Introduction

Changes in prices as measured by the Consumer Price Index (CPI) were automatically linked to $441 billion in federal spending and $595 billion of federal tax receipts and affected the lives of millions of individuals who received federal benefit payments and paid federal taxes in fiscal year 1995. For example, when Congress legislated the use of the CPI to automatically increase Social Security payments, it indicated that this indexation was to offset increases in the cost of living.
According to BLS, the CPI is not a cost-of-living index but measures the change in prices of a fixed market basket of goods and services. However, the CPI has been used in various ways that are related to the cost of living. For example, the CPI is used as an escalator to adjust income payments, tax brackets, and deductions for personal exemptions. Although some elements of the CPI reflect cost-of-living concepts, the CPI was not designed as a cost-of-living index. To date, the federal government has not developed a comprehensive cost-of-living index.
The CPI tracks the change in prices of a fixed market basket of goods and services purchased directly by urban consumers. These purchases are for food, clothing, shelter, fuels, transportation, entertainment, medical services, and other goods and services that people buy for day-to-day living. Only expenditures made by consumers are captured in the CPI.
The CPI does not attempt to measure all changes in the cost of consumption needed for an individual to maintain a constant level of utility, that is, consumer satisfaction. When consumers face rising prices, and especially when some prices rise faster than others, consumers tend to alter their purchasing patterns to maintain as high a living standard as possible. Because the CPI holds the “market basket” constant and does not account for what consumers would pay when they change the amounts they buy, or substitute one product for another, it does not measure consumers’ cost of living. The CPI, therefore, is not a cost-of-living index.
A comprehensive cost-of-living index would be broader in coverage than an index based on consumer expenditures or consumer budgets. In theory, a cost-of-living index would include purchased goods and services; the use of semidurable and durable goods, such as houses and automobiles, owned or rented; free goods of nature; and government-provided goods and services. However, the components of an actual cost-of-living index may vary and there is no single, comprehensive measure of the cost of living.
Some government-provided goods and services, such as public mass transit, that charge for the service are included in the CPI. However, other items that would be in a comprehensive cost-of-living index, particularly public and free goods of nature, are excluded from the CPI because they cannot be readily measured and consumers do not directly pay for their use.

		Background

The Bureau of Labor Statistics (BLS), within the Department of Labor, produces the CPI by measuring the average change over time in the prices paid by urban consumers for a fixed market basket of consumer goods and services. The market basket is determined from detailed records of purchases made by thousands of individuals and families. The items selected for the market basket, such as potatoes, are to be priced each month at retail outlets, such as grocery stores, in urban areas throughout the country. According to BLS, in 1995, approximately 30,000 outlets were visited each month, with prices collected for 94,000 items.
The CPI is used as a measure of price changes to make economic decisions in the private and public sectors. For example, landlords use the CPI to adjust rental payments for the effects of inflation. According to BLS, the CPI has three major uses: (1) indicator of inflation for policymaking and economic decisionmaking; (2) escalator for wages, income payments, and tax brackets to preserve the purchasing power of people receiving government transfer payments and to adjust the tax burden so that people pay in inflation-adjusted dollars; and (3) deflator of selected economic statistical data series to make adjustments to show real changes in the data over time. For additional information about the uses and construction of the CPI, see appendix II.
The CPI was initiated during World War I, when rapid increases in the prices of goods and services, particularly in shipbuilding centers, made such an index essential for calculating cost-of-living adjustments in wages.
In 1921, BLS began regular publication of an index representing the expenditures of urban wage and clerical workers, which was then called the Cost-of-Living Index. The name of the index was changed to the CPI following controversy during World War II over the index’s validity as a measure of the cost of living. According to BLS, it has always been a measure of the changes in prices for goods and services purchased for family living.
Major revisions were made to the CPI about every 10 years to update the fixed market basket; the next major revision is scheduled to be released in January 1998. Because people’s buying habits changed, new studies were made of what goods and services people were purchasing and major revisions of the CPI were made in 1940, 1953, 1964, 1978, and 1987. In the 1978 major revision, several changes were made, including the publication of a new index for all urban consumers—CPI-U. According to BLS, the CPI-U, which represents the expenditures of about 80 percent of the population, takes into account the buying patterns of professional employees, part-time workers, the self-employed, the unemployed, and retired people, as well as those previously covered in the CPI. BLS continued publication of the original index, the CPI-W, which represents the expenditures of urban wage and clerical workers, about 32 percent of the population.

