What Is "Price Indexing"?

by hilzoy

I have been messing around with a long post on Social Security, and in the course of writing it I realized that I did not fully understand what 'price indexing' was, in the context of Social Security. The general concept of price indexing was easy enough: something that is currently indexed to wages would, under price indexing, be indexed to prices instead. Since prices tend to rise more slowly than wages, this would lead benefits to grow more slowly (or: be cut, depending on which you prefer) over time. But what, exactly, were people proposing to price-index? I had somehow picked up the (correct) idea that the mysterious indexed entity was not benefits themselves: these are adjusted each year according to the Consumer Price Index, which is to say: they are price-indexed. Price-indexing in the context of the Social Security debate, I knew, had something to do with the initial calculation of benefits, and thus with the mysterious arcana of Social Security benefit calculations that I have thus far tried very hard to avoid having to figure out. But I realized, as I wrote my Social Security post, that I couldn't avoid this any longer. If I was to be a Truly Responsible Blogger™, I had to figure it out. Having done so, I thought I might as well try to explain it as clearly as possible, since it's not what you might think.

Warning: it's wonky.

Here is how your Social Security benefits are calculated, assuming you retire at 65 and are not disabled:

• First, the Social Security Administration selects the 35 years in which you earned the most. The amount you earned in any of those years before you turned 60 is adjusted by the amount that wages rose between that year and the year you turned 60. (Earnings in years after you turned 60 are not adjusted.) These adjusted annual earnings are then averaged, and divided by 12 to yield your "average indexed monthly earnings" (AIME).


• Next, a formula is applied to your AIME. Each month, Social Security will provide you with 90% of the first $627 of your average indexed monthly earnings; 32% of your earnings between $627 and $3779, and 15% of any covered earnings above that point.


• The dollar amounts just mentioned ($627, $3779) are called "bend points": the points at which additional monthly income stops being replaced at one rate and begins to be replaced at a lower rate. (Imagine a graph plotting Social Security benefits for each dollar of monthly income. These are the points at which the line on this graph would bend.) The 'bend points' are adjusted each year by the increase in average wages. So if wages were to rise 3% this year, then next year's bend points would be 3% higher.


• Once your benefits have been calculated, they are adjusted each year to take account of inflation (that is: they are price-indexed.)

I spelled this out so that you can see that there are a number of adjustments taking place:

• Your earnings are adjusted for to take account of increases in wages in calculating your average indexed monthly earnings.


• The 'bend points' that determine how much of your monthly earnings are replaced at 90%, how much at 32%, and how much at 15% are adjusted to take account of wage growth.


• And your benefits, once they have been calculated, are adjusted to take account of increases in prices.

Clear? I hope so. That's as clear as I can make it.

Now: presumably, the switch from wage-indexing to price-indexing cannot involve a change to the way your benefits, once calculated, are adjusted to keep up with the cost of living, since this adjustment is already price-indexed. It must involve either (a) the calculation of your average indexed monthly earnings, or (b) the calculation of the bend points. And there is a big difference between these two, which turns on the question: when does this indexing begin?

When your average indexed monthly earnings are calculated, you begin with your actual earnings in your 35 best years. Suppose the first of these years occurs after price-indexing takes effect: your actual wages will reflect any growth in wages that has occurred between the onset of price indexing and that year. So any divergence between using wage- and price-indexing in calculating your average indexed monthly earnings would concern the difference between the rates of growth of wages and prices during your working life. Moreover, the difference between wage and price indexing will be greatest in that first year; thereafter, it will shrink. And assuming that the relationship between wages and prices holds steady, each generation will lose about as much as those who came before.

This is not true if price-indexing is used to calculate 'bend points'. These are indexed to a particular year (currently, 1979), and absent any changes in Social Security's rules, they will go on being indexed to that year indefinitely. Thus, the calculation of the first bend point today is as follows: $180 (the first bend point in 1979) times $34,064.95 (the average wage in 2003) divided by $9,779.44 (the average wage in 1979) equals $627.00. If we do not change Social Security, we will continue to calculate the bend points relative to 1979 as long as our country survives.

And this means that changing the sort of indexing used to calculate the bend points is a much, much bigger deal, in the long run, than changing the means of indexing used to calculate your average indexed monthly earnings. If price-indexing is used to calculate your average indexed monthly earnings, then you will be affected only by the divergence between the rates of growth in wages and prices over your working life. But if price-indexing is used to calculate the bend points, then the bend points will continue to decline, as a share of wages, as long as Social Security exists. Moreover, this decline will compound itself, like interest rates. Whereas, if price-indexing were introduced into the calculation of people's average indexed monthly earnings, each generation would lose about as much as the last as long as the relation between wage growth and price growth held steady, using price indexing to calculate the bend points means that every generation will have a smaller share of its income replaced than those that preceded it, until the end of time (or Social Security, whichever comes first.)

