value of exports is a signal that the country's
consumable economic output is growing less rapidly. Indexing to a
wage measure ties changes in benefit levels to changes in the size
of the economic pie. Receivers of benefits will share in the
burden of economic setbacks but will also benefit from productivity
growth.
A variety of wage measures could be used for indexing. These
are briefly described below, and their movements are compared in
Table 4.

Average Hourly Earnings
This is a monthly series giving the dollar average of wages
and salaries of production and nonsupervisory workers in the
private nonfarm economy.
It does not include nonwage benefits
(fringes), nor does it adjust for overtime pay. Another drawback
is that shifts in the relative numbers employed in different
industries or occupations can cause movements in the aggregate
measure without a change in actual hourly wage rates.

Hourly Earnings Index
This is a monthly index covering the same universe as the
average hourly earnings series but adjusted for the effects of
overtime (in manufacturing only) and of relative shifts in employment among high-wage and low-wage industries.
It is based on a
recomputation of the average hourly earnings data using fixed
weights for aggregating industries.
Because of the fixed-weight
format, however, if wages rise more rapidly in industries that are
expanding their employment fastest, the index will tend to understate the actual rise in wage rates.

Compensation Per Hour
This index is published quarterly, using in part data collected for the national income accounts. It covers all workers in
the civilian economy. Besides wages and salaries it includes




57

TABLE 4.

COMPARISON OF PERCENT CHANGES IN ALTERNATIVE WAGE INDEXES

Average
Hourly
Earnings

Average
Hourly
Earnings
Index

1971

6.9

NA

5.7

7.9

NA

1972

7.7

NA

7.4

8.3

NA

1973

6.6

6.4

8.1

4.8

NA

1974

8.3

9.1

11.0

5.7

NA

1975

6.2

7.5

7.7

10.3

NA

1976

7.7

7.3

8.5

5.2

7.2

1977

7.7

7.5

7.4

10.8

7.1

1978

9.0

8.4

9.1

5.3

7.7

1979

7.8

8.1

9.7

7.2

8.7

1980

8.8

9.7

10.0

6.9

9.0

109.6

NA

125.0

100.8

NA

Percent changes,
quarter.

annual

70-80 1/

NOTE:
1/

Compensation
Per Hour

rates,

Spendable
Weekly
Earnings

fourth

quarter

Employment
Cost Index

to

Percent change over ten-year period, 1970:4 to 1980:4.




58

fourth

employer contributions for nonwage benefits, including social
insurance and private benefit plans. It does not, however, exclude
the effects of overtime, or of relative shifts in employment among
occupations or industries.

Employment Cost Index
Currently under development, this new measure will combine
some of the more desirable features of the wage measures already
described. All civilian industries will be surveyed monthly. The
index will cover all levels of workers, excluding only the selfemployed, proprietors, unpaid family workers, and owner-managers.
It will measure the entire compensation package, wages as well as
fringe benefits. It will exclude the effects of overtime (in
manufacturing), and of relative shifts in employment among industries and occupations.
To adjust for employment shifts, a fixed
weighting technique is employed as in the Hourly Earnings Index; it
bears a resemblance to the techniques used for measuring consumer
prices in the CPI.
Currently, this measure is available only at three-month
intervals, and the data refer to the private nonfarm economy.

Spendable Earnings
This monthly series is based on an arithmetic average of
earnings in all production and nonsupervisory jobs, including
part-time, in the private nonfarm economy. It reflects changes in
the length of the average workweek.
The interesting feature of
this measure is that estimated employee payments for Social Security and federal income taxes are subtracted from gross average
weekly earnings. This is done for two categories, a single worker
or a married worker with three dependents.
Indexation using this measure would tie benefit levels to the
after-tax income of the working population.
For example, an
increase in income or payroll taxes would lower spendable earnings
and reduce indexed benefits.
Similarly, an attempt to stimulate
the economy through a tax cut would raise spendable earnings and
increase indexed benefits.




59

POSSIBILITIES FOR NEW MEASURES
Alternatives to the existing statistical measures can be
classified in two groups: first, modifications and improvements of
existing measures, and second, development of CPIs keyed to the
consumption patterns of specific demographic groups.

Modifications and Improvements
Three of the shortcomings of the CPI discussed earlier—the
homeownership problem, the out-of-date weights, and the aggregation
by expenditure—could be substantially remedied. Indeed, considerable effort is under way at the Bureau of Labor Statistics to
develop satisfactory solutions to at least the first two of these
problems. The modifications would have a significant effect on the
CPI, very likely slowing its measured rate of increase, at least if
the inflationary conditions of the 1970s continue to some degree
into the 1980s. The difficulties of introducing such changes are
political and administrative. Users of the index will be very wary
of changes that will push the measured rate of change in a predictable direction.
Consensus may be difficult to achieve among
the principal users, who include organized labor.
Administratively, considerable advance warning would be needed so that users
of the CPI could make changes in the way it is treated in legal
contracts.

Demographic-Specific CPIs
There have been repeated calls for a CPI for the elderly and
retirees, and a CPI for the poor, in the belief that prices for
these groups are rising faster than those for the rest of the
population.
If this is true, then indexation to the current
CPI may not fully compensate for the rise in the cost of living.
To construct additional CPIs of the quality of the existing CPI
would involve an investment similar to that undertaken for the
recent revision of the CPI-W and the creation of the CPI-U.
In
this case two considerations should be kept in mind. Only a small
percentage of the variation in the cost of living among individuals
can be ascribed to differences in age and income level. Furthermore, while the differences accounted for by such factors are
statistically significant, their size is not stable over time.
This raises the possibility that a demographic-specific CPI might
be higher than the overall CPI in one period but lower in another




60

period.
If that were to occur, enthusiasm for such special CPIs
might wane.
Another, more practical consideration is that the
construction of one or two more CPIs might stimulate additional
groups to demand other CPIs.

CONCLUSION
The suitability of a given index measure depends on the goals
of the indexed provision of a particular program. The most desirable index for retiree benefits may not be suitable for farm
support programs. For many indexed programs there appears to be a
need for a general consumption index. The currently used CPI
appears to have been responsible for significant overindexation of
federal expenditures and thus constitutes a liability in its
continued use in federal programs.
Because the CPI has distorted the rate of change in consumer
prices in recent years, the expenditures linked to that index are
now higher than if an alternative measure had been used. It seems
desirable to improve the CPI if it is to continue its role as the
principal cost-of-living measure.
In the event that it may take
several years to implement these improvements, an alternative
measure such as the PCE chain index would offer significant advantages in the interim.
In weighing alternative index choices, one of the most
important considerations, in addition to conceptual suitability,
is the projected cost. Which index measures will rise the fastest
or slowest? The historical evidence is presented in Table 3.
There may be a temptation to use these data for simple extrapolation.
In some cases this may be fairly reliable. For example, a
fixed-weight index will probably rise slightly faster than the same
index in deflator form, and a chain index will follow a course
between the two.
But extrapolation may be unreliable in other
cases. For example, will the official CPI continue to outstrip the
X-l experimental measure? This is extremely difficult to project.
Future differences between the two indexes will be highly sensitive
to two influences—mortgage rates and the ratio of rent increases
to house price increases.
Falling mortgage rates will tend to
lower the official CPI relative to the CPI X-l. Increases in house
prices that are smaller than those of rental rates will also
depress the official CPI relative to the experimental measure.
The difficulty in forecasting the relative behavior of the two
indexes lies in the possibility that these two forces may work

80-400

0 - 8 1 - 6




in opposite directions. At present, house prices are rising faster
than rents, but it is rather doubtful that this can continue
indefinitely.
If inflation subsides, even gradually, mortgage
rates should fall* The outcome will depend on the exact magnitudes
of the offsetting effects. While it is possible that the current
relationship will continue for some time, this is less likely if
inflation subsides and less likely in the longer run as demographic
pressure on housing demand subsides.
In relation to other measures, the CPI X-l is likely to behave
very similarly to the PCE fixed-weight index because of the features they share in common.
The GNP, GDBP, and PNB indexes will
tend to rise less rapidly than other measures if import prices are
rising faster than domestic prices, and more rapidly if the reverse
occurs.
Wage indexes should, over the long run, rise faster than
price indexes if productivity resumes growing.




62

CHAPTER VI.

INDEXATION CHOICES FOR THE FOOD STAMP PROGRAM

The Food Stamp Program
its parameters:

is

effectively

indexed in three of

o

The level of the standard allotment of food stamps is
indexed to the prices of the Thrifty Food Plan;

o

The eligibility criterion for food stamps is determined by
the OMB-defined poverty level, which is adjusted by yearto-year changes in the CPI; and

o

The applicant's income is adjusted—for purposes of determining eligibility and benefits—by a standard deduction
that is indexed to changes in the CPI for all items excluding food, and by itemized deductions the limit on which is
tied to a specialized index.

Use is made of two types of indexes: first, specialized
indexes such as the Thrifty Food Plan and subindexes for adjusting
the value of expenditures on particular types of consumption; and
second, a general consumption index—in this case the CPI—that is
used to adjust the poverty level.
The issues presented by these
two types of indexes differ considerably, as do the alternatives
available for each type. 1/

1/

In addition to the formal or explicitly indexed parameters, the
Food Stamp Program contains some features of implicit indexation. The earnings disregard of 20 percent is one example. If
incomes of beneficiaries rise, the value of the disregarded
portion rises in absolute level at the same rate.
A second
implicitly indexed parameter is the medical deduction available
to all households with members age 60 or over, or receiving SSI
benefits.
In fiscal year 1982, out-of-pocket medical expenses
exceeding $25 per month may be deducted from a householdfs
income, both for eligibility and for benefit determination.
Since medical expenses will increase over time because of price
increases, the amount deducted will rise.
But because the




63

SPECIALIZED INDEXES
Thrifty Food Plan
The index of primary interest in the Food Stamp Program
is the Thrifty Food Plan, because of its use for adjusting the
level of benefits. The Thrifty Food Plan is based on a nutritional
study made by the National Academy of Sciences in 1975, which set
out the requirements of a low-cost but nutritionally adequate
diet. This model diet was then compared to a 1965-1966 survey by
the U.S. Department of Agriculture of the food consumption patterns
of a sample of the low-income population.
From this comparison,
adjustments were made to the model food basket to minimize the
differences from actual consumption behavior, within certain cost
limitations. The cost of the Thrifty Food Plan was then evaluated
at 1975 market prices. Subsequent changes in the cost of this plan
have been calculated by taking price changes for the individual
items from detailed CPI data and combining them using the baseperiod expenditure weights from the Thrifty Food Plan.
This is a well-designed indexing procedure that has much
to recommend it.
It tracks the prices of the types of goods on
which the benefits will be spent, and it weights the individual
items in a manner reflecting the actual behavior of the target
group of recipients. Its shortcomings are those of any Laspeyres
or base-weighted index:
since it uses a fixed market basket, it
does not allow for substitution in response to relative price
changes. The substitution problem may well be proportionally more
important within a food index than in an overall consumption
measure because of the relatively frequent and large swings in
prices of beef, poultry, pork, and other protein sources as well as
of fruits and vegetables.
Among food shoppers substitution is
widely practiced at nearly all income levels. In the case of food,
however, these relative price changes are often transient and
short-run, sometimes reverting to previous relative price patterns
in less than a year. When large relative price changes occur
within food groups, the Thrifty Food Plan is likely to exaggerate

1/

(Continued)
$25 threshold level is not indexed, over time beneficiaries
will be able to deduct a larger proportion of medical costs.
This leads to an increase in benefit levels and a relaxing of
eligibility standards for those who qualify.