		Conceptual Change to the CPI Recommended in 1961

In 1961, the Price Statistics Review Committee of the National Bureau of Economic Research, chaired by George Stigler, identified conceptual problems with the CPI and addressed issues concerning the measurement over time of durable goods, such as housing. The Stigler committee acknowledged that the CPI’s original purpose was to measure average price changes of a fixed market basket of goods and services over time, which could measure the change in consumers’ standard of living if the marketplace did not change. However, given that consumers’ tastes change over time, or that higher quality goods at lower prices may become available, the committee determined that a fixed market basket of goods and services did not realistically represent a consumer’s standard of living. The Stigler committee recommended that the conceptual framework of the CPI be modified to represent a cost-of-living index because the CPI was being used in the private sector as a cost-of-living measure. Specifically, the committee recommended that the asset-price approach for measuring homeownership costs be replaced with an approach that determined the cost of consuming a flow of services generated by durable goods like houses. A flow-of-services approach would measure the cost of consuming housing rather than the change in the investment value of a house that the asset-price approach measured.
According to BLS, the Stigler committee’s effort was the last comprehensive review of price indexes. At the time we were doing our work, a CPI commission appointed by the Senate Finance Committee was conducting a study on the CPI’s accuracy as a measure of the cost of living. The commission issued an interim report in September 1995. According to the interim report, the commission’s formation and charter were motivated by concern that the CPI misstates inflation and leads to inappropriate changes in federal individual income tax brackets and federal benefits. The interim report discusses categories of potential bias in the CPI, such as substitution and quality change.
The commission’s interim estimate was that the CPI overstates inflation by 1.0 percent per year, which fell within a range of 0.7 to 2.0 percent. The commission expects its final report to include recommendations for procedures to improve and/or complement the CPI. The commission’s final report is scheduled to be issued by December 1996.

		Objectives, Scope, and Methodology

The Ranking Minority Member of the House Committee on Banking and Financial Services asked us to (1) determine if a change made to the housing component in the early 1980s made the CPI either more or less suitable for use as a cost-of-living measure and (2) identify the advantages and disadvantages of changing the current measurement of medical care costs to an approach that more closely matches a cost-of-living measure. We surveyed recognized experts to obtain their views on how the change affected the housing component and on the advantages and disadvantages of changing the medical care component. As agreed with the requester, we did not try to identify and address all of the policy issues that might arise in moving the CPI toward a cost-of-living index.
We reviewed relevant literature and held discussions with experts in the field to gain an understanding of the methodologies used in computing the CPI. These experts included individuals associated with the CPI at BLS, as well as private organizations and academic institutions. We also obtained information from BLS officials on their plans to revise and improve the CPI. On the basis of these reviews and discussions, we identified the major concerns that were associated with the asset-price approach, which was used to measure homeowners’ costs before 1983, and the measurement of medical care. We recognize that these concerns and issues we identified are not exhaustive.
To obtain the views of experts, we selected two panels of experts and surveyed them. We chose 10 housing measurement experts from a candidate list of more than 50 names; we also chose 10 individuals to serve as medical care measurement experts from a candidate list of more than 50 names. To obtain diverse candidate lists, we conducted a literature review and asked for nominations of potential experts from those experts in the field and representatives of BLS that we met with during our initial discussions. We then contacted the nominated individuals and asked for their nominations of experts. To avoid potential conflicts of interest, we excluded individuals from the lists who were current political appointees, current BLS employees, and previous BLS administrators responsible for making CPI methodological changes. In selecting the experts, we first selected those who were nominated more frequently than the others and then randomly chose thereafter. We verified that these selections included experts from academic and user communities, such as the American Medical Association, and that the selections contained at least one expert suggested by BLS. The responses we received reflect only the views of the experts included. (See app. IV for a list of the selected experts.)
We surveyed 10 housing measurement experts. The questionnaire we sent to these experts contained a historical synopsis of housing cost measurement in the CPI, including brief descriptions of the concerns that stimulated BLS’ adoption of the rental equivalence method in the 1980s and an overview discussion of the rental equivalence method in terms of measuring the cost of living. We asked the selected housing experts if the rental equivalence method adequately addressed the concerns expressed by critics about the use of the asset-price approach and if any concerns emerged as a result of using the rental equivalence method. In addition, we asked them if the adoption of the rental equivalence method made the CPI either more or less suitable for use as a measure of cost of living. (See app. V for a copy of the information and questionnaire sent to each expert.)
We interviewed 10 medical measurement experts. Before holding the interviews, we sent a letter to these experts in which we provided a background paper that identified and briefly described measurement issues that may result from cost shifting among medical care payers. This material was provided to the experts prior to our interviews as a reference point from which to begin our in-person interviews. At the interviews, we asked the experts about the influence of cost shifting on the medical care component. We also asked the experts to provide advantages and disadvantages of changing the current measurement of medical care costs to an approach that more closely approximates a cost-of-living measure. (See app. V for a copy of the information sent to and the questions asked of each expert.)
We did our work in Baltimore, MD; Boston, MA; Chicago, IL; Philadelphia, PA; Richmond, VA; and Washington, D.C., between July 1995 and January 1996 in accordance with generally accepted government auditing standards.
We requested comments on a draft of this report from the Acting Director of OMB and the Secretary of Labor, or their designees. The comments are summarized and addressed in chapter 4. A more detailed account of our scope and methodology is contained in appendix I.

	Methodological Changes to Homeownership Measure Made the CPI More Suitable as a Cost-of-Living Measure

In the 1980s, BLS began using the rental equivalence method of measuring homeowners’ costs. Recognized experts that we surveyed viewed the change that BLS made as making the CPI more suitable as a measure of the cost of living. They noted, however, that some new issues have emerged as a result of using the rental equivalence method. Although the new method may have made the CPI more suitable as a cost-of-living measure, BLS officials said this was not their objective. Rather, they made the change to better measure housing costs within the CPI’s structure of measuring price changes of a fixed market basket of goods and services.

