BUSINESS
11/09/2012 07:06 pm ET

'Chained CPI' May Be Key In Avoiding Fiscal Cliff

As people in Washington resume their pursuit of freaking out the populace with threats to plunge over the "fiscal cliff" -– the package of spending cuts and tax increases that takes effect in January if the White House and Congress can't work out something more palatable -– the key to a deal may lie in an arcane thing known as chained CPI.

CPI stands for consumer price index -- an inflation benchmark used for cost-of-living adjustments in many government programs, including Social Security and Medicare. Chained CPI is a slightly different way to calculate inflation. If the government used chained CPI as the inflation benchmark, it would reduce what the government spends on enormous programs like Medicare and Social Security, while boosting tax revenues that land in federal coffers.

Former White House chief of staff William Daley said he thinks a preliminary agreement to use chained CPI could be a starting point in negotiations between Republicans and Democrats, according to Bloomberg. Daley was involved in the 2011 negotiations between President Barack Obama and House Speaker John Boehner and said chained CPI was an element both sides okayed.

“It’s logical that that’s where you’d go back to, the points where there was either agreement or close to an agreement and try to begin there,” Daley said.

But using chained CPI is also certain to agitate politicians from both parties and their constituents, given that reducing government outlays for Social Security and Medicare is another way of cutting benefits to retirees. Boosting government revenues sounds to some ears like jacking up taxes.

Nonetheless, whatever unfolds -- a slide over the cliff and perhaps into another recession, or a deal -– is likely to involve chained CPI.

Chained CPI was suggested as part of a plan to trim the deficit in 2011 by the group of senators known as the "Gang of Six." It stirred a fair amount of controversy before the talks broke down.

The standard CPI tracks inflation by monitoring the prices of specific consumer goods and services. The inflation rate determined by the CPI is then used to calculate the increase in government benefits, including Social Security and veterans' disability payments.

But standard CPI fails to account for changes in consumer behavior triggered by fluctuations in prices. Chained CPI was conceived of by the Bureau of Labor Statistics as a way to adjust for this.

In an interview on NPR, Robert Greenstein, from the Center for Budget and Policy Priorities, explained it this way: "If, for example, beef prices rise much faster than chicken prices, and consumers, as a result, buy less beef and more chicken, [chained CPI] picks up the switching from the beef to the chicken."

A sharp rise in beef prices boosts the standard CPI. But the price jump is softened in chained CPI by the reality that consumers do something different and wind up spending less.

Since chained CPI indicates a slower rise of inflation than standard CPI, benefits like Social Security would rise slower. Chained CPI generally shows an inflation rate 0.25 percent less than standard CPI, according to the Congressional Budget Office. So if standard CPI shows inflation at 3 percent, then payments would increase by 3 percent each year -- from $10,000 to $10,300 for example. Using chained CPI, those same payments would rise to only $10,275.

On the revenue side, taxes would increase under a chained CPI system, since tax brackets and other parameters of the federal tax code are adjusted for inflation as well.

According to estimates by the Congressional Budget Office, Social Security payments would be $108 billion less over 10 years with chained CPI. If the new index was applied to the tax code, budget deficits would be reduced by about $90 billion after accounting for changes in both revenues and expenses.

Analysts agree that chained CPI is a more accurate measurement of inflation, Greenstein said.

But academic-style accuracy is often not the decisive factor in the messy process of governing –- a sport in which perceptions often matter more. That means chained CPI may not be the thing that prevents passage over the cliff.

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