64

changes in the overall price level.
In order to minimize this
bias, the expenditure weights would have to be revised annually or
more often—an expensive undertaking. An alternative would be to
update the market basket at five- or ten-year intervals, as is
currently planned, to account for new products, quality changes,
and longer-term trends that modify consumption patterns.

Standard Deduction

The size of the standard deduction used to adjust gross income
in order to determine eligibility and benefits is indexed to a
subindex of the CPI covering a l l items, less food. The use of the
CPI-less-food index for this purpose evolved from changes made in
1977.
Before the Food Stamp Act of 1977, low-income households
were allowed to deduct a number of specific expenditures from their
gross incomes for determining both eligibility and benefits. The
1977 legislation replaced these itemized deductions for expenditures with a standard deduction in order to simplify program
administration. It was indexed in order to maintain the real value
of the deduction as prices rose. The CPI-less-food was chosen for
this purpose because the indexation of food prices was already
e x p l i c i t l y reflected in the Thrifty Food Plan.
Although the
CPI-less-food is a specialized index, i t is sufficiently broad that
the issues attending i t s use are essentially the same as those that
arise in the use of a general consumption index, discussed below.

Itemized Deductions
Income can also be adjusted to offset expenses for dependent
care, or excessive or inordinate expenses for shelter and utility
payments. These itemized deductions are limited, and the limit is
indexed. 2/ The index used is the shelter, fuel, and other utilities component of the CPI-U.

_2/

It should be noted that although at present the cap on dependent care and excess shelter costs is indexed, the Food
Stamp Act Amendments of 1980 remove dependent care from the
indexed category beginning in 1982, by setting a nonindexed $90
per month deduction for dependent care, with no ceiling on
the shelter expense deduction for households with elderly
persons.




65

Several issues arise in the use of the specialized index
of shelter, fuel, and other utilities.
The first is whether
this is an appropriate measure for indexing dependent care. 3/
Dependent care expenses most likely consist of payments for babysitting, day care, or perhaps home nursing. Variations in the
level of these costs would seem to be more closely related to the
behavior of wage rates, or perhaps of the minimum wage, than to
shelter costs.
Another issue is that the shelter subindex of the CPI contains
the much-discussed homeownership measure as a component; this
accounts for five-sixths of the relative importance of the shelter
category. The current treatment of homeownership may have caused
the CPI as a whole to overestimate the rise in the cost of living
by several percentage points in the past few years, and the distortion in the shelter component alone would be more than three times
as great. From a conceptual standpoint, it is questionable whether
this is an appropriate measure.
Can the
target group of food
stamp beneficiaries be assumed to be purchasing houses in the
period in question?
A USDA survey in 1978 of characteristics of
food stamp recipients showed 76 percent as renters and another 8
percent as owning their homes outright. Eleven percent were making
mortgage payments, but it is not known how many had purchased homes
in the previous year.
Thus, home purchase and financing costs
refer to a very small fraction of food stamp beneficiaries.

GENERAL CONSUMPTION INDEXES
Poverty Level Eligibility Criterion
The Food Stamp Program is aimed at the low-income population and seeks to provide a more nutritious diet to those who
might otherwise face some degree of malnutrition.
Eligibility is
based on the Office of Management and Budget's definition of the
poverty level* which in turn is essentially based on the Census or
Orshansky Poverty Level. Persons whose net incomes fall below the
poverty level are eligible; those whose net incomes are higher are
deemed not in need of food stamp benefits.

3/

The effect of an index change on benefit levels would be
relatively small because only about 1 percent of caseload
reports show dependent care costs at the cap amount.




66

Changes in the level of prices will obviously affect the
meaning of the poverty level when it is defined in nominal dollars.
Rising prices will lower the poverty level in real terms. It is
therefore appropriate to adjust the level to rising prices.
Otherwise inflation would cause a larger and larger segment of the
low-income population to become ineligible.
If the indexes used are inappropriate, they will result
in an eligibility criterion higher or lower than that which is
desired. This will have two consequences. It will raise or lower
the number of participants, and it will change the absolute
level of living standards at the defined poverty level.
To the
extent that the CPI has exaggerated the true rise in the cost of
living in recent years, it has raised the costs of the Food Stamp
Program from what they otherwise would have been. The magnitude of
this additional cost is not easy to measure, since it depends not
only on the amount of exaggeration in the CPI but, because the
index provision determines eligibility, upon the frequency distribution of incomes in the neighborhood of the defined poverty level.
CBO estimates that, through its effect on the income criterion
alone, a change in the CPI leading to a 1 percent upward revision
in the net income criterion would increase the number of participants by 100,000 and raise the level of expenditures by $8.4
million in 1981. 4/

POLICY CHOICES FOR INDEXATION
The appropriate index can be chosen only after the purposes of
indexation are made explicit. If the purpose of indexation is to
set an absolute standard of consumption, then an index that accurately measures the change in a relevant set of prices is the
appropriate measure.
Alternatively, fairness or equity considerations may be
introduced. If the economy is burdened with an increase in energy
costs, for example, fairness may dictate sharing that burden as
widely as possible.
Similarly, as productivity increases over

kj

This represents about 0.4 percent of participants and 0.1
percent of expenditures.




67

time, it may be desirable to share the g a i n s — t h e r e being, in
effect, a larger pie to divide up. This would mean adjusting
benefits to a relative rather than an absolute standard of consumption.

Alternatives for Specialized Indexes
Thrifty Food Plan.
Given the choice of the current Thrifty
Food Plan, the present indexing method seems appropriate. It could
be improved by more frequent updating, but ultimately the costs
would outweigh the benefits. If in the future a CPI for the lowincome population is created, then the food portion of that measure
may be a suitable alternative if it is updated more frequently than
the Thrifty Food Plan, and particularly if it takes into account
the differences in retail outlets patronized by the low-income
population.
It seems likely that such a low-income CPI for food
would be more suitable as an index than the current CPI-U for food.
Aside from that, there is little on which one could base a prediction of future behavior of these indexes.
Standard Deduction.
The CPI-less-food index used for the
standard deduction has the same liabilities as the all-items
CPI. These include the homeownership problem and the fixed weights,
both of which have caused this measure to overestimate changes in
the cost of living.
The available alternatives are essentially
the same as those for a general consumption measure, which are
discussed in Chapter VII.
Itemized Deductions. If the Congress should desire to resume
indexing the limit on the dependent care deduction, the alternatives would depend on the character of expenditures permitted under
this provision.
If the allowed expenditures were primarily for
babysitting or child care, then the CPI measure for this i t e m —
which is based on movements of the minimum wage—could conceivably
be made available as a separate series. Otherwise, a wage measure
for service workers might be the most suitable alternative.
In the case of excess shelter costs, the CPI rent index would
appear to be more appropriate than the CPI shelter index.
It
is difficult to justify the inclusion of current house prices and
current mortgage rates, since changes in these prices do not affect
renters or the owners of previously purchased homes.




68

Alternatives for Indexing the Poverty Level
The choices
three types:

for indexing

the poverty

level are

broadly of

o

a general measure of consumer prices that will correct some
of the problems of the current CPI;

o

the construction of a demographically based price index
that takes into account the different purchasing patterns
and points of purchase of low-income households; or

o

new approaches to the indexing problem that modify its
practice so that indexing provisions are not isolated from
changes in real economic circumstances.

The choices within and among these categories will be affected
b y — a s stated before—the goals of indexing eligibility requirements for the Food Stamp Program, These goals may be absolute ones
that define a given cutoff level of income in terms of the ability
to purchase a certain basket of goods, or relative ones that modify
the cutoff level of income in line with changing economic circumstances as well as changing prices.
Currently the poverty level is indexed to a general consumption measure—the CPI, Because both the poverty level definition
and a general consumption price measure are used separately or in
combination in the majority of all indexed federal programs, the
issues that arise are of broader relevance than just for the Food
Stamp Program, Consequently, the indexation choices for a general
consumption index are discussed in greater detail in a separate
chapter (Chapter VII). There the major alternatives are compared
and the trade-offs of advantages and disadvantages are evaluated.




69




CHAPTER VII.

ALTERNATIVES TO THE
INDEX

CPI FOR A GENERAL

CONSUMPTION

This concluding chapter deals with the issue of choosing a
general indexation measure.
The major alternative measures are
listed and their relative advantages discussed.
In addition new
approaches to the indexing problem are suggested, and budgetary
consequences surveyed.

The Present CPI
The present CPI has some advantages as a measure for indexation. These consist primarily in the fact that it is well publicized and widely recognized, and is built up from generally welldesigned samples of price information.
Indeed, other price measures such as the PCE indexes are based largely on detailed CPI
data. It is only in recent years that the CPI's shortcomings have
become a major issue because of their increased impact on the cost
of federal transfer programs. While the distorting effect of the
CPI as a measure of price change—discussed in Chapter V — m a y
not continue at the same magnitude (or in the same direction) as in
the recent past, it nevertheless has certain liabilities as a
measure of appropriate spending levels for federal transfer programs .

