December 4, 1996

Panel Says Errors in Inflation Data Drain U.S. Budget _______________________________________________________________

Analysis: Fixing Scales for Measuring Inflation Won't Be Easy
Panel Likely to Recommend New Price Index, to Better Reflect Actual Buying (Dec. 1) _______________________________________________________________

By RICHARD W. STEVENSON

WASHINGTON -- An independent commission appointed by Congress will report on Wednesday that the government is overstating the inflation rate by 1.1 percentage points, costing it billions of dollars in inflated Social Security and other benefits payments. The commission will call on Congress and the Clinton administration to solve the problem.

The report, on the Consumer Price Index, will stop short of advocating a specific plan for dealing with the predictable political opposition to any step that would rein in benefits like Social Security. But it will specifically recommend that Congress and the administration take a variety of technical steps to fix the index, which is used to calculate cost-of-living increases for many union contracts as well as for government programs like Social Security.

Ultimately, the report suggests, legislation to revise the index might be the best approach, but both parties so far have been reluctant to take the lead on the issue.

The Consumer Price Index is compiled by the Labor Department's Bureau of Labor Statistics. It measures inflation by tracking the prices of a "market basket" of products meant to reflect typical consumer purchases. It has played a major role in shaping the impression that the economy's performance has deteriorated over the past several decades, and, as the most widely used gauge of increases in the cost of living, it has become the basis for many decisions by government and businesses.

Although many of the problems with the index are arcane, any changes to it would ripple across the economy and through the personal finances of nearly everyone.

For instance, Social Security payments for next year are being calculated on the basis of a 2.9 percent increase in the cost of living. If that increase was 1.1 percentage points lower, the average monthly payment, now $724, would go to $737 rather than to $745 -- a difference of $8 a month, or $96 a year. The effect would build on itself because a lower payment next year would mean a lower starting point when the benefit was adjusted for inflation the following year. In 15 years, the difference would amount to several thousands of dollars a year per recipient.

By the same token, the change would have a huge effect on efforts to balance the budget. According to an estimate by the Congressional Budget Office, done before the commission's recommendations, even a reduction of one percentage point in the cost of living increase would save the government $34 billion in payments for Social Security and other retirement and benefit programs in 2002, the year by which both parties have pledged to eliminate the deficit.

Recalculating the index could raise taxes for many individuals by reducing the annual inflation-driven increases in the standard deduction, personal exemptions and the income levels at which higher tax rates kick in. By 2002, a reduction of one percentage point in the index would yield an additional $21.4 billion in tax revenues, the budget office calculates.

Together, the reductions in spending and the higher tax revenues could make up more than a third of the $150 billion annual deficit that the nation is projected to face in 2002.

A change in the price index would also affect union contracts that have wage increases directly tied to the price index, but there are fewer of those than in the past. It is unclear how any changes in the index would affect contracts more loosely based on the cost of living.

The recommendations by the five-member panel, led by Michael Boskin, a Stanford University economist and a former head of the White House Council of Economic Advisers under President George Bush, range from highly technical suggestions for fixing the monthly Consumer Price Index's statistical shortcomings to a call for a new annual index that could reflect cost of living increases more accurately.

Although both Democrats and Republicans have expressed vague support for revising the index, both parties are also fearful of being tagged by the other as willing to pursue fiscal austerity at the expense of the elderly, a fast-growing and increasingly politically powerful group.

As a result, there is little likelihood that the commission's findings will be embraced publicly by either side, at least immediately, although officials at both the White House and in Congress have said they might be willing to discuss the matter as part of a balanced budget agreement.

Senior administration officials said privately that while they remained wary of the political pitfalls associated with the issue, they wanted to send a message to Republicans that they were open to further study and negotiation and to changing the index if a broad technical and political consensus could be reached.

In its public statements, however, the White House was somewhat more restrained.

"The administration considers the Boskin Commission and some experimental work the Bureau of Labor Statistics is doing as the beginning of the process, not the end of it," said Larry Haas, a spokesman for the Office of Management and Budget at the White House. "The president will direct his economic team to study these findings, and we will seek input from other experts before deciding how to react."

Sen. William Roth Jr. of Delaware, a Republican who is chairman of the Senate Finance Committee, which set up the commission, said he was looking to the White House to "provide leadership" on the issue.

"My party is willing to work in a bipartisan manner on this issue," he said. "It can't be done without the president's support."

Horace Deets, the executive director of the American Association of Retired Persons, one of Washington's most powerful lobbying groups, said he was concerned that the issue not become driven by the desire of Congress and the administration to find easy budget savings.

"We don't want to be spending more in benefits or taking in less than we should be in taxes," he said, "but I'm leery of changing the system until we see what the proposed change is."

As a practical matter, Congress and the administration could change the current system in one of three ways. They could direct the Bureau of Labor Statistics to change the price index to reflect the report's concerns. They could pass legislation to create an alternative cost of living index to be used in setting benefit levels. Or they could pass legislation directing that benefit levels be set by subtracting the amount of the mismeasurement from the price index.

Because the Bureau of Labor Statistics has made clear that it believes the Boskin Commission is overstating the scale of the problem, it appears unlikely to go along easily with a wholesale revision, and it is unclear whether either Congress or the administration is willing to put direct political pressure on the agency, which jealously guards its independence.

Next year, the Labor Department will begin publishing an experimental price index that will attempt to account for one of the biggest problems, the tendency of consumers to reduce purchases of items that rise quickly in price and to substitute another product.

Boskin has long argued that the nation needs to improve the accuracy of its economic statistics, and he fought for additional financing for economic measurement programs while at the White House. He, like other economists and policy makers, including Alan Greenspan, the chairman of the Federal Reserve, has argued that the economy's shift from production of goods that are easy to measure, like cars and steel, to more abstract products, like software, has left the nation flying by faulty instrument readings.

The commission is expected to make a dozen specific recommendations to the Bureau of Labor Statistics, most of them highly technical. They are intended to address what the commission viewed as three major problems with the index that result in a mismeasurement of inflation of between 0.8 percentage points and 1.6 percentage points, with about 1.1 percentage points as the best estimate.

Of the 1.1 percentage points, failure to account for quality improvements and new products caused inflation to be overstated by 0.6 percentage points, people who have seen the report said.

The index's inability to account fully for decisions by consumers to substitute cheaper products for more expensive products when prices are rising accounts for 0.4 percentage points of error. The final 0.1 percent of the error stems from the index's failure to pick up changes in where people shop.

Economists have been arguing about how to account for quality changes and the introduction of new products and services for years. Even though there is broad agreement on the nature of the problem, there is little consensus about how to address it.