There's an argument in policy circles that goes something like this: If only we could lower inflation as reported in the consumer price index, we could afford more tax cuts.
You are going to be hearing a lot about his concept in the coming weeks if the Republican tax bill becomes law.
Over the years, I have argued that official government inflation models like the CPI tend to underreport price increases.
What does this have to do with the proposed Republican tax plan? The new tax proposal would replace the current CPI, which is based on changes in prices for urban consumers, with a new version called the chained consumer price index. Various estimates conclude this new measure would lower reported inflation, which is already lower than it actually is, by as much as 0.30 percent a year.
But this yardstick would do something else: It would allow Congress to come up with about half of the funds needed to cover the proposed GOP tax cuts by pushing more people into higher tax brackets and potentially creating a hidden tax on everyone who will ever get Social Security in the future. But for the purposes of today's discussion, let's focus mostly on the latter.
The way we measure inflation matters because it goes into calculations used in cost-of-living adjustments that affect many government benefits. If the measure of inflation is reduced, then the increases in Social Security payouts to the public would also be lowered.
If this sounds familiar, it is because we have been down this road before. The Boskin Commission in the mid-1990s made the dubious claim that government statistics overstated inflation by 1.1 percent. It recommended numerous changes to the ways inflation is measured in order to lower it. One of the key suggestions by the commission involved substitution, meaning that people switch to less expensive products when other goods rise in price.
I have long argued that this approach would distort the CPI, making it less useful as a metric to policy makers. Its goal was an obvious backdoor way to suppress Social Security COLA adjustments. Rather than have an honest conversation about the cost of entitlements, this was a deceptive way to cut benefits without publicly saying so.
Regardless, let’s look more closely at the concept of substitution. It gets the concept of what inflation is precisely backward.
Substitution adjusts inflation for consumer behavior. When steak prices rise, consumers switch to less expensive proteins such as chicken or hamburger. Thus, goes the theory, the consumer is spending no more on meat than before, and -- voila! -- there's no inflation. In reality, the consumer has been priced out of steak due to its rising cost. In other words, inflation hasn't disappeared; it's been masked. This is what chained CPI is in a nutshell; prices in the real world may still be rising, but that won’t be reflected as much in the official numbers.