Alternatives for a General Consumption Price Index
CPI X-l. This experimental measure differs from the present
CPI in employing a rental equivalence proxy for homeownership
costs. Although improvements should be made to the sample used to
collect rental data, even in its current form it dramatically
reduces the volatility and distortion stemming from the present
measure of homeownership.
In other respects, the CPI X-l retains
the benefits and shortcomings of the present CPI,
PCE Chain Index. The PCE chain index differs from the present
CPI in using a rental equivalency proxy for shelter c o s t s — a s




71

does the CPI X-l—and in its constantly updated market basket. A
chain index appears more desirable than the alternatives of a
fixed-weight PCE index or the PCE deflator—largely because of the
tendency of the former to overestimate and of the latter to underestimate the actual rise in the cost of living.
The most common objection to the use of a PCE index is that
the published numbers are subject to numerous revisions in subsequent years. This need not be an insurmountable barrier, however,
since revisions occurring more than three months after the end
of the period are normally small. Moreover, by calculating benefit
adjustments from the index level instead of from changes in the
index, these errors will not cumulate, since each year's adjustment of the index level takes into account any revision in a
previous year's data.
GNP Measures.
An alternative that would prevent rising
import prices from serving as a basis for indexation would be to
use GNP measures. Here the possibilities include the gross national
product index which covers the entire domestic economy, the gross
domestic business product index which covers just the private
sector of the economy, and the private nonfarm index which excludes
the agricultural sector. Each of these is available as a chain or
fixed-weight measure in addition to its usual implicit deflator
form.
Wage Measures.
If equity considerations make relative standards a more important goal, the most useful recourse for indexing
would be to a wage measure. 1/ The choice of a wage measure,
however, depends, as in the case of price indexation, on the
specific goal of indexation.
In order to measure changes in labor earnings, the index, as
well as adjusting for hours worked, should take into account fringe
benefits and also income taxes withheld.
It should be broadly

1/

Social Security benefits are adjusted on the basis of a general
wage index in Argentina, Austria, Bolivia, France, West Germany, The Netherlands, and Peru.
See Comparative Studies
Staff, "Adjustment of Old-Age Benefits in Foreign Programs"
Social Security Bulletin (forthcoming).




72

representative of all wages. Unfortunately, no one index has all of
these characteristics. 2/
The three measures that come closest have the following characteristics:
o

The Employment Cost Index includes fringe benefits as well
as wages, covers the private nonfarm sector, and adjusts
for overtime hours in manufacturing and for shifts in
relative unemployment in low-wage and high-wage industries.
Some would consider the inclusion of fringe benefits a
disadvantage.

o

The Average Hourly Earnings Index is similar to the Employment Cost Index except for its exclusion of fringe
benefits.

o

The Spendable Earnings series is based on weekly earnings
from which subtractions are made for estimated payroll
taxes and income taxes paid by the average worker.
Thus
it is an after-tax measure, but no adjustment is made for
shifts in the composition of employment and for overtime
hours.

Thus, a choice between the Average Hourly Earnings Index
and the Employment Cost Index revolves primarily on the question
of whether to include fringe benefits.
To choose the Spendable
Earnings series would be to sacrifice the adjustment for composition shifts and overtime in favor of obtaining a measure of changes
in after-tax or spendable earnings. The latter would allow federal
benefits to be adjusted in line with variations in take-home pay.
If payroll tax increases or income tax bracket creep caused a

2/

Some would argue that certain elements—such as fringe benefits—should not be included.
This argument is based on the
fact that the bulk of fringe benefits counted in measures of
employee compensation are employer payments of payroll taxes
for social insurance.
A rise in these taxes would, through
indexation to employee compensation, feed right into higher
federal benefits and create a need for further increases in
payroll taxes. This kind of feedback mechanism would be avoided
by using an hourly earnings measure.




73

reduction in real spendable earnings, this would be reflected in
the level of benefits.

New Indexes
Another alternative would be to create demographic-specific
price indexes that would reflect the consumption pattern of the
target population of a program such as Food Stamps.
This would
involve certain costs. Although budgetary patterns classified by
demographic characteristics are available from the 1972-1973
Consumer Expenditure Survey, appropriate information on points of
purchase and item selection does not currently exist.
Thus the
construction of suitable CPIs for the poor or the elderly would
require additional survey data. The desirability of such a survey
would depend on the cost of undertaking it, together with the
extent to which a new index would differ from the current collection of price measures.
Questions would also arise as to which
demographic groups should have their own indexes and whether, once
created, such indexes should determine benefits, even when other
indexes were higher. But such an idea is, in any case, an option
for the future, not one that is available now.

New Approaches to the Indexing Problem
Several alternatives have been set forth in the public discussion of indexing that go beyond mere substitution of another
index for the CPI. These approaches attempt to deal with the
problem of financing benefit increases that result from external
shocks such as oil price increases as well as with the issue of
fairness that arises when benefits increase faster than wages. The
first approach would put a cap on increases.
The cap could be
applied in two ways. Increases could be limited to a certain
proportion of CPI changes, say 85 percent.
It would reduce the
costs of indexation considerably, but it has the disadvantage of
being arbitrary.
Alternatively, the cap could be applied in a
discretionary way as is now done with the pay of federal workers.
Here, an automatic increase can be superseded by a different
proposal by the President, unless disapproved by the Congress. The
advantage of this is flexibility.
Prices change for different
reasons, and it may not be good economic policy to index benefits
to all price increases at all times. The other side of this coin
is uncertainty on the part of beneficiaries about the future
purchasing power of their benefits.




74

Another approach would be the switching proposal discussed in
Chapters II and III. Escalation of federal benefits according to
the rate of increase in wages or prices—whichever is lower—would
aim at making indexing practices more equitable.
Beneficiaries
would not receive greater inflation protection than wage earners.
It would also address the issue of financing rising benefit levels
at a time when declining real wages retard the growth in tax
revenues.
Choices would have to be made among the wage and price
measures discussed above. One drawback to the switching proposal
is that—to the extent that switching actually occurs—it will
cause a progressive reduction in real benefits, since the benefit
increases will never exceed price increases and will sometimes be
lower.
This could be circumvented by a catch-up mechanism that
would restore real benefits after real wages had regained their
previous level.

Budgetary Implications of Modifying Indexing Procedures
Indexing with the current CPI has led to a significant overadjustment of benefit levels. For example, the divergence between
the growth in the CPI and the PCE chain index from 1974 to the
present amounts to a difference of 13.3 percentage points. Had the
PCE index been in use during that time, federal expenditures in
1981 would be lower by some $11 billion.
Changing to another index at this time would not, however,
guarantee budget savings in the long run. It would have done so in
the short run only if implemented in time for the July 1981 adjustment of Social Security benefits. Much of the distortion in the
CPI results from the excessive weight given to interest rates. The
distortion will operate in reverse if there is a significant
decline in interest rates. This suggests that it might be better
not to make a change now, when the CPI may be near the peak of its
distortion, but to wait for some of this distortion to be reversed.
The trouble with this approach is that the timing and extent of
such a change with the CPI is highly uncertain.
The switching proposal discussed earlier would not lead
to
savings unless wages continue to advance less rapidly than prices.
A problem arises, however, when nominal wages are deflated with a
CPI that exaggerates the change in living costs. This results in
overdeflation, making real wage declines look bigger than they
actually have been. By contrast, deflation of nominal wages by the
PCE chain index shows the fall in real wages both in 1974-1975




75

and in 1979-1980 as less than half of that computed using the
official CPI. The switching proposal would, however, serve as a
sort of budgetary safety valve if the economy continued to suffer
severe setbacks that prevented real growth.
Two other approaches would offer budget savings.
The first
would be the capping of increases, either by an arbitrary formula
or through the discretionary approach that is now used with
federal pay. The second would consist of steps to reduce the
windfall benefits that are granted each year because of the cumulation of past measurement errors in the CPI. As mentioned above,
this windfall will amount to $11 billion in 1981. Removal of all
or part of this windfall would move beneficiaries to or toward the
level of benefits they would be receiving if a change to a better
index—such as the CPI X-l or the PCE chain index—had been made
back in 1975.
Execution of this second approach would be quite
simple, requiring only a one-time adjustment in benefit increases
to bring them in line with what would have been provided by a more
accurate measure. This could reduce the scheduled 1981 increase in
benefits from around 11.2 percent to about 3 percent, saving about
$16 billion in 1981 and 1982.
Thereafter, straight indexation
could be resumed, possibly with an improved index. Savings would
continue to be generated in the long run, however, because subsequent upward adjustments would be made from a lower level of
benefits.
Many modifications of this approach are, of course,
possible.




76

APPENDIXES

80-1+00

0 - 8 1 - 7







APPENDIX A.

A CATALOGUE OF INDEXED FEDERAL PROGRAMS

Tables A-l and A-2 present summary information on federal
programs containing explicit forms of indexation.
Table A-l
presents essential information on each of the indexed entitlement
programs: the type of provision being indexed, the index used, the
timing of the adjustment, the enacting legislation, estimated
outlays in fiscal year 1981, and an estimate of the current costs
of a 1 percent change in the relevant index. Table A-2 presents
the same information for nonentitlement programs containing explicit indexation provisions except that it does not include an
estimate of the costs of a 1 percent change in the relevant index.
The definition of an indexed program and its classification
as indexed or quasi-indexed is not straightforward in all cases.
For example, Aid to Families with Dependent Children (AFDC) is
a federal entitlement program that matches the funds spent by
individual states. Although states have the option of indexing the
benefit levels of this program, few have done so. Moreover, even
for those states that have adopted indexing, state funding still is
subject to an appropriation process.
Consequently, AFDC obligations at the federal level (matching state funding) are thought
to be virtually unaffected by formal indexation, and AFDC is
not included in the list of indexed programs. On the other hand,
the Federal Reserve Board Employees Retirement System is included
because, although receiving nothing from the federal government
directly, it is funded out of surpluses generated by Board activities that would otherwise be turned over to the federal government as revenues.
Still another federal expenditure—outlays for
unemployment insurance claims—increases with higher unemployment
rates and also with rising wage levels, but this program is not
included in the listing since the indexing is implicit rather than
explicit.
A total of 26 programs is included in Table
Table A - 2 . In some cases, where programs fall
enacting law or are administered by the same agency
in a similar manner, they are grouped together
purposes.

A-l, and 64 in
under the same
and are indexed
for descriptive

The information contained in these tables was gathered from
data compiled by the Office of Management and Budget, the Congressional Research Service, and individual government agencies.




79

TABLE A-l.

INDEXED FEDERAL
YEAR 1981

Name of Program

Federal Old Age
Survivors and
Disability Insurance (OASDI)
(Entitlement)

Supplemental
Security
Income
Benefits
(Entitlement)




ENTITLEMENT PROGRAMS,

OUTLAYS , AND COSTS OF INDEXATION, FISCAL

Indexed Provision
Timing of
Measure of
Adjustment
Indexation

Initial benefit level:
Computation of total
covered earnings, a
portion of which will
be the amount paid back
to the retiree in the
form of monthly Social
Security benefits, employs BLS wage index
(annual avg. changes)
& CPIW (1st. qtr. to 1st
qtr.). Benefit COL
Adjustment: Benefits
are indexed to 1st qtr.
to 1st qtr. changes in
CPIW, provided the change
is greater than 3%. b/

Annually,
effective
July 1.

Payment Standard (benefit
paid to household with no
income) indexed to COL
increases in Social Security Benefits (CPIW,
1st qtr. to 1st qtr.)

Annually,
effective
July 1.

Legal
Citation

Social
Security
Act as
amended:
Sec. 215
(a), (b),
(i), Sec.

