October 18, 1995
"Truth About Inflation Might Be Unwelcome"
San Jose Mercury News
By Timothy Taylor
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REPUBLICANS AND Democrats alike are eyeing an intriguing method of cutting the deficit: tinker with the way inflation is calculated to produce a lower inflation rate. The idea could raise a lot of money, but it's also a rubber grenade: Once you've thrown it, you can't be sure where it will bounce and explode.

Inflation affects both taxes and spending. One-third of federal spending, mainly in retirement programs, rises automatically with the inflation rate. Tax brackets also increase automatically with inflation, which means that a higher inflation rate reduces taxes from the level that would otherwise have been collected.

If the rate of inflation were just 1 percent lower over the next 10 years, then the budget deficit would be $140 billion lower in 2005 than it would otherwise be, according to the Congressional Budget Office. Over the next decade, the lower inflation rate would cut total government debt by a whopping $634 billion.

Better still, there is a solid economic case that the present methods of calculating inflation may actually be overstating the inflation rate by 1 percent or more.

The basic approach to measuring inflation is to define a basket of goods purchased by a hypothetical average consumer, including a certain quantity of housing, food, clothing, transportation, travel and other goods. Then, see how the price of buying this overall basket of goods changes over time.

Government surveyors troll through cities all over America every month, writing down prices for everything, to provide the raw material for this calculation. This procedure is reasonable enough in theory, but inevitably hard to implement in practice.

What if consumers change their buying patterns so they are buying a different basket of goods? What if goods improve in quality, but their price doesn't change? What if entirely new goods are offered, like a new drug? What if more consumers are shopping at discount stores, but the price surveyors are still looking at prices in upscale shopping malls?

A commission of prominent economists, headed by Michael Boskin of Stanford University, concluded last month that these factors taken together mean that the official consumer price index overstates the true rate of inflation by between 0.7 and 2 percentage points. They suggest 1 percentage point as a reasonable estimate of the upward bias.

Government economists are always re-evaluating how the inflation rate is calculated. It now seems likely that they will tinker with their calculations in ways that reduce the official inflation rate at least slightly, although perhaps by less than the Boskin commission recommended.

As the impact of this lower inflation rate accumulates over time, it will be a nice windfall for the budget balancers in Congress. But if or when the government starts calculating inflation in a way that provides a lower rate, my guess is that everyone else will find something to dislike about the idea.

Republicans, the self-designated defenders of lower taxes, will find that the lower inflation reduces upward creep of tax brackets, putting those whose income is rising in higher brackets and thus raising their taxes.

Democrats, the self-designated defenders of Social Security, will find that a lower inflation rate makes the checks for the elderly increase more slowly than they otherwise would have.

Voters will gripe because many annual pay raises are linked to the announced rate of inflation, whether officially by union contract or unofficially by habit. A lower announced rate of inflation will lead to smaller raises.

Finally, there is an implication no one wants to talk about. If the rate of inflation is overstated, that logic applies to the past just as well as to the future. The Boskin commission carefully wrote: "Of course, no one would suggest retroactively undoing the overindexing..."

Well, I hereby suggest it. If inflation has been overstated by 1 percentage point each and every year, then tax brackets and Social Security payments have been ratcheting up faster every year than they otherwise would have been if the consumer price index had been calculated more accurately. The cumulative impact has surely been as substantial in the past as the Congressional Budget Office projects for the future.

If the official inflation rate has an upward bias that should be adjusted in the future, it is perfectly logical to reduce the unfairly high adjustments that have occurred over recent years. The politically astute way to do this would be to reduce or suspend the inflation adjustments for tax brackets and Social Security brackets for a few years.

The discovery that the inflation rate has been overstated should be happy news; it implies that inflation is under even better control than one might have thought, and offers the prospect of a semi-automatic reduction in the budget deficit. But when a nation has written into law or custom that something will be automatically adjusted for inflation - whether it is Social Security payments, tax brackets, or a union contract - then we create groups of people who have reason to feel that lower inflation has an element of bad news as well.

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