		Historical Development of Housing Measures in the CPI

Homeownership was not included in the original CPI that was designed to represent 1917 through 1919 expenditures of wage earner and clerical worker families in large shipbuilding and industrial centers, for the main reason that these families typically did not own homes. Costs associated with homeownership were first included in 1953 because homeownership among the urban wage earner and clerical worker population increased following World War II. The homeownership measure in the CPI—the asset-price approach—was designed to measure changes in the cost of acquiring, financing, and maintaining houses. This concept was used from 1953 to 1983. For more information on the historical development of the measurement of housing, see appendix III.

			BLS Adopted the Rental Equivalence Method

Following publication of the Stigler committee report, BLS started in the 1960s to explore measures of the flow of services received from owner-occupied homes. However, because methodologies had not yet been developed on how to measure these services, BLS had to develop new methodologies.
BLS decided to explore two flow-of-services methods: user cost and rental equivalence. BLS staff considered the two methods to be equally powerful in concept; however, problems raised over implementation of the user cost method outweighed its attractiveness. A user cost index measures total cost to owners living in their homes by adding the various explicit costs, such as payments for mortgage interest and property taxes, and implicit costs, such as depreciation, which homeowners incur in providing shelter for themselves. The user cost approach was abandoned after much review because it involved estimating the appreciation or depreciation value of a house over time and the cost of not having access to equity in the house. BLS noted that calculating such estimates was difficult because of substantial variations in housing data. BLS also found that the method sometimes provided some peculiar results.
Rental equivalence, on the other hand, was easier to explain to the public and the users. The rental equivalence method attempts to infer the income that homeowners forgo when they reside in their own homes rather than rent them to others.
In 1977, when it was time to implement methodological changes for the 1978 major revision to the CPI, BLS’ advisory groups had not reached a consensus on an appropriate flow-of-services approach, so the asset-price approach was continued. In addition, some users of the CPI thought it should reflect the cost of purchasing a home because most families lived in their own homes and did not rent. Therefore, it was not changed.
BLS, however, decided to continue research and consultation and, in 1980, began publication of experimental indexes that represented alternative homeownership concepts. These indexes were variations of the user cost method and the asset-price approach, as well as the rental equivalence method. By the early 1980s, however, changes in real estate and mortgage markets—high prices of housing and high interest rates—drew attention to the limitations of the approach used to measure homeowners’ costs. For a detailed description of issues associated with the asset-price approach, see appendix III. In 1981, the Commissioner of Labor Statistics announced that beginning in 1983, BLS would use the rental equivalence method to measure homeownership costs.
In January 1983, BLS changed the measurement of homeowners’ costs in the CPI-U from an asset-price approach to a flow-of-services approach. The CPI-W was not changed until January 1985 because BLS wanted to provide adequate notice of the conceptual change, since the CPI-W was used to escalate long-term labor contracts and federal programs.

		Experts Said That the Rental Equivalence Method Makes CPI More Suitable as a Cost-of-Living Measure

We asked 10 experts their views on whether the rental equivalence method made the CPI more or less suitable as a cost-of-living index. All 10 were expert in measuring housing costs and were very familiar with the CPI housing component.
All of the housing measurement experts agreed that the adoption of the rental equivalence method made the CPI more suitable for use as a measure of the cost of living. Our analysis of the experts’ comments showed that most of the experts responded that the CPI is now more suitable because it measures the cost of housing services that are used, rather than the cost of buying the house or its value as an asset. One of the experts said that the cost-of-living index “concept is based on consumer utility theory which suggests that utility comes from consumption, or use. Since rent is the ‘price of using,’ rental equivalence enhances the use of the CPI as a proxy for the cost of living.” A few of the experts also noted that additional improvements, such as including environmental costs and taxes in the CPI, would make it more like a cost-of-living index. A few of the experts noted that the rental equivalence method was not perfect for measuring the cost of living because renting is not the same as owning a home.

			Experts Agreed That Concerns About the Asset-Price Approach Were Adequately Addressed With the Rental Equivalence Method

All of the housing measurement experts reported that in general, the rental equivalence method adequately addressed the concerns that had been expressed about the use of the asset-price approach, which had been used prior to the early 1980s. A few of these experts commented that in comparison with the asset-price approach, the rental equivalence method was better in the representation of inflation and tracking the changes in the cost of occupying a home. The rental equivalence method was viewed by a few experts to be more appropriate than the asset-price approach, especially if the CPI is to approximate the cost of living. A few of the experts also noted that rental equivalence addressed long-standing concerns with the mortgage and housing price data that were associated with the asset-price approach (e.g., mortgage interest rates overstating actual interest expenses). According to a few of the experts, rental equivalence could represent all sections of the housing market, as long as rental housing of similar quality is available. A few of the experts also commented that the rental equivalence method in comparison to the user cost index method, which was also proposed in the 1970s as an alternative methodology, was easier to understand, more stable, and was not subject to arguable assumptions.
A few experts mentioned alternative methods to the rental equivalence method. These experts’ general comments indicated some interest in using variations of current mortgage payments, down payments, or mortgage interest to measure homeowners’ costs. However, there was no consensus on any one variation. As one of these experts noted, the “suggestion is not in any way intended to invite a return to the asset-price approach used until 1982.”

