Getting Prices Right

Debate Over the Consumer Price Index

Dean Baker

• Publisher: Routledge
• Year: 2016
• ISBN:
  9781315502632
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Compiled by the Bureau of Labor Statistics, the CPI is used to index Social Security payments and many other federal programs, as well as to adjust tax brackets. Today, the accuracy of the CPI is being hotly debated, particularly in light of the Boskin Commission report that concluded in December 1996 that the CPI overstates inflation by 1.1%. If accepted and applied in the formulation of economic policy, the report would have major implications for balancing the federal budget. It would have a direct impact on the lives of Americans who are beneficiaries of government programs as well as on everyone who pays taxes. In this book, Dean Baker introduces and explains the significance of the debate, presents the full text of the Boskin Commission report and finally discusses in a far-reaching and insightful analysis both the Commission's research methodology and its conclusions.

PART I

Toward a More Accurate Measure of the Cost of Living

Final Report to the Senate Finance Committee from the Advisory Commission to Study the Consumer Price Index

DECEMBER 4, 1996

Michael J. Boskin, Chairman

Ellen R. Dulberger

Robert J. Gordon

Zvi Griliches

Dale Jorgensen

Executive Summary

1. The American economy is flexible and dynamic. New products are being introduced all the time and existing ones improved, while others leave the market. The relative prices of different goods and services change frequently, in response to changes in income and technological and other factors affecting costs and quality. This makes constructing an accurate cost of living index more difficult than in a static economy.

2. Estimating a cost of living index requires assumptions, methodology, data gathering and index number construction. Biases can come from any of these areas. The strength of the CPI is in the underlying simplicity of its concept: pricing a fixed (but representative) market basket of goods and services over time. Its weakness follows from the same conception: the “fixed basket” becomes less and less representative over time as consumers respond to price changes and new choices.

3. There are several categories or types of potential bias in using changes in the CPI as a measure of the change in the cost of living. 1) Substitution bias occurs because a fixed market basket fails to reflect the fact that consumers substitute relatively less for more expensive goods when relative prices change. 2) Outlet substitution bias occurs when shifts to lower price outlets are not properly handled. 3) Quality change bias occurs when improvements in the quality of products, such as greater energy efficiency or less need for repair, are measured inaccurately or not at all. 4) New product bias occurs when new products are not introduced in the market basket, or included only with a long lag.

4. While the CPI is the best measure currently available, it is not a true cost of living index (this has been recognized by the Bureau of Labor Statistics for many years). Despite many important BLS updates and improvements in the CPI, changes in the CPI will overstate changes in the true cost of living for the next few years. The Commission’s best estimate of the size of the upward bias looking forward is 1.1 percentage points per year. The range of plausible values is 0.8 to 1.6 percentage points per year.

5. Changes in the CPI have substantially overstated the actual rate of price inflation, by about 1.3 percentage points per annum prior to 1996 (the extra 0.2 percentage point is due to a problem called formula bias inadvertently introduced in 1978 and fixed this year). It is likely that a large bias also occurred looking back over at least the last couple of decades.

6. The upward bias creates in the federal budget an annual automatic real increase in indexed benefits and a real tax cut. CBO estimates that if the change in the CPI overstated the change in the cost of living by an average of 1.1 percentage points per year over the next decade, this bias would contribute about $148 billion to the deficit in 2006 and $691 billion to the national debt by then. The bias alone would be the fourth largest federal program, after Social Security, health care and defense. By 2008, these totals reach $202 billion and $1.07 trillion, respectively.

7. Some have suggested that different groups in the population are likely to experience faster or slower growth in their cost of living than recorded by changes in the CPI. We find no compelling evidence of this to date (in fact just the opposite) but further exploration of this issue is desirable.

8. The commission is making over a dozen specific recommendations to the BLS. These include the following:

i.	The BLS should establish a cost of living index (COLI) as its objective in measuring consumer prices.
ii.	The BLS should develop and publish two indexes: one published monthly and one published and updated annually and revised historically.
iii.	The timely, monthly index should continue to be called the CPI and should move toward a COLI concept by adopting a “superlative” index formula to account for changing market baskets, abandoning the pretense of sustaining the fixed-weight Laspeyres formula.
iv.	The new annual COL index would use a compatible “superlative-index” formula and reflect subsequent data, updated weights, and the introduction of new goods (with their history extended backward).
v.	The BLS should change its procedure for combining price quotations by moving to geometric means at the elementary aggregates level.
vi.	The BLS should study the behavior of the individual components of the index to ascertain which components provide most information on the future longer-term movements in the index and which items have fluctuations which are largely unrelated to the total and emphasize the former in its data collection activities.
vii.	The BLS should change the CPI sampling procedures to de-emphasize geography, starting first with sampling the universe of commodities to be priced and then deciding, commodity by commodity, what is the most efficient way to collect a representative sample of prices from which outlets, and only later turn to geographically clustered samples for the economy of data collection.
viii.	The BLS should investigate the impact of classification, that is item group definition and structure, on the price indexes to improve the ability of the index to fully capture item substitution.
ix.	There are a number of additional conceptual issues that require attention. The price of durables, such as cars, should be converted to a price of annual services, along the same lines as the current treatment of the price of owner-occupied housing. Also, the treatment of “insurance” should move to an ex-ante consumer price measure rather than the currently used ex-post insurance profits based measure.
x.	The BLS needs a permanent mechanism for bringing outside information, expertise, and research results to it. At the request of the BLS, this group should be organized by an independent public professional entity and would provide BLS an improved channel to access professional and business opinion on statistical, economic, and current market issues.
xi.	The BLS should develop a research program to look beyond its current “market basket” framework for the CPI.
xii.	The BLS should investigate the ramifications of the embedded assumption of price equilibrium and the implications of it sometimes not holding.
xiii.	The BLS will require a number of new data collection initiatives to make some progress along these lines. Most important, data on detailed time use from a large sample of consumers must be developed.

