A Chained CPI and Federal Employee Retirement COLAs

The chained CPI has been incorporated into the federal tax system. What does this mean, and will it have an impact on the COLA calculations for federal retirees?

What is the “chained CPI”, and what does it have to do with retirement income for a federal employee? What does the new tax reform bill have to do with a chained CPI?

What is the Chained CPI?

Currently, a consumer price index (CPI) determines the amount of any COLA awarded for the coming year. There are different CPI indices that could be used though.

While a CPI changes with the rise and fall of expenses for fixed items, a “chained CPI” would also consider choices people may make as a result of behavioral changes. For example, if the price of beef goes up, many people will buy chicken instead because it may be a substitute that costs less. Also, when the price of a product goes up, people will probably buy less of that product.

The chain weighted CPI would incorporate changes in both the quantities and prices of products. The result is that when calculating costs for multi-billion dollar programs—such as Social Security or the federal retirement system—a chained CPI would result in smaller benefit increases and save the government money over time.

The chained CPI is often considered a more accurate measure of inflation. But, for a variety of reasons, a chained CPI will not as accurately reflect increased costs for older Americans.

Pros and Cons of a Chained CPI

As an executive summary for one legislative proposal to implement a chained CPI noted, over a 10 year period the federal government would save approximately $150 billion. As noted by the same executive summary of a legislative proposal in the last Congress, “Since the chained CPI grows more slowly than the traditional CPIs, benefits and eligibility thresholds would grow more slowly, resulting in lower spending.”

The advantage of the chained CPI is that the federal government would spend less money. And, since the federal government is drowning in debt, and with consistent calls to increase spending even more, the many trillions of dollars now owed by the federal government continues to grow every year.

The disadvantage of the chained CPI is obvious: It would result in smaller future increases for Social Security recipients and federal retirees.

How is the Current COLA Amount Calculated?

Determining the amount of the COLA for the next year is currently determined through a complex formula. The COLA is currently determined by calculations using the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). In effect, it is a CPI but it is not the chained CPI.

The CPI-W is the index used for measuring increases in the prices of consumer goods such as food and beverages, housing, clothing, and gasoline. The two percent increase for 2018 was determined by computing the percentage increase in the CPI-W from third-quarter months of July, August and September. To trigger a COLA for the upcoming year, the average CPI-W for the third quarter must be greater than the highest previous third-quarter average. For the 2018 COLA, the differential was 2 percent.

You can try this calculation on your own each year (good luck) or check back with FedSmith on a regular basis during the year to see the current prognostications for next year’s COLA amount.

The Tax Reform Bill and the Chained CPI

The new tax reform bill that recently passed references a chained CPI. To eliminate the suspense, the new law does not change how the annual COLA is currently calculated.

But, while it does not change the current COLA, it could have an impact on future COLA calculations. While the language in the bill is virtually incomprehensible to anyone without ready access to a number of other laws referenced in the bill, the bill does require that the federal government start using the chained CPI in some ways.

Effective January 1st, use of the chained CPI is one change that has not received much attention. The change reflects how tax provisions are now indexed for inflation.

Under the new legislation, marginal personal tax rates, tax credits and the standard deduction are indexed to inflation. The measurement for determining the rate of inflation will be the Chained Consumer Price Index for All Urban Consumers. This is apparently the first time the chained CPI has been used by the federal government, and it will now be used for measuring inflation for these tax purposes.

Under the new tax rules, the standard deduction has doubled to $13,000. That will reduce taxes for many or even most taxpayers. But using the chained CPI as the index will likely have an impact on the amount of taxes that will be paid in the future.

The increase in the standard deduction means a worker who earns $50,000 only reports $37,000 in taxable income at the end of the year. While the personal exemption has been removed, overall, most people can deduct an extra $2,350 from their income when calculating their taxable earnings.

While the new tax bill will result in lower taxes for many Americans, changing to the chained CPI is likely to have a larger impact over time by reducing the amount that can be deducted (although the amount of the standard deduction has been increased has noted above).

The Tax Reform Bill and Federal Employee COLAs

The new tax bill does not impact how the annual COLA is calculated for those receiving Social Security or for federal employees who are receiving an annuity from the federal government. The calculation method for this purpose is still incomprehensible to many and will remain so for the time being.

The biggest concern of organizations that lobby to improve or retain current government benefits is that there will be another move to change retirement COLA calculations to the chained CPI.

And, in fact, there is likely to be an effort to make this change. But, because there are so many people who would be impacted by the change, Congress will be reluctant to make such a change, despite the fact it would reduce expenses of the federal government, as it would likely have a negative impact on the reelection of Congressional representatives.

About the Author

Ralph Smith has several decades of experience working with federal human resources issues. He has written extensively on a full range of human resources topics in books and newsletters and is a co-founder of two companies and several newsletters on federal human resources. Follow Ralph on Twitter: @RalphSmith47