			Mixture of Issues With the Rental Equivalence Method

Overall, the experts’ responses to whether issues have emerged as a result of using the rental equivalence method were mixed. The majority of experts said there were issues with the method, but none of the specific issues was identified by more than two experts. Although the experts found the rental equivalence method to be a good replacement for the asset-price approach, a few of the experts expressed concern that the rental units used in the methodology may not be similar to the owner-occupied housing units they are to represent. One expert said that this “could lead to errors, but in both directions.”
A few of the experts noted another concern that the CPI overstates inflation because of the time at which the rental equivalence method was implemented. The change to rental equivalence occurred at a historical peak in mortgage interest rates. As a result of the timing of the switch in methodology, the subsequent decline in mortgage interest rates was not captured in the CPI. One of the experts noted that “government transfer payments would be . . . lower today if the switch had not been made at the interest rate peak. Moving to a better index, but at the wrong time, has been extremely costly.”

		BLS Views Rental Equivalence as Consistent With Fixed Market Basket Definition

BLS officials told us that the adoption of the change to the rental equivalence method was simply a change in the measurement of the costs of homeownership rather than one intended to move the index toward a cost-of-living index. In making changes to the CPI, BLS said it seeks to improve the presentation of out-of-pocket expenditures, not to move the CPI conceptually toward a cost-of-living index.

	Advantages and Disadvantages Cited for Changing Measurement of Medical Care

Medical care expenses, including health insurance premiums, directly paid by consumers have historically been included in the CPI. Medical care expenses paid by third parties, such as employers, which make up about two-thirds of all medical care expenses, are excluded from the CPI. A CPI based on comprehensive cost-of-living concepts would include expenses paid by third parties.
The 10 medical care measurement experts responding to our structured interview survey offered various advantages and disadvantages to changing the medical care component to an approach that more closely matches a cost-of-living measure. A majority of the experts said that some types of third-party expenses should be included in determining the level of importance BLS would assign to medical care price changes. Medical care expenses paid by third parties are excluded because, according to BLS, the CPI is designed to measure only out-of-pocket expenses and given that the most important purposes are probably Social Security and tax bracket indexation, it is not clear that health insurance fringe benefits should be included.
All of the experts we interviewed said that prices that are actually paid by consumers and third-parties should be used in the CPI. Since 1987, BLS has been moving toward collecting more transaction prices for medical care items.

		Determining Medical Care Costs in the CPI

The CPI is constructed from two kinds of data. One kind is used to determine what items are to be included in the CPI components and the relative importance of the components. The second kind of data reflects the prices paid for items in the CPI. (See app. II for more information on the construction of the CPI.) These two kinds of data are used to construct the medical care component; and over the years, BLS has tried different methods of incorporating these data.

			Difference Between Weighting and Pricing

The goods and services that consumers purchase are collectively referred to as items in the market basket. These items are grouped together into components. For example, hearing aids and dental services are items in the medical care component. BLS assigns weights to items within a component and to the components. Weighting is the proportionate emphasis given to price changes of one item or component in relation to other items and components. In the medical care component, weighting is affected by the presence or absence of third-party payers. In addition, prices paid by consumers are collected for the items in the market basket. For the medical care component, BLS may collect several different prices for the same item from medical care providers. For example, one hospital may have a list price that is charged a patient who pays the fees directly, while another hospital reports a discounted transaction price for the same procedure that has been negotiated with third-party payers.
To further illustrate how weighting and pricing differ, consider a hypothetical example of a consumer who receives medical care at a physician’s office. The consumer pays a $5 insurance co-payment and the insurance provider pays the physician an additional $12 under a negotiated fee arrangement. The combined payment to the physician of $17 is less than the price that the physician “lists” for the service provided, $20. In computing the CPI, such a transaction may have the following effects:
The $5 co-payment is the “out-of-pocket” expenditure, which is used to set the amount of the weight. To determine the share of consumer expenditures spent on medical care or other components, BLS added that $5 together with all other consumption expenditures in the Consumer Expenditure Survey (CEX), which includes the consumer’s cost of premiums paid for health insurance. This aggregate of medical expenses is compared with the aggregate of expenditures on all goods and services in the market basket. The percentage of medical care expenses in relation to all expenditures becomes the expenditure weight assigned to the medical care component. In its pricing surveys, BLS would price the medical service at $20, the list price. The transaction price would be $17 in this hypothetical situation, assuming that this payment method were selected for pricing.