Outlays

Costs of
Indexation a/

$140,117
billion

$1,401
billion

$7,438
billion

$50.0
million c/

230

Social
Security
Act.
Sec. 1617

(Continued)

TABLE A-l

(Continued)

Name of Program

Indexed Provision
Timing of
Measure of
Adjustment
Indexation

Civil Service
Retirement
System
(Entitlement)

Benefits indexed to CPIW.
June to December, December
to June changes.

Railroad
Retirement
Benefits
(Entitlement)

Three-tier benefit forAnnually,
mula. First tier: Initial effective
benefit level computed
July 1.
as in Social Security,
using a BLS wage index
(annual average changes)
and CPIW (1st qtr. to
1st qtr.). Benefit
COL Adjustment tied
to Social Security costof-living adjustments (CPIW,
1st qtr. to 1st qtr.).
Second tier: Benefits
indexed to 32.5% of 1st
qtr. to 1st qtr. change in
CPIW. Third tier: unindexed.

Federal Reserve Board
Employees'
Retirement f/




Benefits indexed to
CPIW. December to
June, June to December
changes.

Semiannually,
effective
March 1,
Sept. 1.

Semiannually,
effective
March 1,
Sept. 1.

Legal
Citation

Title V,
Sec. 8340
P.L. 94440
Railroad
Act of
1974, Sec.

Outlays

Costs of
Indexation a/

$17,326
billion

$173.3
million

$5,296
billion

$40.0
million d/

$4.4
million

$0,044
million

4(f)(4),
3(b)(2),
3(d), 3(.

e/

(Continued)

TABLE A-l

(Continued)

Name of frogram

Indexed Provision
Timing of
Measure of
Adjustment
Indexation

Legal
Citation

Federal Judiciary Survivors Benefits
(Entitlement)

Survivors Benefits reNot
ceive a 3% increase
applicable
for each 5% increase
in pay granted to active
judges, with a 5% threshold.

United States
Presidents
Pension
(Entitlement)

Benefits indexed to
increases in pay
granted to heads of
executive departments
(executive level 1).

Not

Veterans Pensions
(Entitlement)

Benefits indexed to COL
increases in Social SeSecurity Benefits (CPIW,
1st qtr. to 1st qtr.).

Annually,
effective
July 1.

Military Retirement Pay
(Entitlement)

Benefits indexed to CPIW.
June to December, December to June changes.

P.L.
Semiannually,
94-440
effective
March 1,
Sept.l
(legislation
proposed for
annual adjustments).




applicable

Outlays

Costs of
Indexation a/

$1.7
million

$0,017
million

Title 3,
$0,209
USC, Chap. million
2, Sec.

$0,002
million

Title 28,
USC, Sec.
371-376

102

USC 38,
Sec. 3112

$3,844
billion

$38.04
million

$13,781
billion

$137.8
million

(Continued)

TABLE A-l

(Continued)

Name of Program

Indexed Provision
Timing of
Measure of
Indexation
Adjustment

Legal
Citation

Outlays

Costs of
Indexation a/

U.S. Coast
Guard Retirement Pay
(Entitlement)

Benefits indexed
to CPIW. June to
December, December to June
changes.

Semiannually,
effective
March 1,
Sept. 1.

10 USC
1401(a)

$232
million

$2.32
million

Foreign Service Retirement and Disability Fund
(Entitlement)

Benefits indexed to
to CPIW. June to
December, December
to June changes.

Semiannually,
effective
March 1,
Sept. 1.

Foreign
Service
Act of
1946 as
amended.
22 USC
1061-1121

$174
million

$1.74
million

CIA Retirement
and Disability
System
(Entitlement)

Benefits indexed to
CPIW. June to Decembar, December
to June changes.

Semiannually,
effective
March 1,
Sept. 1.

78 Stat.
1043,
P.L. 88643, Oct.
13, 1964.
50 USC
403 as
amended.

Classified




(Continued)

TABLE A-l

(Continued)

Name of Program

Indexed Provision
Timing of
Measure of
Adjustment
Indexation

Legal
Citation

Outlays

Costs of
Indexation a/

Department of
Defense: Survivor Benefit
Plan (SBP), Retired Servicem a n ^ Family
Protection
Plan (RSFPP),
Guaranteed Minimum, Inc. (GMI)
(Entitlement)

Benefits for SBP,
RSFPP indexed to
increases in
Military Retirement Pay (CPIW,
June to December,
December to June
changes). Benefits for GMI
indexed to increases in Veterans Pensions
(CPIW, 1st qtr.
to 1st qtr.).

SBP, RSFPP:
semiannual ly,
effective
March 1,
Sept. 1.
Proposed
legislation:
annual adjustments. GMI:
annually,
effective,
July 1.

P.L.
95-397,
P.L.
92-425,
86 Stat.
706, P.L.
94-496

$322
million

$3.22
million

Federal Employee Compensation
Act (FECA)
(Entitlement)

Benefits indexed
to December to
December changes
in the CPIW.

Annual,
effective
March 1.

use

$376
million

$3.76
million




8146(a)

(Continued)

TABLE A-l

(Continued)

Name of Program

Indexed Provision
Measure of
Timing of
Indexation
Adjustment

H.H.S. Special
Benefits for
Disabled Coal
Miners (Part B)
(Entitlement)

Initial Benefit Level:
level set at Federal Employee Compensation Act
benefit levels which are
indexed to December to December changes in the CPIW.
Benefit COL Adjustment:
benefits indexed to federal salary scales, as
determined by the Federal
Pay Comparability Program.

D.O.L. Special
Benefits for
Disabled Miners
(Part C)
(Entitlement)

Initial Benefit Level:
Level set to Federal
Employee Compensation Act benefit
levels, which are
indexed to December
to December changes
in the CPIW. Benefit
COL Adjustment:
benefits indexed to
federal salary scales,




Initial pay
levels set
at indexed

(FECA)
level when
payments
begin. COL
adjustments
effective
annually,
beginning
each fiscal
year.
Initial pay
levels set
at indexed
(FECA)
level when
payments
begin. COL
adjustments
effective
annually,
beginning

Legal
Citation

Outlays

Costs of
Indexation a/

Federal
Coal Mine
Health
and Safety
Act of
1969,
amended
1972

$1,057
billion

$10.6
million

P.L. 91173 as
amended
1972

$922
million

$9.2
million

(Continued)

TABLE A-l

(Continued)

Name of Program

Child Nutrition Programs:
National School
Lunch Program
(Commodity Subsidy/cash-inlieu of commodities),
National School
Lunch Program
(Cash Subsidies)
School Breakfast
Program (Cash
Subsidies)
Summer Food
Service Program (Cash
Subsidies),
Child Care




Indexed Provision
Timing of
Measure of
Adjustment
Indexation

as determined by
the Federal Pay
Comparability
Program,

each fiscal
year.

In general, eligiblity
based on percent of
OMB poverty guidelines which are
indexed to CPIU,
annual average to
annual average
changes, updated
to reflect March
CPIU. Benefits
for each program indexed to either (1)
Nov. to May, May
to Nov. changes
in CPIU for food
away from home, or
(2) Annual change
in March-April-May
average value for

Annually
effective
July 1.

National
School Lunch
Program (Commodity
subsidy/Cashin-lieu of
commodities)
and Summer
Food Service
Program

Legal
Citation

Outlays

P.L. 95$3,790
166, P.L. billion g/
95-267,
P.L. 92433, P.L.
93-150, P.L.
95-627

Costs of
Indexation a/

$37.9
million

TABLE A-l

(Continued)

Name of Program

Indexed Provision
Measure of
Timing of
Indexation
Adjustment

USDA price index for
Food Program
(Cash Subsidies) Food Used in Schools
and Institutions
Child Care
(based on BLS
Food Prodata).
gram (Commodity
Subsidies)
(Entitlement)

Guaranteed
Student Loan
Program
(Special Allowances )
(Entitlement)

a/
~"




Special allowance assured to
lenders indexed
to average bond
equivalent
rates of 91-day
Treasury bills
auctioned for
each period.

Legal
Citation

Outlays

Costs of
Indexation a/

adjusted
annually
each July 1,
and each Jan,
1, respectively. Others
adjusted semiannual ly,
in July
and
January.
Quarterly,
effective
April 1,
July 1,
October 1,
January 1.

Sec. 438
Higher
Education
Act

$401
million

$4.0
million

"Costs" of indexation are defined as the change in annual federal outlays resulting from
an additional one percentage point increase over the year in the appropriate index,
provided that other economic and demographic conditions are at the levels assumed for
fiscal year 1981, and that all indexation threshhold criteria are met.
(Continued)

TABLE A-l (Continued)
J>/

The wage index is calculated as the average taxable wage of all employees covered by
Social Security, and is derived from BLS survey data. Changes in the index are used to
inflate an individual's past covered monthly earnings up to the year in which that individual reaches age 62. If the individual remains employed past the age of 62, the average
of the indexed monthly earnings, as well as of any covered monthly earnings earned
after age 62, is inflated up to the time at which Social Security payments begin, using
the CPIW. This results in the Average Indexed Monthly Earnings (a present-valued average
of the individual's covered lifetime earnings), a percentage of which becomes the beneficiary's monthly Social Security benefit payment. Cost-of-living adjustments are made
by inflating the Average Indexed Monthly Earnings by changes in the CPIW, to maintain its
constant dollar value.

c/

Although the payment standard (benefit paid to a household with no countable income) is
indexed to the CPIW through the Social Security Program, the actual SSI payments to any
household receiving both SSI benefits and monthly Social Security benefits in excess of
$20 will fall in real terms as a result of inflation. The erosion of real SSI benefits
under these circumstances comes about as the result of a failure to index the $20 disregard of monthly Social Security income in computing countable monthly income. Monthly
SSI benefits are exactly the amount that is necessary to bring a household's countable
monthly income up to specified (indexed) national standards. The computation of countable
monthly income involves the summation of all countable monthly income other than Social
Security payments, plus monthly Social Security payments in excess of $20. Since the
$20 disregard is unindexed, countable monthly income increases as nominal Social Security
benefits increase, even though real Social Security benefits remain the same. This causes
actual SSI benefits to fall in real terms, even though the SSI payment standard remains
constant in real terms. For this reason, the estimated "costs" of indexation for SSI
reflect a less than one-to-one increase in benefits.

dV

The first tier provides mandatory coverage for railroad 'employees, and benefits are
computed under the Social Security benefit and cost-of-living adjustment formulas. The




(Continued)

TABLE A~l (Continued)

second tier provides additional optional coverage, and benefits in this tier are indexed
to 32.5 percent of the change in the CPIW.
Under current law, tier 2 indexation will
cease in 1981, but legal changes have been proposed to allow this indexation to continue.
The third tier is unindexed. Therefore, a given change in the index produces a less than
one-for-one change in program outlays.
e/

The Federal Reserve Board generates
operating costs) for the federal
Reserve Board Employees Retirement
affect federal outlays, does affect

_fV

The Federal Reserve Board indexing policy is an administrative practice, and consequently
there is no law providing for the indexation of benefits.

g/

Although the Child Nutrition Programs receive most of their funding through appropriation,
a portion ($365 million in 1981) is funded directly through U.S. Customs receipts. The
outlay figure here represents the total funding.




net revenues from its operations (gross revenues minus
government.
Consequently, indexation of the Federal
System—one of its operating costs—while it does not
the budget through federal receipts.