The version of price indexing that President Bush seems to be considering is a version of the second: adjusting the 'bend points' in accordance with the growth in prices, not wages. Specifically, he seems to be considering "progressive price indexing", a sort of hybrid between wage and price indexing. According to the Pozen plan (warning: long wonky pdf) on which the President's vague gestures in the general direction of a plan are supposedly based, people who make around $20,000 a year would have their benefits calculated as they do now. The cap on maximum earnings replaced by Social Security, by contrast, would be price-indexed. And the bend points in between would be calculated using a combination of the two approaches.

This means that while people making below $20,000 a year would receive the same benefits under the President's approach that they would receive if Social Security remained unchanged, people making more would receive significant cuts. The more time goes by, the deeper those cuts become. Eventually, the difference between the benefits given to those making below $20,000 and those making more would approach zero. (The Center for Budget and Policy Priorities estimates that benefits would be essentially flat for anyone making $20,000/year or more by 2100.)

All of this, of course, doesn't take into account the effects of personal accounts; but that's a topic for another day. All I really wanted to do with this post was to make it clear what 'price indexing' is, on the assumption that if I, a reasonably well-informed person, didn't get it, I might not be alone.

*UPDATE* There came a point, when I was writing this post, when I considered going to bed and finishing it this morning, but didn't. Possibly I should have. In any case, here (from the 'long wonky pdf' linked above (the Social Security Administration's assessment of the Pozen plan) is the exact way the Pozen plan's progressive price indexing would work:

"A. Begin by computing the percentage benefit reduction that would apply for the highest career-average earner becoming eligible for a retired worker benefit in each year 2012 and later based on CPI-indexing the PIA formula (as specified in Model 2 of the President’s Commission to Strengthen Social Security).

B. Then create a new “bend point” in the Social Security PIA formula at the level of the career-average earnings of the retiree at the 30th percentile of those becoming eligible for benefits in 2010, and wage index this bend point forward like the two current bend points. This new bend point is estimated to be 28.6 percent of the way up from the current first bend point to the current second bend point.

C. Calculate the percentage reduction to the “PIA factors” (32 and 15) that applies beyond the new PIA bend point that will provide the benefit reduction described above for the “maximum” earner reaching retirement eligibility for each year 2012 and later.

This proposal would replicate benefit reductions for the very highest career-average earners that are provided under a CPI-indexed benefit formula. Benefit levels would be reduced to a lesser extent for workers with lower career-average earnings, with no reduction for those at or below the 30th percentile of career-average earnings (AIME). The career average annual indexed earnings level used for Social Security benefit purposes is estimated to be about $25,000 at the 30th percentile for retirees becoming eligible for benefits in 2012. "

So, basically: The proposal is to create a new bend point, which does not fit in with, but sort of overlays, the previous ones. (You apply one function using the previous bend points, and then another using this new one.) This bend point is now at $20,000, and it will be wage-adjusted in future. Leave benefits that are due to earnings below this level alone.

Then: figure out what would have happened to the highest-earning worker under pure price-indexing of the bend points, starting in 2012. (Note: since Social Security only replaces income up to about $90,000 a year, the 'highest-earning worker' is anyone who makes this much or more. It's not necessarily Bill Gates.) Then figure out what adjustments to the percentage of income above the new bend point ($20,000) that is replaced by SS benefits would produce this result for the highest earning worker. (Currently, SS replaces 32% of some of that income and 15% of the rest; this will involve reducing these percentages by whatever amount is needed to produce the desired effect in people making about $90,000 or more.) Then apply this reduction to all earnings above the new bend point ($20,000.)

Comments

[Blar]

Very lucid, hilzoy. I'd heard about bend points before and had a vague idea of what was going on, but it's all so much clearer now.

Just one question. Presumably, that $20,000/year cut-off is going to be adjusted as the years go by. Will it be indexed to prices or to wages? My guess is prices - it'll just grow with inflation.

[Ogosdinos]

Hilzoy,

Thank you for the post. Why is it that prices rise more slowly than wages?

[notyou]

Why is it that prices rise more slowly than wages?

Good question, because they haven't lately.

The old answer was, I think, "wages track productivity growth; prices track wage growth."

[Anarch]

Excellent post, hilzoy. I love the smell of education in the morning!

[hilzoy]

Blar; it will be indexed to wages. Think of it as the point at which wage indexing is replaced by price indexing. Ogo: I dunno.

[Ogosdinos]

I want to preface everything I say here with the caveat that I don't know spit about economics.

Notyou: If the issue is just how they track, that sounds like a feature of a time of a lag, not a persistent differential that compounds over time, as Hilzoy's post asserted (I believe).