			BLS Tried Different Methods to Price Medical Care Costs

Medical care has always been in the CPI, and consumer-purchased health insurance has always been included as a medical expense. Over the years, BLS tried different methods of pricing medical care, including health insurance directly paid by consumers, but has not altered the method used to determine the weight of the medical care component.
Originally, the price change rate for health insurance was assumed to be equal to the average of other medical items. In the 1950 revision, BLS deviated from this approach and began to directly price health insurance policies. In 1964, the approach was changed to an approach that again based health insurance price changes on prices observed for other medical goods and services, as well as the insurance carriers’ operating costs and profits. In 1978 and 1987, BLS made minor adjustments in measuring health insurance with most of the changes occurring in publication of health insurance price changes.
In 1987, BLS began to collect medical care transaction prices, actual prices paid, which include fees that have been negotiated between medical care providers and third-party payers. BLS plans to collect transaction prices for all medical care items by January 1997. (See app. III for a detailed historical description of the measurement of medical care items.)

		Trends in Medical Care Expenditures

In 1965, households directly paid for about two-thirds of all medical care expenses. About 30 years later, these medical care expenses, upon which the CPI is based, represented less than one-third of all medical care expenses. As shown in figure 3.1, the proportion of total medical care represented in the CPI steadily declined since 1965.
The most recent data available, for 1991, indicate that about 28 percent of total consumption of medical care is represented in the CPI. Because the medical care component is based only on out-of-pocket medical expenses and health insurance premiums reported in the CEX, not all medical care expenditures are included in the CPI (see fig. 3.2). The CPI does not include medical care that consumers receive through employer-provided benefits and government-provided health care programs, such as Medicaid and part A of Medicare. Although employees and the self-employed make contributions to the Medicare hospital insurance trust fund, BLS considers these contributions as employment taxes and thereby excludes expenses paid under these programs.

		Researchers’ View of the CPI’s Measurement of Medical Care

Like other aspects of research on the CPI and cost-of-living indexes, research on the medical care component has sought to determine the appropriate weights and prices for medical care. Research into the issue of cost shifting between third parties and consumers has drawn attention to the impact that the inclusion of third-party payments may have on the weight given to the medical care component of the CPI. Similarly, research findings on medical care providers using multiple prices for the same medical care service have led to an examination of the CPI’s use of list prices rather than transaction prices.

			Concerns About Medical Care Weight

The appropriateness of the weight assigned for medical care in the CPI has been questioned by some researchers who contend that the current weight distorts price changes that result from cost shifting among health care payers. They contend that the current weight based on expenditures directly paid by households can result in an inaccurate level of importance being assigned to this component of the CPI, as compared with a weight based on all medical expenditures. The inaccuracy can occur when costs shift between payers who are included in the CPI and those who are excluded. For example, if employers decrease the amount that they pay of their employees’ medical care expenses, then the employees’ direct expenses, which are used to set the CPI medical care component weight, increase thereby increasing the weight assigned to medical care. An inappropriate weight of a component in the CPI can lead to over- or understatement of the rate of inflation, if the rate of price change for that component differs from other components in the CPI. A weight based on all medical care expenses, however, would not be affected by cost shifting over time between payers because all costs, regardless of who paid for the care, would be represented in the CPI.
Cost shifting over time can be illustrated by employers’ efforts to constrain increases in annual health insurance premiums by raising deductibles and shifting more of the premium costs to employees. BLS reported that the proportion of families paying all or part of their health insurance premiums has increased from 60 percent in 1984 to 67 percent in 1992. BLS reported that between 1984 and 1992 average household out-of-pocket medical care expenditures rose from $1,049 to $1,634, a rise of about 7 percent per year. These data suggest that the weight for medical care, which is based on 1982 through 1984 CEX data, is lower than one that would be derived from more recent out-of-pocket medical expenses.
A comprehensive cost-of-living index would include out-of-pocket, government-provided, and employer-provided medical care costs to incorporate all medical care expenses. In a 1994 study, the Congressional Budget Office (CBO) noted that, if the measurement of all medical care expenses were more appropriate for measuring the cost of living, the current CPI would have a downward bias relative to the cost of living.Using data from the National Income and Product Accounts, CBO estimated in 1994 that the influence of medical care price changes on the CPI would more than double if all medical care expenses were incorporated.

			Concerns About How Medical Care Expenses Are Priced

In addition, researchers have noted the divergence in medical care price indexes when one group of payers subsidizes another. Cost shifting within the marketplace also occurs when third-party payers are charged prices that differ from prices paid by consumers. BLS does not use transaction prices for all medical care goods and services included in the CPI; it has announced plans to do so. Any collection and use of inappropriate medical care prices could lead to over- or understatement of the rate of inflation, if the rate of change for transaction prices differs from the prices used in the CPI. (See app. II for a description of the collection of medical care prices for the CPI.)
In its 1994 study, CBO noted that a CPI based on out-of-pocket medical costs fails to capture price distortions caused by cost shifting. In this case, cost shifting may occur when the government does not reimburse health care providers for full cost of services to Medicare patients, and providers try to recoup the difference by increasing the costs to their private-pay patients (e.g., those paying for services themselves). CBO found that Medicare reimbursement in the early 1990s paid for 88 percent of the costs of covered services, compared with full reimbursement during the mid-1980s. CBO observed that the CPI for out-of-pocket medical care costs increased faster than the price index for Medicare during the mid-1980s to early 1990s because of cost shifting. The study suggests that the CPI overstates the rate of inflation because it fails to capture the price paid by the federal government.
However, HCFA disputes CBO’s findings on cost shifting. According to an HCFA official, any findings that Medicare or Medicaid pays less per day of hospital care than others is not evidence that these programs are shifting their costs elsewhere.
The medical care measurement experts we surveyed indicated in their general comments that this issue is not resolved. A few of the experts said that cost shifting does not occur between government-provided programs and other payers and cited research on cost shifting in Illinois and California hospitals. The study of Illinois hospitals supported CBO’s findings that hospitals offset most of the rise in unreimbursed Medicare costs during the 1980s by generating higher revenues from private payers, which were cited in the background paper sent to the medical care experts. The author, however, suggests that as private sector pricing becomes more competitive, the ability and willingness of hospitals to cost shift will decline. The study of California hospitals found no cost shifting from publicly funded patients to privately insured patients.