TABLE A-2.

OTHER FEDERAL PROGRAMS CONTAINING INDEXATION PROVISIONS , AND OUTLAYS IN FISCAL YEAR
1981

Name of Program

Food Stamp
Program
(Appropriation)

Food Donations
Program: Elderly Feeding Pro-




Measure of
Indexation

Indexed Provision
Timing of
Adjustment

Eligibility criterion indexed to annual average
changes in the CPIU through
the use of OMB poverty
guidelines, and Sept. to
Sept. changes in various
CPIUs through indexation
of income deductions.
Standard allotment indexed to monthly changes
in the Thrifty Food Plan
through Sept. for
FY81, projecting changes
through Dec. for FY82.
Actual benefits (standard
allotment minus 30% of
net income) further indexed
to various CPIU subindexes
through computation of net
income using indexed deductions.

Eligibility criadjusted annually,
effective July 1.
Income deductions adjusted ,
annually, effective January 1.

Per meal federal reimbursement floor indexed
to CPIW for food away

Annually, effective October 1.

Legal
Citation

P.L. 95-113
Title XIII,
P.L. 96-249

Outlays

$10,954
billion

Annually, effective January 1.

P.L. 93-351
Sec. 5,42
use 3045f
—

$85
million

i •

(Continued)

TABLE A-2 (Continued)

Name of Program

Measure of
Indexation

Indexed Provision
Timing of
Adjustment

Legal
Citation

Outlays

gram (commodity
from home, Aug. to
cash subidies)
Aug. changes.
(Entitlement) a./
Special Milk
Program:
Free Milk
Program
(Entitlement)

Special Supplemental Program
for Women, Infants and Children (WIC)
(Appropriation)




Eligibility indexed to
OMB poverty guidelines
which are adjusted by
annual average changes
in CPIU, updated through
March CPIU for use in
this program.
Minimum subsidy to
schools for each portion of milk served indexed to PPI for Fresh
Processed Milk, July
to July changes.b/

Annually,
effective
July 1

Eligibility indexed to
CPIU, through OMB poverty
guidelines. OMB guidelines indexed to year
to year average change
in CPIU. Updated
to March CPIU for this
program.

Annually,
effective
July 1

P.L. 95-627

$163
million

P.L. 95-627
Sec. 3,
42 USC 1786

$862
million

Annually,
effective
September

(Continued)

TABLE A-2

(Continued)

Name of Program

Indexed Provision
Timing of
Measure of
Adjustment
Indexation

Hospital Insurance Program
(Medicare,
Part A)
(Entitlement)

Federal routine hospital
cost reimbursement limited
to not more than 112% of
annual average costs of
the HCFA market basket
of hospital goods and
services, c/

Supplemental
Medical Insurance Program
(Medicare,
Part B)
(Entitlement)

Maximum federal reimbursement for physicians1
fees is indexed to annual
average changes in the
H.H.S. Medicare Economic
Index which employs BLS

Annually,
effective
July 1

Annually,
effective
July 1.

Legal
Citation

Outlays

Social Security Act,
Sec. 1813
(a)(3)
Sec. 1813
(b)(2)

$27,625
billion

Social Security Act,
Sec. 1839
(c)(3)

$12,650
billion

Social Security Act,
Sec. 1617

$16,026
billion

average weekly hours and
local hospital cost data. d/
Federal Medicaid
Program
(Entitlement)




Persons receiving SSI

Annually,
effective
benefits are eligible for
July 1.
Medicaid. Eligibility of
a small number of SSI beneficiaries indexed to increases in SS benefits, e/
Employs both indexing
Annually,
practices described in
effective
Medicare parts A & B.
July 1.

(Continued)

TABLE A-2

(Continued)

Name of Program

Grants to
States

for
Social
Services
(Entitlement)

Community
Services
Administration
Community Action
Operations:
Local Initiative Senior
Opportunities,
State Economic Oppor-




Measure of
Indexation

Indexed Provision
Timing of
Adjustment

Legal
Citation

Outlays

Ceiling for allotments to states
indexed to CPIW,
lower of: (1) 2nd
qtr. to 2nd qtr.
change or (2) annual
FY inflation rate.
Ceiling cap of
$3.3 bll. by FY
1985. Ceiling
increased by multiples of $100,
000,000 and rounded
down to nearest
multiple.

Annually, effective at beginning
of each fiscal
year

Social
Security
Act,
Sec. 2002(e)
(2)(A), as
amended

$3,283
billion

Eligibility indexed
to annual average
changes in the
CPIU through the
CSA poverty
guidelines, f/

Not less than
once per year,
effective March/
April, or two to
three months
after calculation

P.L. 92-424
Stat. 697

$487.7
million

(Continued)

TABLE A-2

(Continued)

Name of Program

Indexed Provision
Timing of
Measure of
Adjustment
Indexation

Legal
Citation

Outlays

tunity, Community Food
and Nutrition,
Energy Conservation Services,
Youth Sports
Programs
(Appropriation)
Lower Income
Housing Assistance
(Section 8
Program)
(Appropriation)




Maximum allowable
contract rents (of
which government
pays a portion)
are adjusted by
the "fair market
rent," which is
indexed to a combination of actual
and projected
month-to-month
changes in the
rent and utilities
components of the
CPIU, for national
and/or selected areas.

Annually,
effective
in April/

May

Section 8

(2 (A,B,C))

$3.07
billion

of U.S.
Housing

Act

(Continued

TABLE A-2

(Continued)

Name of Program

Indexed Provision
Measure of
Timing of
Indexation
Adjustment

Legal
Citation

Outlays

Legal Services
(Appropriation)

Eligibility criterion
based on OMB poverty
guidelines, which are
indexed to CPIU, annual average changes,
updated to April.

Annually,
effective
June 1

43 USC
2996-8012

$317.0
million

Health Services
Administration
Community Health
Services: Comunity Health
Centers, Migrant
Health Services,
Home Health
Services
(Appropriations)

Fees charged and income
limit for free services
indexed to annual average changes in the CPIU,
through the CSA Poverty
Guidelines.

Annually, effective
March-April.

Title 42
SIC 303F,
56 603E
SIE 106A7

$372.4
million

Senior Companions
(Appropriation)

Eligibility indexed to
higher of 125% of CSA
Poverty Guidelines (CPIU,
annual average changes)
or OMB Guidelines plus
SSI state supplements.

Not less than once
per year, effective
May/June or 2 to 3
months after
calculation

Sec. 421
Sub. 4
42 USC
5061(4),
Sec. 211F
42 USC 5011

$12.8
million

Foster

Eligibility indexed to

Not less than once

Sec. 421

$48.4




(Continued)

TABLE A-2

(Continued)

Name of Program

Indexed Provision
Timing of
Measure of
Indexation
Adjustment

Legal
Citation

Outlays

Grandparents
(Appropriation)

higher of 125% of CSA
Poverty Guidelines (CPIU,
annual average changes)
or OMB Guidelines plus
SSI State Supplements.

per year, effective
May/June or 2 to 3
months after cal-.
culation

Sub. 4
42 USC
5061(4),
Sec. 211F
42 USC 5011

million

H.H.S. Low
Income Energy
Assistance
Program
(Appropriation)

Ceiling on eligibility inAnnually, effective
come levels (states may
May/June.
set lower) indexed to
higher of BLS Lower
Living Standard, which incorporates Oct. to Oct.
changes in CPIU subindexes,
and 125 % of OMB Guidelines.

P.L. 96-223
Title 3

$1.85
billion

Community Services Administration Energy
Crisis Intervention Program
(Appropriations)

Eligibility criterion indexed to annual average
changes in CPIU, through
OMB poverty guidelines.

Not less than once
per year, effective
May/June or 2 to 3
months after calculation.

P.L. 92-424

Department of
Energy Weatherization Aid
(Appropriation)

Eligibility indexed to
annual average changes in
the CPIU through the CSA
Poverty Guidelines.

No less than once
per year, effective
May/June or 2 to 3
months after cal-

P.L. 94-385
P.L. 95-619




$192.9
million

(Continued)

TABLE A-2

(Continued)

Name of Program

Indexed Provision
Timing of
Measure of
Indexation
Adjustment

Legal
Citation

Outlays

culation
Basic Education
Opportunity
Grants (Full
Grants)
(Appropriations)

The amount of grant money
for which a family is
eligible is a function
of the Family Size Offset, which is generated by the Social
Security Administration
(based on Census Poverty
Guidelines, annual
average CPIU changes)
adjusted to reflect
changes in CPI (U
some years, W others),
up to Oct.

Annually,
effective
January 1.

P.L. 93-318

$2,353
billion

Supplemental
Education
Opportunity
Grants
(Appropriation)

The amount of grant money
for which a family is
eligible is a function of
(1) the Family Size Offset,
which is based on the Census Poverty Guidelines
(annual average changes in
CPIU) adjusted to reflect
changes in the CPI (U some
years, W others) up to

Annually,
effective
January 1.

45 CFR
176.13

$370.0
million




(Continued)

TABLE A-2

(Continued)

Name of Program

Indexed Provision
Measure of
Timing of
Indexation
Adjustment

Legal
Citation

Outlays

45 CFR
175.13

$550.0
million

45 CFR
174.13

$201.0
million

Oct., or (2) alternative
accepted procedures, h./
College Work
Study
(Appropriation)

The amount of grant money
for which a family is
eligible is a function of
(1) the Family Size Offset,
which is based on the Census Poverty Guidelines
(annual average changes in
CPIU) adjusted to reflect
changes in the CPI (U some
years, W others), up to
Oct., or (2) alternative
accepted procedures, h/

Annually,
January 1

National Direct
Student Loan
Program
(Appropriation)

The amount of grant money
for which a family is
eligible is a function of
(1) the Family Size Offset,
which is based on the Census Poverty Guidelines
(annual average changes in
CPIU) adjusted to reflect
changes in the CPI (U some
years, W others), up to

Annually,
effective
January 1




(Continued)




TABLE A-2

(Continued)

Name of Program

Indexed Provision
Measure of
Timing of
Indexation
Adjustment

Legal
Citation

Outlays

Oct., or (2) alternative
accepted procedures, h/
Health Profession Scholarship
Program
(Appropriation)

Monthly Stipend indexed
to National Health Service Corps Scholarship
Program, which is indexed
to increases in federal
pay scales (Federal Pay
Comparability Act). Thus,
indexation to BLS survey
wage data is not explicit.

