Milton Friedman wrote in 1974 that indexation could be used to reduce inflation
But I know of no other that has been suggested that holds out as much promise of both reducing the harm done by inflation and facilitating the ending of inflation.
Indexation is the gradual increase of a payment based on some index, generally a price-based index such as the consumer price index (CPI). The objective, as Friedman noted, is to offset inflation. In theory, an indexed payment stream will maintain its real purchasing power.
Price indexes such as the CPI, or the non-farm GDP deflator, are of course statistical estimates. They are approximations of true inflation.
The CPI tends to overstate inflation for at least four reasons
- substitution effect: when the price of a product in the consumer basket increases relative to other products, consumers tend to substitute to other products
- quality bias: although the ABS to some extent uses hedonic pricing, it does not fully capture improvements in quality – the car one can buys today is much more reliable than the one bought 10 years ago (for example)
- new product bias: new products are not introduced to the basket until they have been well established. The dramatic price falls associated with technology are not captured in the CPI
- outlet bias: the shift to online purchasing and new ways of buying products has not been captured in the CPI.
The eminent economist Ted Sieper thought that these biases meant that the CPI tended to overstate inflation by 100 to 150 basis points.
If the objective of an indexed payment stream is to maintain real purchasing power, then, the index would be approximately CPI minus 1 percentage point. In practice the CPI index has been used, which actually means the recipient of the income stream is gradually becoming better off.
One would think this would be the end of the argument. Yet successive governments have used higher indexes for various payment streams. For the age pension and the disability support pension, it is the higher of several indexes, including the CPI, the pensioner and beneficiary index and the Male Total Average Weekly Earnings index. As I noted in an earlier post, the Reserve Bank unilaterally increased its indexation of the Reserve Bank Superannuation Scheme to MTAWE in 2002.
Latterly there has been a campaign from recipients of the Military Superannuation and Benefits Scheme to increase indexation. The previous government asked Trevor Matthews to conduct a review of the indexation of public service and military superannuation schemes. His 2008 review report recommended that the indexes for these schemes be maintained at CPI.
Importantly Matthews found that the majority of defined benefit schemes around the world are indexed to prices (ie: CPI equivalent) rather than wages (ie: MTAWE equivalent). The Australian State defined benefit schemes are similarly indexed to CPI.
I agree with Matthews’ assessment. The indexation for all defined benefit superannuation schemes: public service, military, political and judicial, should be the CPI. I agree with this even though I would personally benefit if the indexation was to be increased.
We have an ageing population, with an increasing number of people who will collect the age pension. We have a large cohort of people receiving the DSP.
All of these schemes should be indexed to the CPI.
There is no case, except jealousy, for pensions and defined benefit superannuation schemes to be indexed to a higher rate. We need to reduce pressures on the budget. Otherwise there is an increasing likelihood that tax rate will need to rise.
The Government should cut all indexation to the CPI, and legislate so that the Reserve Bank’s scheme reverts to its 2002 indexation of the CPI.