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Sunday, February 11, 2007

Progressive Indexing

One proposal for Social Security that is floated repeatedly is to move to progressive indexing. Currently, until retirement, Social Security payments grow with wage inflation which, according to theory, ought to grow at the rate of inflation plus the rate of productivity growth. This allows a worker to receive payments consistent with the standard of living at the time of retirement.

Under progressive indexing, payments are linked to inflation only, they don't increase with productivity. What difference would this make over the life of a worker?

Assume a standard of living equivalent to $10,000 per year in 1960. At a 2% rate of inflation and a 2.5% rate of productivity growth, here is the difference between wage indexing and inflation indexing:

Indexing1

At the end of 40 years, (e.g. start working at 25, retire at 65) the difference in nominal income would be $58,164 - $22,080 = $36,084.

But what is the difference in real term? The next graph shows the difference between a constant real income of $10,000 - as with inflation indexing - and income that grows in real terms with the rate of productivity of 2.5% as with wage indexing:

Indexing2

At the end of 40 years, after the standard of living has more than doubled, the difference is $26,851 - $10,000 = $16,851. That's how much less, in real terms, a worker eligible for this level of payments would receive at retirement under progressive indexing, a large loss in relative terms.

Update: A comment says this demonstrates price versus wage indexing, not progressive indexing.  Fair enough - I wanted to avoid all the detail and focus on the essence of price indexing which is at the core of progressive indexing proposals (and not have several categories to present with different combinations of price and productivity adjustments). This shows how it would work for those who face a full phase out of productivity growth adjustments. Intermediate cases are easy to figure out from the diagrams. The main goal was to illustrate how these indexing proposals work in general and show the source of any saving from reduced benefits.

    Posted by on Sunday, February 11, 2007 at 01:28 PM in Economics, Social Insurance, Social Security | Permalink  TrackBack (0)  Comments (71)

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