		Experts’ Views on Changing Medical Care Measurement Were Mixed

We asked 10 experts for their views on the advantages and disadvantages of changing the current measurement of medical care costs to more closely match a cost-of-living measure. We also asked about the types of medical care expenses that should be included in the weighting of the medical care component, as well as the types of prices that should be incorporated in calculating the changes in medical care costs.

			Advantages and Disadvantages Cited by Experts of Moving to a Cost-of-Living Concept

All but one of the experts cited advantages to changing the current measurement of medical care to an approach that more closely approximates a cost-of-living measure. Our analysis of the experts’ responses showed that a few of the experts said that policymaking would be improved with such a change. These experts said that a change to a cost-of-living concept could support the implementation of appropriate health care policies. For example, one expert cited a need for accurate information during a debate on pharmaceutical drugs. A few experts also cited each of the following advantages:
A change would improve macroeconomic policymaking; one expert noted that the Federal Reserve was currently guessing at the amount of overstatement of inflation in the CPI.
A change to cost-of-living concepts for the medical care component would allow private and public policymakers and researchers to have a better understanding of what is happening in medical care costs.
The change would improve the Gross Domestic Product’s (GDP) implicit price deflator thereby improving research that used the implicit price deflator.
All of the experts cited at least one disadvantage to changing the medical care component to more closely approximate a cost-of-living measure. A few of the experts were concerned about the measurement of utility (as previously defined in footnote 3, p. 10) in the medical area. For example, one expert questioned how one would measure a patient’s satisfaction from a procedure that had a very high mortality rate but also offered, when successful, a long-term survival rate. In addition, a few experts noted the following disadvantages:
A change would mean a break in the continuity of the price data, which would affect long-term trend analyses.
Measures based on cost-of-living concepts were susceptible to manipulation because of the subjectivity of measuring satisfaction.
It would be expensive to switch to the new methodology, and it would also be more expensive than the current methodology to maintain. For example, one expert noted that transaction price data would be regarded by health care providers as sensitive information and burdensome to provide to BLS. More specifically, this expert said that physicians would have to go through each of their third-party contracts to obtain this information. In general, the political environment is not conducive to making a change in medical care indexes. For example, one expert noted that recognition of a previous overstatement in the CPI would anger those whose benefits are indexed with the CPI.
In addition, a few of the experts were concerned about changing the medical care component without changing other components at the same time to more closely approximate a cost-of-living measure.

			Most Experts Said Additional Expenses Should Be Included in the Weighting of Medical Care

In addition to obtaining the experts’ opinions on the advantages and disadvantages of changing the current measurement of medical care costs, we took the opportunity to ask the experts how cost-of-living concepts would be implemented. All but one of the experts said that some types of medical expenses other than those already captured in the CPI should be included in weighting the medical care component. The majority of the experts said that employer-provided and union-provided medical care should be included in the weighting of the medical care component. One-half of the experts supported the inclusion of government-provided care. Fewer experts supported the inclusion of medical expenses provided by charitable organizations and expenses absorbed by health care providers. One expert said that no additional expenses should be included in the weighting of the medical care component. This expert said that if the CPI is used to adjust wages or payments, then only out-of-pocket expenses paid by consumers should be included in the CPI.
Our analysis of the experts’ responses showed that a few of the medical care measurement experts who supported the inclusion of all medical care expenses commented that it was logical to include all expenses if the burden of payment fell upon the general population. Of the experts who supported the inclusion of additional expenses other than those provided by charities or the government, a few said that expenses that affect the buying power of consumers should be included in the medical care component.
There was no consensus on how to implement weighting that is based on cost-of-living concepts. The experts’ observations on whether public-provided health care should be included illustrate both the diverse and occasionally contradictory comments of the experts. A few of the experts did not want such care included because other government-provided services (e.g., national defense) were not in the CPI. Other experts expressly told us that government-provided care should be included because consumers pay for this care through taxes and lower wages. These experts also supported the inclusion of taxes in the CPI. And still other experts were silent on this issue. A few of the experts expressed the opinion that the medical care component should not be changed to measure cost-of-living concepts unless all components were changed at the same time.