Annually,
effective
July 1

212

H.H.S. National
Health Service
Corps Scholarships, Indian
Health Scholarships Stipend
(Appropriation)

Monthly stipend is indexed to increases in
federal pay scales (Federal Pay Comparability
Act). Thus, indexation
to BLS survey wage data
is not explicit.

Annually,
effective
July 1

Public Health $38.0
million
Service Act
Sec. 751(g)(3)

Comprehensive Employment and
Training Programs (CETA):
Title II, Title

Eligibility is indexed to
higher of OMB Poverty
Guidelines (annual average changes, CPIU), or
70% of the BLS lower

Annually,
effective
April/May

CETA
Sec.
Sub.
Sub.

10 USC

Act
122,
1,
3,

$25.0
million

$7,194
billion

(Continued)




TABLE A-2

(Continued)

Name of Program

IV-A, Title
IV-B, Title
IV-C, Title
VI, Title

VII
(Appropriation)

Indexed Provision
Timing of
Measure of
Adjustment
Indexation

Living Standard (Oct.
to Oct. changes, CPIU
subindexes)• Wage
levels indexed to annual
average changes in
the ratio of wages
in prime sponsor areas
to national average
wages (BLS survey
data).

Legal
Citation

Outlays

1978
amendments
Annually,
effective
beginning
of fiscal
year

Funds to states are indexed to Oct. to Oct.
changes in CPIU with a
limit at a changing, but
not formally indexed
ceiling.

Annually,
effective
beginning
of fiscal
year

Head Start
(Appropriation)

Eligibility indexed to
annual average changes in
the CPIU through the OMB
Poverty Guidelines.

Annually,
effective
July 1.

Economic
Opportunity
Act, Sec. 525

$870.0
million

Follow Through
(Appropriation)

Eligibility indexed to
annual average changes in
the CPIU through the OMB
Poverty Guidelines

Annually,
effective
July 1.

Economic
Opportunity
Act, Part B,
Sec. 551

$44.0
million

Vocational Retation Program
(Appropriation)

Vocational
Rehabilitation

$956.0
million

Act

(Continued)

TABLE A-2

(Continued)

Name of Program

Indexed Provision
Measure of
Timing of
Indexation
Adjustment

Legal
Citation

Outlays

Senior Community
Service Employment and Training
Program
(Appropriation)

Eligibility indexed to
annual average changes in
the CPIU through the OMB
Poverty Guidelines

Annually,
effective
July 1.

Older
Americans
Act of 1974

$265.0
million

Price Support
Loans for Rice,
Honey, Tobacco,
Upland Cotton
(Entitlement)

Price supports for rice
indexed to target
prices. 1/ Price supports for honey and tobacco
indexed to percentage
of parity, j_/ Price supports for upland cotton
indexed to percentage of
Northern European prices,
or percentage of average
U.S. cotton prices over
3 of the last 5 years.

Annually,
effective
October 1.

Agriculture
Act of 1944,
1977,
P.L. 95-279

-$22.0
million
k/

U.S.D.A. Price
Supports for
Wool and Mohair
(Entitlement)

Support prices indexed to
percentage of parity, j /

Annually,
effective
January 1

Agriculture
Act of 1977,
P.L. 95-113

$36.2
million

Dairy Price
Support

Support price of milk is
indexed to a percentage

Semiannually,
effective

7 USC
1446C & D




y
$925.0
million
(Continued)

TABLE A-2

(Continued)

Name of Program

Indexed Provision
Timing of
Measure of
Adjustment
Indexation

Legal
Citation

Outlays

(Entitlement)

of parity. 1/

October 1,
April 1

P.L. 96-127

y

Target Price
Programs for
Wheat, Feed
Grains, Cotton,
and Rice
(Entitlement)

Payments are made to
farmers for difference
between target and market price, i/

Annually,
effective
October 1

Food and
Agricultural
Act of 1977
as amended

$0.0

U.S.D.A. Export
Suspension
Protection
(Entitlement)

Loan rate, for any commodity for which suspension of export sales
due to short domestic
supply is in effect, is
indexed to 90% of
parity, as determined
on the day suspension is
initiated. There are no
adjustment provisions
once the loan rate is
set. j /

Not applicable

1977 Form Act
Title X,
Sec. 1002A

$0.0

Bureau of Indian
Affairs—Navajo

Authorization indexed to
qtr. to qtr. changes in

Not applicable




43 USC
61500/84

y

y

$495.0
million

(Continued)




TABLE A-2

(Continued)

Name of Program

Indexed Provision
Timing of
Measure of
Adjustment
Indexation

Indian Irrigation Project
(Appropriation)

engineering cost indexes
applicable to types of
construction involved.

Territorial and
International
Affairs Grants
to the Government of the Commonwealth of the
Northern Mariana
Islands
(Appropriation)

Basic annual grant amount
indexed to GNP implicit
price deflator, 3rd qtr.
to 3rd qtr. changes.

Territorial and
International
Affairs-Guam
and Virgin
Islands Construction
Projects
(Appropriation)
Department of
Interior Water
and Power Resources Ser-

Legal
Citation

Outlays

Stat. 867

(authorization)

Annually, effective beginning
the following
fiscal year

48 USC
168 V90
Stat. 273

$24.0
million
(authorization)

Authorization indexed to
qtr. to qtr. changes in
engineering cost indexes
applicable to types of
construction involved.

Not applicable

P.L. 95-348

$32.0
million
(obligations)

Project appropriation
authorization ceiling
levels indexed to qtr.
to qtr. changes in

Not applicable

Each authorization is
indexed in
separate laws

$590.0
million
(Budget
Authority)
(Continued)

TABLE A-2

(Continued)

Name of Program

Indexed Provision
Measure of
Timing of
Adjustment
Indexation

vice Construction Program
(Appropriation)

engineering cost indexes
appropriate to projects.

State Department
Overseas Station
Allowances for
Civilian
Employees
(Appropriation)

Allowances computed through
HA (Housing Allowances),
COLA (Cost-of-Living
Allowances) data gathered
by overseas commands and
the State Dept. Index
ratios between foreign
and domestic prices
give percentage which
is applied to employee's
basic pay to yield allowance.

Department of
Defense Overseas
Station Allowfor Uniformed
Servicemen
(Appropriation)

Allowances computed through
HA (Housing Allowances),
COLA (Cost-of-Living
Allowances) data gathered
by overseas commands and
the State Dept. Index
ratios between foreign
and domestic prices
give percentage that




Annually, at different times for
different countries, effective
3 months after
price survey completed. Adjustments
for exchange rate
changes made every
two weeks.

Annually, at
different
times for different
countries, effective
3 months after price
survey completed.
Adjustments for exchange rate changes
made periodically.

Legal
Citation

37 USC
405

37 USC
405

Outlays

$11.0
million
(obligations)

$486.0
million

(Continued)

TABLE A-2

(Continued)

Name of Program

Indexed Provision
Measure of
Indexation

Timing of
Adjustment

Legal
Citation

Outlays

is applied to employee's
basic pay to yield allowance.
Office of Personnel and Management Living
Allowance Program for Alaska, Hawaii,
Puerto Rico,
Virgin Islands
and Guam
(Appropriation)

Additional allowances are
equal to employees basic
pay multiplied by the
ratio of living costs in
the appropriate area to
living costs in Washington, D.C., less basic
pay. Living costs are
determined in yearly
surveys performed in
conjunction with BLS.

Annually; costSec. 59-41
of living data
Title
collected in
Susc.
September for
Alaska and Hawaii
in February for
Puerto Rico, and
in May for Guam.
Data for D.C. collected at all four
periods• Adjustment
becomes effective
3 months after data
survey.

Military Barrack & Officers
Quarters Construction Authorizations
(Appropriation)

Authorizations for projects
indexed to area construction cost index, with discretion.

Not applicable




Each authorization is indexed in
separate
laws

$120.0
million

$227.6
million

(Continued)

TABLE A-2

(Continued)

Name of Program

Indexed Provision
Measure of
Indexation

Timing of
Adjustment

Legal
Citation

Outlays

Federal Pay
Comparability
Program (Genneral Schedule)
(Appropriations)

Federal civilian GS wage
levels indexed, subject
to discretionary approval,
to BLS wage survey data
of private sector (annual
average changes).

Annually,
effective
beginning
of fiscal
year.

5 USC
5305-5308

$38.97
billion

Federal Pay
Comparability
Program
(Blue Collar)
(Appropriation)

Federal civilian
blue-collar wage
levels indexed
subject to discretionary approval to BLS
area wage survey data for like
employment
in the private
sector •

Annually,
effective
at different times
for different areas.

5 USC.

53

$10,368
million

Regular Military
Compensation
(Appropriation)

Compensation levels indexed to federal civilian base salary increases which are determined under the Federal
Pay Comparability Program.

Annually,
effective
beginning of
fiscal year.

37 USC 203
P.L. 90-207

$33,588
billion




(Continued)

TABLE A-2

(Continued)

a/

Although this is an appropriation program at the state level, federal reimbursement of
the states is an entitlement.
Therefore, for purposes of this paper, the program is
considered an entitlement.

_b/
~~

In schools with no other federal nutrition programs, the floor on federal reimbursement
for paid milk is indexed, but this describes only a small number of cases, and has not
been treated as a separate indexed program in this paper.

c/

The value of the HCFA market basket used in the calculation of maximum routine hospital
cost reimbursement rates represents forecasted levels based on historical data through the
end of the most recent calendar year.

d/

The Medicare Economic Index reflects wage data with a one-year lag.

e/

Beneficiaries who are receiving both SSI and SS, and who lose SSI eligibility due to
increasing SS benefits, cannot by law lose Medicaid eligibility—hence, for those beneficiaries, the eligibility criterion for Medicaid is indexed to Social Security benefits.

f/

The CSA poverty guidelines are equivalent to the OMB guidelines, except that there is
occasionally a shorter lag period between the collection of price data and its incorporation into the CSA poverty guidelines.

g/
~~

Budget authority for the Community Services Administration's Energy Crisis Intervention
Program beginning in FY81 rests with the Health and Human Services Low Income Energy
Assistance Program.
CSA will continue to operate the program, but its funding will come
through the funding of the HHS program.

h./

The income eligibility formula described above is the Basic Grants formula. Under current
law, institutions are given an option as to the formula used to determine program eligibility, provided that the chosen formula is either the Basic Grants formula or generates




(Continued)

TABLE A-2

(Continued)

income eligibility figures within $50.00 of the BLS Lower Income Standard in at least 75
percent of the sample cases. Pending legislation will require a more consistent procedure, since the Basic Grants formula itself, were it at present to be subjected to the
same test, would not qualify.
1/

Target prices are adjusted annually to reflect changes in variable, machinery, and farm
overhead costs for each crop. An amendment to the 1977 act allows additional adjustments
to be made for wheat and corn to reflect changes in "short term costs" as determined by
the USDA, those costs which producers must meet to stay in business from one year to the
next.
Disaster payments for these commodities are also indexed to the target price.

j/
~~

The present method of computing parity prices for farm commodities is defined in the
Agricultural Adjustment Act of 1938, as amended by the Agricultural Acts of 1948, 1949,
1954, and 1956. The parity price for any agricultural commodity is determined by multiplying the commodity's adjusted base price by the current Index of Prices Paid by Farmers
(commonly known as the parity index). A commodity's adjusted base price is determined by
dividing the most recent 10-year average price received for the commodity by the most
recent 10-year average of the Index of Prices Received by Farmers. The Index of Prices
Received is a measure of changes in the average price level of all agricultural commodities that farmers sell.

k./

Outlay estimates for the agricultural commodity programs are subject to a wide margin of
error.




