Indexation links the value of one financial item to another, typically a price index, to minimize the impact of inflation. The most commonly used measure of inflation in the US is the Consumer Price Index (CPI), which is used to adjust retirement payments and income tax brackets. Indexing can be controversial, as it affects tax payments, public treasury, and retirees.
Indexation is the means by which the value of one financial item, typically duty or tax payments, is linked to the value of another, typically a price index. When the linked value increases or decreases, the payment amount automatically changes to reflect that increase or decrease. Indexing is intended to minimize or eliminate the impact of inflation on those who receive or make these payments.
There are a wide variety of indexing techniques, but they all involve comparing current values with historical values. In some cases, current values are compared to those of years ago; in others, the comparison is month-to-month, quarter-to-quarter, year-to-year, or the current period to the corresponding period one year earlier. In the United States, the most commonly used measure of inflation is the Consumer Price Index (CPI), which is the change in the value of an average “market basket” of universally necessary goods and services, including food, housing, transportation and health care. The value of the market basket is compared to previous values, and the exchange ratio is the actual amount of the index.
The best known payments that are subject to indexation are those made to retirees. The underlying logic for indexing retirement payments is that since inflation is almost inevitable, retirees’ pensions would automatically lose their purchasing power over time because they are not eligible for the salary increases available to active workers. In the US, Social Security benefit payments to retirees are subject to an annual Cost of Living Adjustment (COLA), so that retirees do not suffer a significant loss in the purchasing power of their benefits due to inflation. In addition, US income tax brackets are indexed to offset the effect of inflation, thus protecting taxpayers from a phenomenon known as “creeping,” which is the increase in the income tax rate that results from the worker earns more money, even when the purchasing power of that additional income is diminishing. Both index adjustments are based on the change in the CPI, although no adjustment is made if the change is negative.
Indexing can be a controversial issue because it influences the amount of tax paid by individual taxpayers, the amounts paid from the public treasury, and the amounts received by retirees and others. When Social Security COLA adjustments are announced in the US, for example, retirees typically complain that the adjustment is not enough to meet the effects of inflation and claim that the CPI is an inaccurate measure of inflation. .
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