			Experts Agree That Transaction Prices Should Be Used

All of the medical care measurement experts said that transaction prices should be used in gathering price data for medical goods and services. A few of the experts observed that consumers are paying transaction prices and that list prices should only be used in instances when nothing else is available, or if list prices are cheaper to collect. A similar number advocated the pricing of comprehensive health care packages, such as basic health maintenance organizations’ (HMO) plans. However, one expert advocated using list prices in geographic areas where HMOs had not penetrated the market. A few of the experts made the following additional comments:
List prices could be transaction prices in some instances.
Transaction prices are available for data collection.
BLS was not recording the appropriate transaction prices.
List prices usage in the CPI has led to the overstatement of inflation, especially in pharmaceutical drugs.
BLS’ pricing of medical care items was inappropriate. These experts told us that BLS should be pricing the cost of a treatment or cure of an illness. They said that the current approach of pricing the cost of medical care items, such as x-rays, doctor visits, diagnostic tests, and hospital stays, is inappropriate for today’s CPI.
BLS’ methodologies are not capturing the substitution of new treatments for items in the CPI’s medical care market basket. For example, one expert said BLS should be pricing the cost of treating medical conditions, such as heart attacks, rather than hospital stays. This expert stated that BLS’ methodology used for the CPI indicates that the per day charges for hospital stays are going up for heart attack patients, when in reality new treatments allow patients to go home earlier. According to this expert, by incorrectly pricing hospital stays, the current BLS methodology results in overstatement of inflation.
In addition, a few of the experts also provided an example of the difference in rate of price change between transaction and list prices. They noted the lower rate of increase for hospital rooms in the Producer Price Index (PPI), which uses transaction prices. The difference between the CPI and the PPI for physicians fees that both use transaction prices, however, is not as large as that for hospital rooms.
BLS began collecting and using medical care transaction prices in 1987. Since then, it has expanded the collection of transaction prices for additional medical care items. It plans to collect transaction prices for all medical items by January 1997. (See app. III for further details.)
According to BLS, the incorporation of discounted transaction prices was accomplished through a series of improvements in detailed data collection procedures; therefore, the experts were unlikely to know that BLS had already begun to incorporate hospital transaction prices in the CPI. According to a BLS official, about 15 percent of hospital prices in the CPI are transaction prices.
While BLS officials considered the capturing of medical transaction prices to be an improvement, they said many problems remain in measuring price change in medical care. They agreed with our experts who noted that measuring specific commodities and services used in medical treatments does not capture changes in the approaches for treating specific medical problems. However, according to the officials, every treatment is administered, not just to a medical condition but to an individual with that condition. Therefore, according to these officials, the treatment administered in different cases with a given condition, such as a heart attack, need not be the same. Using the same example of hospital stays cited by one of the experts, BLS said that some patients will require shorter or longer hospital stays, or different combinations of drugs or surgical procedures, which further complicates defining what is to be priced and calculation of expenditure weights. According to BLS, in some cases a shorter hospital stay might not be better (if, for example, the patient were weaker and at greater risk for complications when he or she left the hospital), while in other cases it might be better.

			Other Comments

When asked if they would like to make additional comments, the medical care measurement experts identified several issues related to changing the approach used to measure medical care. In their general comments, a few of the experts said that the United States measures medical care better than other developed countries. One expert said that if the United States changes its approach to measuring medical care, the other countries are likely to change their methodologies to whatever the United States does. Other comments stated by a few of the experts included
The CPI cannot be used for their work because the CPI uses list prices.
They were concerned about how a change to cost-of-living concepts would measure quality changes and noted that the implementation of these concepts would involve value judgments.
The distinction between prices and quantities had to be clear, implying that an increase in total expenditures cannot be easily translated into increases in prices or increases in quantities without the collection of additional data.
Also, a few experts questioned whether the CPI should be used as a measure by which to make cost-of-living adjustments. These experts suggested that BLS develop CPIs for specific demographic groups.

		BLS Does Not Plan to Include Third-Party Payments

BLS does not plan to include third-party payments in the medical care component. BLS officials hold this position for several reasons.
BLS views the CPI as an index that measures the changes in prices of goods and services that consumers purchase directly—the fixed market basket. Therefore, the CPI excludes payments made by private third parties. The changes to the CPI that BLS seeks to make are to improve the representation of out-of-pocket expenditures, not to move the CPI conceptually toward a cost-of-living index.
BLS considers medical care provided through employment as a cost of doing business rather than a consumer expenditure.
BLS excludes income taxes, which pay for government-provided health care, because they are indirect payment for medical care. The CPI only includes taxes that are paid as a result of consumption, such as sales taxes.
According to the Commissioner of Labor Statistics, methodologies have “not advanced to the point where anyone knows how to construct true cost-of-living measures” for medical care and other CPI components.
According to BLS, the most important purposes for use of the CPI are probably the indexation of Social Security payments and federal income tax brackets. BLS says it is not clear that health insurance fringe benefits should be included in the CPI because these benefits are not taxed.

