COLA Wars: Deficit Cutting Takes Aim at Cost of Living Adjustments

Last Updated Jul 5, 2011 2:23 PM EDT

The annual cost of living adjustment (COLA) added to public employee pensions and Social Security payouts looks to be increasingly in the cross-hairs of lawmakers aiming to reduce government deficits.

In two separate court decisions delivered last week, public employees in Minnesota and Colorado were told their state pensions could indeed scale back COLAs to help deal with budget deficits. And New Jersey legislators recently passed a controversial pension reform bill that eliminates the COLA for many public employees until the state's pensions are back to being at least 80 percent funded, a level not expected to be reached anytime soon. Those moves could mean similar COLA cuts could soon be coming to a deficit-addled state near you. The lawyer who represented Minnesota and Colorado employees fighting their COLA reductions suggested that "state legislatures may be emboldened by the decisions."

Moreover, it looks like the Social Security COLA may also be on the chopping block. Lawmakers looking for ways to make a dent in the federal deficit -- so that we can get a debt ceiling deal before August 2nd -- are said to be considering a new formula for calculating inflation that would end up reducing the annual COLA for Social Security recipients.

Changing the COLA Formula
Right now the government uses two different Consumer Price Indexes (CPI), one for figuring out changes to the tax code (income tax brackets are adjusted in line with inflation) and other federal programs, and a separate measurement that is used specifically to set Social Security and federal pension COLAs. What's under consideration is indexing all these changes to a different measurement called Chained CPI. I'll spare you all the wonky explanations for why the chained CPI is seen as a better model than the other indices. (You can read more here). But the basic idea is that it will supposedly better reflect our buying habits when we experience rising prices. Rather than assume we will just keep buying more of the same (more expensive) items, the chained CPI factors in the likelihood that we will change our buying habits. The classic example: if apples skyrocket in price, we don't just keep buying the same amount of apples, and instead look for other less expensive fruit as apple substitutes.

The important upshot is that the chained CPI doesn't increase as much as the current inflation measurements we're using. A bipartisan analysis concluded that since 2000, the chained CPI has been on average 0.25 to 0.30 percentage points lower each year than standard CPI measures. Add in the effect of compounding and since 2000, the CPI we use today shows that inflation is up 30 percent. Chained CPI, however, shows a 26 percent increase.

Potential Savings from Chained CPI
Shifting government programs to a model that uses the chained CPI could save the federal government an estimated $300 billion over the next 10 years. Just for a bit of perspective, that's about 100 times the savings we would get from President Obama's jawboning desire to scale back the tax break on corporate jets.

The bulk of the savings from a move to the chained CPI would be borne by Social Security recipients. Over the next 10 years, Social Security COLA payouts would be an estimated $112 billion lower than if we stick with the current system. (Another $33 billion would be saved through lower COLAs on federal pensions.) One advocacy group estimates the cost to a 65 year old retiree today will be an annual benefit at age 75 that is $500 lower, and $1,000 lower at age 85.

Pulling Social Security into the deficit debate is exactly what AARP said it would fight, lobbying guns ablazing. That said, it's important to note that no current benefits would be cut; what we're talking about is the pace at which benefits rise to reflect changes in inflation. With the chained CPI, inflation adjustments still occur, but they will be smaller than the hikes that occur using the current CPI formulas.

A Stealth Tax Hike, Too
Adopting the chained CPI would impact more than Social Security. Income tax brackets are adjusted to keep pace with inflation. If we shift to the chained CPI for that calculation, it's likely incomes will rise faster than inflation-adjusted tax brackets. That means more of us will be pushed into higher marginal brackets, a move that could raise an estimated $87 billion in tax collections over 10 years.

There's no way to know at this juncture how serious Congressional negotiators are about making chained CPI part of any debt ceiling/deficit deal before the August 2nd deadline. Saving $300 billion is indeed compelling. What's going to be interesting is what other cuts might accompany this move. If we're going to have seniors take a bit of a hit, it has to be along with other serious deficit-reduction moves that share the pain, right? Perhaps we finally address non-discretionary spending cuts, and raising taxes on the wealthy.

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