9. The Commission is making several recommendations to the President and Congress. These include the following:

xiv.	Congress should enact the legislation necessary for the Departments of Commerce and Labor to share information in the interest of improving accuracy and timeliness of economic statistics and to reduce the resources consumed in their development and production.
xv.	Congress should provide the additional resources necessary to expand the CES sample and the detail collected, to make the POPS survey more frequent, and to acquire additional commodity detail from alternative national sources, such as industry surveys and scanner data.
xvi.	Congress should establish a permanent (rotating) independent committee or commission of experts to review progress in this area every three years or so and advise it on the appropriate interpretation of then current statistics.
xvii.	Congress and the President must decide whether they wish to continue the widespread substantial overindexing of various federal spending programs and features of the tax code. If the purpose of indexing is accurately and fully to insulate the groups receiving transfer payments and paying taxes, no more and no less, they should pass legislation adjusting indexing provisions accordingly.

This could be done in the context of subtracting an amount partly or wholly reflecting the overindexing from the current CPI-based indexing. Alternatively, a smaller amount would need to be subtracted from indexing based on the new revised annual index if and when it is developed and published regularly, to more closely approximate the change in the cost of living.

We hasten to add that the indexed programs have many other features and raise many other issues beyond the narrow scope of a more accurate cost of living index. We also wish to express our view that these findings and their implications need to be fully digested and understood by the BLS, the Congress, the Executive Branch and the public.

I. Introduction¹

Accurate measures of changes in the cost of living are among the most useful and important data necessary to evaluate economic performance. The change in the cost of living between two periods, for example 1975 and 1995, tells us how much income people would have needed in 1975, given the prices of goods and services available in that year, to be at least as well off as they are in 1995 given their income and the prices of goods and services available then. For example, if a family with a $45,000 income in 1996 would have needed $15,000 in 1976, the cost of living has tripled in the interim.

If the American economy was quite static, with very few new products introduced, very little quality improvement in existing products, little change in consumers’ income, and very small and infrequent changes in the relative prices of goods and services, measuring changes in the cost of living would be conceptually quite easy and its implementation a matter of technical detail and appropriate execution. Fortunately for the overwhelming majority of Americans, our economy is far more dynamic and flexible than that. New products are being introduced all the time and existing ones improved, while others leave the market. The relative prices of different goods and services change frequently, in response to changes in consumer demand, and technological and other factors affecting costs and quality. Consumers in America have the benefit of a vast and growing array of goods and services from which to choose, unlike consumers in some other countries or our ancestors many decades ago.

But because the economy is complex and dynamic is no reason to bemoan the greater difficulty in constructing an accurate cost of living index. Major improvements can and should be made to the various official statistics that are currently used as proxies for changes in the cost of living, such as the well-known Consumer Price Index (CPI).

The Consumer Price Index measures the cost of purchasing a fixed market basket of goods and services. Based on surveys of households from some base period, the index sets weights (expenditure shares) for different goods and services. The weights reflect average or representative shares for the groups surveyed.² Keeping these weights fixed through time, the CPI is then calculated by attempting to measure changes from one month to the next in prices of the same, or quite closely related, goods and services.

But through time consumption baskets change, in part because of changes in the relative prices of goods and services, and therefore the weights from the base period no longer reflect what consumers are actually purchasing. Representative purchases also change as discount coupons, buyers’ clubs and other marketing devices determine the best value and alter buying patterns. This failure to adjust for the changes in consumer behavior in response to relative price changes is called substitution bias. It is a necessary result of keeping the market basket fixed. Because the market basket is updated only every decade or so, as we get further away from the base period, there is more opportunity for relative prices to diverge from what they were in the base period, and for consumption baskets to change substantially.

Just as there are changes in what consumers purchase, there are also trends and changes in where purchases are made. In recent years, there has been a transformation of retailing. Superstores, discount stores, and the like now comprise a large and growing fraction of sales relative to a decade or two ago. As important as keeping up with the basket of goods that consumers actually purchase is keeping up with the outlets where they actually purchase them, so that the prices paid are accurately recorded. The current methodology suffers from an outlet substitution bias, which insufficiently takes into account the shift to discount outlets.

Many of the products sold today are dramatic improvements over their counterparts from years ago. They may be more durable and subject to less need for repair; more energy efficient; lighter; safer; etc. Sometimes, at least initially, a better quality product replacing its counterpart may cost more. Separating out how much of the price increase is due to quality change rather than actual inflation in the price of a standardized product is far from simple, but is necessary to obtain an accurate measure of the true increase in the cost of living. To the extent quality change is measured inaccurately or not at all, there is a quality change bias in the CPI.

The same is true with the introduction of new products, which have substantial value in and of themselves — not many of us would like to surrender our microwave ovens, radial tires, and VCRs — as well as the value of greater choice and opportunities opened up by the new products. To the extent new products are not included in the market basket, or included only with a long lag, there is a new product bias in the CPI.

Finally, in a dynamic, complex economy like the contemporary United States, there are literally many thousands of goods and services consumed. Price data are collected at a considerable level of disaggregation and how the price changes are aggregated into an overall index involves quite technical issues that can lead to a formula bias in the CPI.

Even if no federal program on either the outlay or revenue side of the budget were indexed, it would still be desirable to improve the quality of measures of the cost of living from the standpoint of providing citizens a better and more accurate estimate of what was actually going on in the economy, a way to compare current performance to our historical performance or to that of other countries. For example, the most commonly used measure of the standard of living is real income or output per person. To measure changes in real income requires the separation of nominal income changes from price changes. Obviously, that requires an accu...