About 30 million recipients of US Social Security benefits did not receive any increase in benefits for 2010 to adjust for cost of living (COLA) increase. Based on the Consumer Price Index for urban wage earners and clerical workers (CPI-W), there was no increase in the cost of living from the third quarter of 2008 to the third quarter of 2009. In fact, the reference price index had fallen over the period due to the economic recession.

The Consumer Price Index (CPI) is a monthly measurement of retail price changes. It reports on the price changes of 80,000 items that represent a cross-section of goods and services purchased by urban households. The index is supposed to measure how price changes affect the purchasing power of income. When the index rises, the dollar buys less of the representative basket of goods and services included in the index.

Because the index is intended to measure economy-wide price levels, it is used for:

• Preserving the purchasing power of government benefits (such as Social Security benefits and food stamps), union worker wages and pensions through automatic adjustments of the money payments. These are the so-called COLA adjustments.

• Adjusting income tax brackets to prevent taxpayers from paying higher tax rates based on their nominal income rather than their real income. This is the so-called “bracket creep” issue.

• Deflating economic indicators such as GDP and retail sales that are measured in nominal terms to separate real changes from nominal changes in price levels. The CPI is sometimes referred to as the price deflator in this context.

• Formulating monetary and fiscal policies to prevent the economy from overheating. A high CPI may indicate the need for higher interest rates and tighter government budget.

But constructing an accurate consumer price index is by no means easy. To make the index meaningful over time, the representative basket of goods and services and the weights given to each category of expenditures must be fixed for a period of time. Indeed, the base basket changes only once every 10 years. But due to consumption substitution away from more expensive items, the actual weights change over time. New goods and services appear and the quality of goods improves, among other things. Needs and tastes also change over time.

It is therefore not surprising that the 1996 Boskin Commission found systemic overstating of the CPI index. Since then, the Bureau of Labor Statistics has introduced changes that cumulatively have reduced the CPI by 7/10s of a percentage point (Barron’s). This downward adjustment has serious implications for the government budget. For example, according to the Congressional Budget Office, the impact of a one percent point downward adjustment in the CPI over seven years from 1996 would see tax revenues increase by $98 billion; Social Security save $102 billion; other spending drop $43 billion; and debt service decrease $39 billion. The net result would be a $281 billion reduction in the national deficit! (BNET)