Wednesday, March 27, 2013

Indexation Perils

Copyright, The New York Times Company

Indexing fiscal policy parameters to consumer price inflation was a nice improvement in the 1970s when both price and wage inflation took off, but the American economy is different now and may require different index approaches.

Economic policy often involves setting benefit amounts or thresholds for program eligibility or for new tax brackets. A few examples are the federal poverty line of $23,550 (for a family of four), the maximum food-stamp benefit of $668 a month and a $113,700 cap on income subject to taxation for Social Security.

Ideally, policy parameters are chosen to balance costs and benefits. The $110,100 threshold might have been pretty sensible for 2012, but we doubt that a $110,100 threshold would be equally sensible in 2017 or 2022. If nothing else, the existence of inflation means that a dollar will not have the same economic value in the future as it does now.

Costs and benefits could be re-evaluated every year, but it is sometimes easier to set a formula for automatic updating — guessing, in effect, how the optimal policy will change over time. Many fiscal policy parameters are now indexed to consumer price inflation, based on the assumption that they should remain in a fairly fixed ratio to consumer prices.

The income tax code was not always indexed, and the rapid inflation of the 1970s awakened many Americans to “bracket creep,” as inflation raised the dollar earnings of the poor and middle class and put them in tax brackets originally meant for higher-income taxpayers, without necessarily giving them any additional purchasing power.

However, many costs and benefits of fiscal policy, especially those related to incomes and jobs, depend on wages rather than consumer prices and arguably fiscal policy parameters should be indexed to wages rather than consumer prices. A few policy parameters are indexed to wages, such as parts of the benefit formulas for Social Security and unemployment insurance, but consumer price indexation is more common.

If wages and consumer prices always moved together, the distinction would be largely academic. But in reality, wages change differently than consumer prices do. There is a tendency for wages to increase more than consumer prices over long periods of time, thanks to labor productivity gains.

Indexing can play a role in political debates, as the parties that believe that a policy parameter is too low might want it indexed to wages rather than consumer prices in order that it increase more over time (for the same reason, they might want it indexed to the average wage rather than the median wage, because average wages have tended to increase more than median wages have). Parties on the other side might push for consumer price indexation, or no indexation at all.

For example, if you think that the poverty line is too high, you are glad that the line is not indexed to wage inflation and might wish that it were not indexed at all, so that more of the population might creep out of the poverty category.

But in these times, we may see political parties switching sides on the indexing question, because a number of forces may cause wages to increase less than consumer prices, if at all.

Rising health insurance costs tend to reduce cash wages or cause them to grow less than consumer prices, as employers cannot compete well when they are paying more in cash wages and more for employee health insurance. I noted in an earlier post that the least-skilled workers are seeing their wages fall over time, largely because they are out of work and failing to acquire the skills that come with working.

Employers are also facing new health care regulations expected to reduce cash wages as many employers of low-skill workers are hit with per-employee fines of about $3,000 per employee per year. Were a federal sales tax, such as the value-added tax used in many European countries, to be created, consumer prices would increase significantly more than wages do.

While we can be thankful we are not now experiencing the high inflation rates of the 1970s that urgently introduced inflation indexing into fiscal policies, we may want to reconsider policy thresholds and how they relate to the labor market fundamentals.

1 comment:

Mel M said...

The Huffington Post recently commented that when the costs of hiring a worker go up, employers typically act by reducing wages rather than passing on costs to consumers. Is that a commonly understood economic principle? If you've written on it, I'd be grateful for the link. Thanks!