APPENDIX B.

ESTIMATED
CHANGES
IN INCOME
SELECTED BENEFIT PROGRAMS

FOR

RECIPIENTS

OF

This appendix examines the income changes that have occurred
between fiscal years 1976 and 1980 for three groups whose benefits
are subject to differing degrees of indexation. The groups chosen
for examination are the recipients of (1) Aid to Families With
Dependent Children (AFDC); (2) Supplemental Security Income (SSI);
and (3) Social Security and Railroad Retirement (SS/RR) benefits.
Indexation provisions for these groups vary considerably.
For example, AFDC benefit levels are set by the states, which
generally do not index them. In most states, adjustments to benefit levels are made on an irregular and ad hoc basis. There is no
federal requirement for automatic indexation of any portion of
AFDC benefits, and few states have enacted automatic cost-ofliving increases.
The SSI program is a partially indexed transfer program.
Basic income guarantee levels are set by the federal government,
and these basic SSI levels are adjusted annually for changes in
the CPI.
Most states, however, supplement the federal SSI
guarantee
for
some
or
all
of
the
recipients
in
their
jurisdictions.
States that pay supplements are required to pass
through the federal cost-of-living adjustments, but there is no
requirement that state supplementary benefit levels be similarly

1.

Only California, Hawaii, and Massachusetts have introduced
explicit indexation into their benefit formulas, and these
provisions have been intermittently suspended during recent
periods of high inflation.
See Vee Burke, "State AFDC
Benefit Levels and Inflation:
Law and Recent History,11
Congressional Research Service (February 1979; processed).

109
80-400

0 - 8 1 - 9




indexed.
Since few states index
benefits are only partially indexed.

the

supplements,

the

total

The SS/RR program is fully indexed.
Initial benefit levels
are based on preretirement earnings, adjusted annually thereafter
for changes in the CPI.^
In this appendix, the discussion assumes that changes in
purchasing power or real income are measured by adjusting nominal
income for changes in the Consumer Price Index (CPl) because this
is current practice. As the text has indicated, the CPI may not
be the best index to use for this purpose.
If an alternative

2.

All states except Texas pay some SSI supplement, but not all
recipients of federal SSI benefits within a state receive the
supplement. In June 1980, 46 percent of federal SSI recipients were receiving state supplements. Over the period from
1976 to 1980, maximum supplementary benefits in 26 states
kept pace with the rate of increase in the federal SSI
benefit level.
They increased at a rate below the rate of
increase in the federal SSI benefit in 12 of the states that
paid state supplements over the whole period and increased at
a rate above that for the federal payments in 5 of these
states.
Three states plus the District of Columbia introduced state supplements during this period. Data for three
states are unavailable.
The cross-state average of maximum
federal plus optional state-supplement SSI benefit levels
rose over the five-year period 1974 to 1979 at the same rate
as the indexed federal benefit.
However, the average of
maximum benefit levels masks considerable diversity across
the states as well as among recipients within each state.

3.

All of the Social Security benefit is automatically adjusted
for changes in the CPI. Tier I of the railroad retirement
benefit is automatically adjusted, but Tier II is not. The
data do not permit separation of RR beneficiaries from SS
beneficiaries. Because railroad retirement beneficiaries are
a small proportion of SS/RR recipients, there is little
inaccuracy in treating SS/RR as a fully indexed program. See
Handbook of Public Income Transfer Programs: 1975, Paper No.
20, Studies in Public Welfare, Subcommittee on Fiscal Policy
Joint Economic Committee, U.S. Congress (December 31, 1974),
pp. 42-50.




110

measure such as the Personal Consumption Expenditure (PCE) index
were used, measured cost-of-living increases over the period from
1976 to 1980 would be smaller, resulting in larger increases or
smaller decreases in real income than are obtained using the CPI.
Over the period from 1976 to 1980, the real value of maximum
AFDC benefits for a family of four fell by about 19 percent, on
average across states. Maximum SSI and SS/RR benefits maintained
almost constant value, on average. In this appendix, changes in
the total income of these target population families are examined
in order to determine how these transfer program effects have been
offset by changes in other family income sources.
Because of
limitations in the data available for this purpose, however, the
income differences reported are partly the result of changes in
the composition of the target populations sampled rather than
solely of income changes for a fixed group of families.
This appendix consists of three sections: a summary, estimates of changes in income, and a description of the method used
to estimate income changes for the target groups.
SUMMARY
The information presented in this appendix must be viewed as
preliminary. The data used to prepare these tabulations are based
on CBO projections for fiscal year 1980, and on CBO imputations of
transfer income for fiscal years 1976 and 1980. Although great
care has been taken in the development of these data bases,
accuracy in projections is difficult, if not impossible, to
ensure. The 1980 data base, in particular, must be viewed with
caution. However, the following observations may be made:
o

Despite a decline in the real value of maximum benefits
under the AFDC program (an unindexed program), it appears
that female-headed AFDC families were able to maintain
average real total income levels by a substantial increase
in family earnings.
Most of this increase in family
earnings occurred within the AFDC filing unit.
This
population was one of the poorest in relative terms in
1976 and, despite
its success
at maintaining
real
purchasing power, remained one of the poorest in 1980.
Only SSI-unrelated individuals were poorer among the
populations examined here.




Ill




o

Despite the real income protection afforded SSI benefits,
multiperson SSI families experienced a decline of 24
percent in purchasing power from 1976 to 1980, due largely
to a reduction in their family earnings.
By contrast,
unrelated individuals receiving SSI payments experienced
an increase of 10 percent in real purchasing power—due
largely to a substantial increase in Social Security
receipts—but despite this increase they were still the
poorest of the groups examined.

o

Although SS/RR benefit levels kept pace with inflation—
with only a small lag—from 1976 to 1980, this population
experienced a 7 or 8 percent decline in purchasing power
over the period.
This is because their earnings and
private unearned family income failed to keep pace with
inflation.

Despite the decline in average real purchasing power
described above for several of the target populations,
none of them experienced an increase in the incidence of
poverty over the period from 1976 to 1980, when food
stamps are included in the income measure.
When food
stamps are not included in the measure of income, the SSI
population
(both families and unrelated
individuals)
experienced a small increase in poverty incidence.

o

The food stamp program acts as a partial offset to money
income changes resulting from the combined effects of cash
transfer programs and other family income sources. Gains
in money
income that would otherwise increase real
purchasing
power
and
reduce
poverty
incidence
are
partially neutralized by food stamp benefit reductions.
On the other hand, money income changes that would
otherwise be insufficient to maintain real purchasing
power or to meet increased family needs are supplemented
by the food stamp program. Thus, food stamp benefits are
inversely related to the recipient unit's money income.
This is because the bonus value of food stamps to which a
recipient unit is entitled is equal to the value of the
unit's food stamp guarantee less a portion of its income.

112

ESTIMATES OF CHANGES IN MEAN INCOME
Few of the population groups examined here maintained their
real income over the period from 1976 to 1980 (see Table B-l).
For the total population of multiperson families, average money
income as well as money income plus food stamps increased by
nearly 29 percent over this period, while the CPI increased 35
percent.
Among
the
transfer
target
populations,
only
female-headed AFDC families had average income gains equal to or
greater
than
the
CPI.
Male-headed
AFDC
families
(the
unemployed-parent component of AFDC), SSI families, and SS/RR
families lost ground in real-income terms.
The figures also
indicate, however, that it is earnings, rather than changes in
transfer payments made to each target group, that largely account
for the total income changes.
Further, because average family
size declined over the period from 1976 to 1980, a decline in real
income did not necessarily translate into a decline in living
standard.
Real income for the total population of unrelated individuals
increased from 1976 to 1980, although this is more likely to have
reflected a change in the composition of the population of
unrelated individuals than a widespread increase in real income
for particular individuals.
The average value of their money
incomes (and of their money incomes plus food stamps) increased by
46 percent from 1976 to 1980, exceeding the increase in the CPI
over the period. Because a larger proportion of the population is
choosing now to live alone, especially among the relatively
affluent, the average change in income reported in Table B-l for
unrelated individuals may overstate the change experienced by
particular individuals.
AFDC Families.
Few states have indexed their AFDC benefit
schedules, and periodic ad hoc adjustments have generally failed
to keep pace with the CPI. Program data from the Department of
Health and Human Services for the latter half of the 1970s show a
10 percent reduction in the real value of AFDC maximum benefit
levels for a family of four, averaged across all states.
This

4.

See "Transfer Recipients and the Poor During the 1970ls,ff by
Richard Kasten and John Todd (October 1980), p. 10, giving
weighted average data for 1975 and 1979.




113

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198

ion S
report
Ctl

1976

result is consistent with those shown in Table B-l, which imply a
16 percent reduction in average real benefits paid to AFDC
families over a nearly comparable period.
Real benefits paid
would decline more than real maximum benefits for two reasons:
(1) the decline in average filing unit size (from 3.15 to 3.03);
and (2) the increase in earnings by AFDC filing units that
occurred over the period.
Both before and after food stamps were included in the income
measure, female-headed AFDC families maintained their real incomes
from 1976 to 1980 and gained slightly relative to the income of
the total population—but
only because
of the
substantial
increases in their earnings.-*
The nominal value of food stamps
for AFDC families declined slightly over the period; this occurred
because the value of (and eligibility for) food stamps is reduced
as other family income rises.
The gain in relative welfare was larger than the relative
income gains, because AFDC family size fell relative to that in
the total population.
The combined effects of real income
increases together with family size reductions are evident in the
welfare ratios presented in Table B-2. The mean welfare ratio for
female-headed AFDC families rose from 1.1 in 1976 to 1.2 in 1980,
when money income alone is counted. When the value of food stamps
is included in the income measure, the welfare ratio for
female-headed AFDC families rose from 1.2 in 1976 to 1.3 in 1980.

5.

AFDC program data show a smaller increase in earnings over a
nearly
comparable
period,
and
a smaller proportion of
recipient units with earnings, than the data used here. This
difference occurs, at least in part, because the program data
contain earnings information only for those months during the
year in which the family unit was receiving AFDC, ignoring the
probably larger earnings received during the remainder of the
year.

