What's a Chained CPI and How Might It Impact States?

President Obama has proposed changing how the Consumer Price Index is calculated in a way that could help states cap some costs.
June 27, 2013

It's not exactly a household phrase -- the chained CPI, that is. But this past April, President Obama nudged it toward the mainstream when he suggested in his 2014 budget that it be used to calculate annual Social Security cost-of-living adjustments (COLAs) and other programs affected by inflation. As it stands now, the government uses the Consumer Price Index (CPI) for Urban Wage Earners and Clerical Workers.

Under a chained CPI, consumer behavior is taken into account when working out price changes in the basket of consumer goods. That is, if filet mignon is an item in the basket and the price of that top-of-the-line cut of beef rises, consumers are likely to bump down to a lower-priced cut of steak. The switch to a chained CPI would, therefore, lower estimates for the rate of inflation. Many economists maintain that it is a more accurate measure of inflation because it reflects real world behavior: People respond to higher costs by buying cheaper substitutes.

Still, some aren't sure it is good policy to apply chained CPI to indexing Social Security benefits. For arguments sake, though, if the feds are considering using chained CPI for Social Security and other inflation-affected programs, what about the states? How would they be impacted by such a move? And what if they adopted a chained CPI as a benchmark for some of their programs or benefits?

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I put these questions to Norton Francis, a senior research associate at the Urban Institute and head of the State and Local Finance Initiative that operates under the umbrella of the Urban-Brookings Tax Policy Center. Here is an edited version of our conversation.

Can you give me a quick and easy description of how a chained CPI is different from the usual CPI?

The CPI is put out by the Bureau of Labor Statistics. The main way a chained CPI differs [from the traditional CPI] is that it includes substitutability of purchases. What that means is when you have a choice between this product and that product that had a similar value, you might go with the cheaper one. Not only do prices change but consumers change preferences. So this is capturing consumer preferences for choosing lower priced goods.

What are the implications for state and local governments if a chained CPI was adopted at the federal level?

It would mostly be on any federal grants and entitlements that states might receive that are indexed by the CPI. Those grants and entitlements would grow slower. One example: Medicaid reimbursement rates might be affected. There would be less growth in those rates. Basically, the chained CPI would reduce the growth trend.

Have you heard of any states that are considering a switch to a chained CPI?

I haven't heard anybody propose using it. Everyone is watching to see what the feds do. If the feds actually adopt it, you might see some states look at it. In most states, any increase in state benefits is tied to the CPI. So that begs the question: When there were decreases -- as there were in 2008 -- did anybody decrease benefits? I'm pretty sure the answer is no. States have the ability to move beyond the CPI if they think it's not enough or too much. They can adjust. Lawmakers have a lot of flexibility on establishing those benefits and what they choose to use as a measure. Some use a local or regional CPI -- a CPI for, say, the South or for California -- and those don't have a chained index. A chained CPI is only at the national level.

If states could switch to a chained CPI, what might they use it for?

They might use it for COLAs on salary increases and pension payouts. With budgets, if they do a structural forecast to see how expenditures change in the long run, it would have impact there. But it won't change a lot for current budget years. Where you might see it show up is in actuarial plans for pensions -- but it would be a very small fix for state pension problems.

[In states that have income taxes], it could change income tax brackets, which might increase revenue because brackets wouldn't expand by much. Right now, if a state has brackets indexed to the CPI, a $100,000 bracket will go up by 2 percent with the regular CPI and less with a chained CPI. So, if the bracket is $100,000, it would increase to $102,000 with the regular CPI and to $101,050 with the chained CPI. That means that under the chained CPI, more of a taxpayer's money -- anything between those two levels -- is now taxed at a higher rate. More income is exposed to higher rates.

Ultimately, I don't see a lot of states adopting this because it is not going to change a whole lot for them. [But] you might see people looking at it for pensions, much as the feds are looking at it for Social Security.