Hilzoy: As I recall, the classical idea was that this sort of thing should be incoherent. Prices can't rise any more quickly or slowly than wages because prices are wages. Or, at least, prices are wages plus profits. You can have a profit squeeze over the short- or medium-run, but it's hard to imagine how this could be a permanent feature of economic life. How could that share grow indefinitely as a proportion of the whole? Wage growth is, of course, a big cause of inflation, so if to imagine, as a historical fact, that prices grew more slowly than wages, I think you'd have to imagine a persistent inflationary pressure with a deflationary market outcome.

I really hope that this is the case, because it would be a great argument for capitalism. If wages rise more quickly than prices, then wage-earners have larger command of the overall stock of goods. The converse prediction, by the way, is exactly why Marxists economics turns out wrong. Marx and Ricardo both predicted that wages would be a lesser and lesser share of national income, leading to increased relative impoverishment, hoarding, insufficient consumption, and market contraction.

[Ogosdinos]

Let me just add that there must be something I'm missing, because too many people who know far more about this than I do keep stating it as if it were a law of nature that prices rise more slowly than wages.

But I don't know what it is, and if anyone knows, I'd very much appreciate it if they told me. Be blunt. Be unceremonious. I need to have a confrontation with the truth here.

[Bernard Yomtov]

Ogosdinos,

Wages are thought to rise more quickly than prices because real wages depend on productivity. As individual productivity increases, so should wages.

Think about a completely self-sufficient family. They grow their own food, build their own house, etc. If they become more productive - improve their agricultural methods perhaps, or learn how to make better tools, their "wages" rise. They have more goods to show for the same amount of work.

[notyou]

...following Bernard Yomtov's comment, prices rise as increasing wages chase the (more or less) same number of products (i.e. inflation). Prices can't rise faster* than wages, because it's rising wages that push prices up.

-------------------
*Unless they do, as has been happening recently, because of slack in the labor market and/or price spikes in key commodities.

[Bernard Yomtov]

Actually, rising wages do not cause inflation. This used to be thought to be the case, as people spoke of "wage-push" inflation, but I don't think this is a widely held view at this time. Note that in my example, while there is a rise in wages, it is exactly matched by a rise in output. The ratio of income to production has not changed. There is just more of both.

It is also possible for wages to rise while declining as a share of income. Remember that production increases increase income. How that increase is divided is a separate matter.

[notyou]

This used to be thought to be the case, as people spoke of "wage-push" inflation, but I don't think this is a widely held view at this time.

It appears I'll need to update my limited economics background.

It is also possible for wages to rise while declining as a share of income. Remember that production increases increase income. How that increase is divided is a separate matter.

One would assume the recent productivity gains have been captured by capital, given recent weak wage growth. This may counter Ogosdinos' theory that capitalism offers workers an ever increasing share of the goods over time. Instead, workers can get more of goods when they can enforce a claim on a greater share. Right now they can't.

[Ogosdinos]

Yomtov: If wages increase [say because of tough union action], businesses may or may not, depending on elasticities, be able to pass that off to consumers. If they succeed, profits aren't squeezed, but the increased buying power of wage-earners vanishes. What's the difference between demand-pull and wage-push inflation? Are you saying that nobody believes in demand-pull inflation either? If I'm understanding this right, they're two sides of the same coin and the difference rides only on which market mechanism dominates. Do businesses increase prices because they are incurring higher labor costs or do they increase prices because they suddenly find an increased demand? But whichever it is, it seems to have no bearing on the issue of how wages and prices track one another.

But if nobody believes in wage-push inflation, this is great news for liberals. It means that there is no serious ideological opposition to unionization any more. And so much for all the incomes and price policies of the 70s.

Yomtov, I'd be grateful if you explained why it might be that no one believes in wage-push inflation any more.

I'm beginning to see your point about wages. If the wage rate = price level * the productivity of labor, and the productivity of labor is ever increasing, the wage rate has to grow faster than the price level.

[Bernard Yomtov]

Ogosdinos,

I'm no macroeconomics whiz, so I can't answer your good questions too precisely. Suffice it to say, for now, that inflation has to do with the money supply relative to production, the degree to which people want to hold money (as opposed to longer term investments), and interest rates and so on.

It's important to note that a price increase in one sector of the economy does not necessarily imply inflation. Prices elsewhere may drop. Relative prices - the price of one good in terms of another: how many apples an orange costs - change constantly.

Suppose the UAW extracts major wage increases from the car companies. What happens? The price of cars may rise, but then fewer will be sold. Demand for steel and rubber may drop. Some workers, and car salesmen, may be laid off, reducing demand elsewhere in the economy. Some people who were thinking of buying a new car will change their mind and keep the old one. Used car prices rise, etc. The effects are manifold, but the point is that this by itself does not increase inflation.

I'm going to try to give you a better answer, but it will take a while.