6.

"Welfare11 is measured by welfare ratios, which are calculated
as the ratio of total family income to the poverty-line income
appropriate for each given family. A value greater than one
indicates that income exceeds the poverty line for that
family.




116

TABLE B-2.

RELATIVE INCOME CHANGES FOR
FISCAL YEARS 1976 AND 1980

THE

AFDC

POPULATION,

Female-headed
AFDC Families
1976
1980

All AFDC
Families
1976
1980

0.54
0.59

0.60
0.63

0.41
0.44

0.38
0.41

1.17

1.14

1.18

1.10

1.09
1.22

1.20
1.29

1.34
1.44

1.27
1.35

Ratio for Recipient to
Total Population of
Average Income
Excluding food stamps
Including food stamps
Ratio for Recipient
to Total Population
of Average Family Size
Average Welfare Ratio
Excluding food stamps
Including food stamt>s
Percent with Income
Below the Poverty Line
Excluding food stamps
Including food stamps

SOURCE:
NOTE:

64.0
47 .0

51 .0

52 .0

44.0

40.0

46 .0
40 .0

Special tabulation from CBO tapes.

All income values are for the family unit,
include people other than program recipients.

which

may

The incidence of poverty among AFDC families fell slightly
from 1976 to 1980, although it remained high. When money income
alone is considered, the incidence of poverty among these families
fell from 64 percent to 51 percent. When both money income and
the value of food stamps are considered, the incidence of poverty
fell from 47 percent in 1976 to 44 percent in 1980.




117

In short, although female-headed AFDC families experienced
some relative income gains over the period examined here, their
relative living standard remained very low. Further, what gains
these families made were due to increases in earnings that more
than offset the decline in real AFDC benefit levels that occurred
over the period.
Not all AFDC families fared as well as those headed by
women.
Earnings increases for male-headed AFDC families (which
were about 18 percent of all AFDC families in 1980) were not large
enough to maintain real income levels in the face of inflation and
a decline in the real value of maximum AFDC benefit levels.
AFDC recipients in particular states may have
ably worse (or better) than these nationwide
indicate. Further, these findings depend heavily
of the imputations and projections used by CBO in
of the data bases.

fared consideraverage figures
on the accuracy
the preparation

The SSI Population.
SSI families experienced a loss of 24
percent in purchasing power between 1976 and 1980 (see Table
B-l). Although the SSI population of families started at a higher
level of income in 1976 than the AFDC population—relative both to
the general population and to the poverty line—they did not make
comparable gains.
The mean income of SSI families increased by
less than 3 percent over the period, while the CPI rose by 35
percent.
Again, the change in real income for SSI multiperson families
that occurred between 1976 and 1980 was due largely to the effects
of changes in earnings.
On average, SSI maximum benefit levels
kept pace (with a lag) with the CPI over the years from 1976 to
1980.
Average benefits paid out to recipients in multiperson
families actually increased by more than the CPI.
The major
reason for this is the increasing number of SSI recipients
classified as living in their own household and, hence, not
subject to the reduction in benefit applicable to those living in
others f households.

7.

The percent of SSI recipients living in others1 households (by
the SSI program definition) has fallen in recent years from
9.2 percent at the end of 1977 to 8.2 at the end of 1978, 7.1
percent at the end of 1979, and 6.5 percent in early 1980.
This information was obtained from the Office of Research and
Statistics, Social Security Administration.




118

Despite this increase in SSI benefits, total income (including or excluding food stamps) increased very little—because of a
large drop in earnings—so real incomes fell sharply.
Although
the size of SSI families declined a little from 1976 to 1980, the
larger decline in real income from 1976 to 1980 caused a drop in
the mean welfare ratio and a small increase in the incidence of
poverty for this population (see Table B-3).

TABLE B-3.

RELATIVE INCOME CHANGES FOR THE SSI POPULATION, FISCAL
YEARS 1976 AND 1980

Multiperson
SSI Families
1976
1980

Unrelated SSI
Individuals
1976
1980

0.66
0.67

0.53
0.53

0.41
0.42

0.42
0.43

1.04

0.98

1.00

1.00

2.43
2.46

1.94
1.98

1.11
1.14

1.21
1.25

Ratio for Recipient
to Total Population
of Average Income
Excluding food stamps
Including food stamps
Ratio for Recipient,
to Total Population
of Average Family Size
Average Welfare Ratio
Excluding food stamps
Including food stamps
Percent with Income
Below the Poverty Line
Excluding food stamps
Including food stamps

SOURCE:
NOTE:

18 .0
14 .0

19 .0
14 .0

52 .0
50 .0

54 .0
50 .0

Special tabulation from CBO tapes.

All income values are for the family unit, which may include people other than program recipients.




119

SSI
recipients
who
are
unrelated
individuals
are
substantially poorer than those living in families, but their
relative position improved slightly over the 1976 to 1980 period.
SSI families have a relatively low incidence of poverty (14
percent), whereas unrelated individuals have a high incidence (50
percent).
Here, the principal sources of family income are SSI
and SS/RR benefits. Average SSI payments increased by less than
the CPI, but this is apparently the result of the large increase
in the average value of SS/RR payments received by these
individuals. (After a small exclusion, SSI benefits are cut back
dollar-for-dollar with Social Security receipts.)
The large
increase in SS/RR receipts for the SSI population between 1976 and
1980 was itself probably the result of two factors:
(1) greater
eligibility among the SSI population for Social Security benefits;
and (2) higher Social Security benefits for those eligible because
of the more favorable earnings history of more recent retirees.
The net result of changes in SSI and SS/RR receipts for unrelated individuals in the SSI population was a gain in real income
and a small gain relative to the total population of unrelated
individuals (see Table B-3). Average nominal income increased by
49 percent between 1976 and 1980. The mean value of the welfare
ratio for this population increased slightly—from 1.1 to 1 . 2 —
and, when food stamps are included in the income measure, the
incidence of poverty remained constant. When only money income is
counted, however, the incidence of poverty increased slightly,
from 52 to 54 percent.
Once again, SSI recipients in particular states may have
fared worse (or better) than these nationwide average figures
indicate.
The SS/RR Pojmlation. In terms of the level of their income,
the Social Security population is in the best position of the
three target groups examined here, but their real incomes declined
between 1976 and 1980. While the CPI rose 35 percent over this
period, the incomes of families receiving SS/RR payments rose 25
percent; the incomes of unrelated individuals receiving SS/RR
payments rose 24 percent (see Table B-l).
This decline in purchasing power was not the result of the
failure of SS/RR benefit levels to increase in step with the CPI.
Since SS/RR benefits are essentially fully indexed to the CPI,
changes in benefits closely approximated changes in the CPI over




120

the period from 1976 to 1980. Small differences may have occurred
for a number of reasons:
(1) benefit levels are adjusted to the
CPI with a lag; (2) from 1972 to 1979, new Social Security
recipients were overcompensated for historical changes in the CPI
because of an error in the formula initially used for indexation;
and (3) earnings of those receiving SS/RR benefits may change
slowly over the years, thus changing average benefit levels.
SS/RR recipients lost ground relative to the average income
of the total population because of a real decline in average
earnings and private unearned income sources.
This decline was
not offset by reductions in family size, so that the average
welfare ratio fell between 1976 and 1980 both for families and for
unrelated individuals in the SS/RR population (see Table B-4).
Despite the fall in the average welfare ratio, the incidence
of poverty for the SS/RR population also declined between 1976 and
1980.
When only money income is considered, poverty incidence
fell from 5 to 3 percent for multiperson families, and from 20 to
14 percent for unrelated individuals. With food stamps included
in income, poverty incidence fell from 4 to 2 percent for families, and from 19 to 12 percent for unrelated individuals.
ESTIMATION METHOD
Income changes for a given target population may be examined
in several ways. One way is to focus only on the maximum benefits
guaranteed to the target population, ignoring changes in other
components of their total income.
If interest were limited to
this, summary findings would be easy to come by. For example, the
real value of maximum AFDC benefit levels for a family of four
fell by about 19 percent, on average, across states. In contrast,
maximum SSI benefits maintained almost constant real value. This
is because, on average across states, the maximum optional state
supplement to SSI rose at approximately the same rate as the
federal SSI benefit, which is fully indexed to the CPI. The same
is true of SS/RR benefits, which are fully indexed to the CPI
(with a short lag). On the other hand, considerable variation
across states is masked by this summary information.
In some
states (mostly in the West), AFDC benefit schedules have kept pace
with inflation.
In many states, SSI state supplement schedules
have not.




121

TABLE B-4.

RELATIVE INCOME CHANGES FOR THE
FISCAL YEARS 1976 AND 1980

Multiperson
SS/RR Families
1976
1980

SS/RR

POPULATION,

Unrelated SS/RR
Individuals
1976
1980

Ratio for Recipient
to Total Population
of Average Income
Excluding food stamps
Including food stamps
Ratio for Recipient
to Total Population
of Average Family Size

0.81
0.81

0.79
0.79

0.91
0.91

0.77
0.77

0.70

0.71

1.00

1.00

4.03
4.04

3.71
3.72

2.47
2.48

2.27
2.28

5.0
4.0

3.0
2.0

Average Welfare Ratio
Excluding food stamps
Including food stamps
Percent with Income
Below the Poverty Line
Excluding food stamps
Including food stamps

SOURCE:
NOTE:




20.0
19.0

14.0
12.0

Special tabulation from CBO tapes.

All income values are for the family unit,
include people other than program recipients.

122

which

may

In this appendix, changes in the total income of target population families have been examined in order to determine whether
transfer program effects are offset by other income sources. To
accomplish this purpose, the ideal data source would be a repeat
survey (1976 and 1980) of the same target population families.
That kind of data is not available. Instead, the data used here
are from the annual Current Population Surveys (CPS).°
Because
the families sampled in the CPS change from year to year, this
means that the income differences observed from 1976 to 1980 are
partly the result of changes in the composition of the target
populations sampled, rather than solely of income changes for a
fixed group of families.

8.

The March 1975 CPS was aged to represent fiscal year 1976.
The March 1978 CPS was aged to represent fiscal year 1980; in
addition, income imputations were made to account for underreporting. For a description of the procedures see: Congressional Budget Office, Poverty Status of Families under Alternative Definitions of Income (June 1977); Analysis of Current
Income Maintenance Programs and Budget Alternatives, Fiscal
Year 1976, 1978, and 19&2: Technical Documentation and Basic"
Output, Mathematica Policy Research (March 1977); and Pat
Doyle, David Edson, Norma Pappas, and William Boulding, Creation of 1980 andv 1984 Data Bases from the March 1978 Current
Population Survey, Volume I, Mathematica Policy Research
(February 19, 1980).




O

123


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102