	Observations

According to BLS, the CPI is not a cost-of-living index but a measure of the change in prices of a fixed market basket of goods and services. But questions have surfaced from time to time as to whether the CPI could and should be made into a cost-of-living index. The Stigler committee’s landmark study in 1961 said the CPI should be changed to better reflect the cost of living because of the uses that were being made of it at that time. However, additional uses have been made of the CPI since 1961, most notably indexing Social Security benefits and individual income tax brackets and deductions for personal exemptions.
Since the Stigler committee’s report, BLS changed the way in which the CPI measures homeownership. It went from an asset approach to a rental equivalency method. For our review, we asked 10 housing measurement experts whether the change made the CPI more or less suitable for use as a cost-of-living measure. They all said it made the CPI more suitable as a cost-of-living index.
BLS has said that it did not make the change to move the CPI closer to a cost-of-living index, whether or not it had that effect. According to BLS, it made the change to improve the presentation of consumers’ out-of-pocket expenditures, which was in keeping with the concept it follows to construct the CPI.
BLS likely would be unable to remain faithful to that concept if it were to make the medical care component truly reflective of the cost of living. The medical care component is not reflective in large measure because it excludes payments made by third parties for medical care that consumers receive. BLS is opposed to adding third-party payments to the CPI because the payments do not reflect what consumers spend directly and because BLS officials do not believe that adding such payments would make the CPI a clearly better index for its most important uses.
We discussed with 10 medical care measurement experts the advantages and disadvantages to changing the medical care component to more closely match a cost-of-living measure. A majority of the experts offered advantages and all identified disadvantages to making such a change. Also, we discussed with the experts the question of what types of medical care expenses the CPI should include in determining the weight of the medical care component. Their answers were not unanimous, and cautionary statements were made. Most experts would include some type of third-party payment, but there was no consensus on how to implement weighting that is based upon cost-of-living concepts. A few questioned whether a single CPI should be used as a measure by which to make cost-of-living adjustments.
The overall impact of changing the medical care component of the CPI is unknown. In terms of the weighting of the component, a 1994 CBO study suggests that the present system leads to an understatement of the rate of inflation. Regarding the pricing, a few of the medical care measurement experts we interviewed stated that the use of list prices leads to an overstatement of the rate of inflation. Taken together, the overall magnitude or direction of a possible misstatement from the current weighting and pricing of medical care items is unknown.
Taking into account the views of our experts and the scope of our work, we do not have a view as to whether the medical care component should be changed to reflect the cost of living. The Stigler committee held that the CPI and the uses made of it should match. Although BLS cannot control the uses made of the CPI, we believe there is a fundamental soundness to the principle of the index matching its uses. However, the federal government uses the CPI in a variety of ways today, some of which did not exist when the Stigler committee did its work. Because the relationship between the current CPI and these uses has not been assessed, it is not clear whether the current CPI, a CPI based on cost-of-living concepts, or even multiple new indexes would best meet all of the purposes for which the CPI is now used. Further, there would be inevitable technical and policy choices to be made in any effort to change the CPI. These choices would reflect on the cost, scope, and quality of such an altered index. Because these issues were outside the scope of our review, we are not making recommendations on whether BLS should work toward making the CPI a comprehensive cost-of-living index.

		Agency Comments and Our Evaluation

OMB and BLS commented on a draft of this report. At a July 15, 1996, meeting, OMB’s Chief Statistician characterized the draft as a fine report and said it had an educational quality that would make it useful for laymen and policymakers. She and her staff identified several places where a technical change could be appropriate or the wording of the report could be improved, and we made these alterations where appropriate.
The BLS Commissioner focused her comments on the medical care component. Appendix VI contains a copy of the Commissioner’s July 11, 1996, letter and our additional comments. The Commissioner said the draft report asserted that incorporating expenditures on medical care goods and services by third-party payers would move the CPI toward “the cost-of-living concept.” According to the Commissioner, this argument implies that there exists one theoretically correct, comprehensive measure of the cost of living and that the CPI deviates from this measure because it lacks a cost-of-living concept as a measurement objective. Neither assumption is strictly correct, the Commissioner said.
Elaborating on this statement, the Commissioner presented information to indicate that different index concepts are required to address different policy concerns and uses, implying that it is infeasible to change the CPI to conform with every possible use. She said developing a separate index measure might be a better way to address the concerns with tracking medical care costs than changing the CPI. The Commissioner also identified conceptual and operational difficulties, some of which she termed formidable or impossible to overcome, that she associated with developing a comprehensive cost-of-living measure. Finally, concerning the exclusion of employer-provided benefits from the medical care component, the Commissioner said BLS’ decision to exclude those benefits reflected a variety of considerations about the scope and use of the CPI but not a rejection of the cost-of-living concept.
We did not intend to suggest that there was a single, correct, and comprehensive measure of the cost of living or that there could only be one measure. Accordingly, we made this position clearer in the executive summary and in chapter 1.
As we said earlier in this chapter, because of the limitations of our scope, we have not taken a view as to whether the medical care component should be changed to reflect the cost of living or whether multiple indexes should be developed. We agree with BLS’ contention that designing a cost-of-living index is not an easy task. However, to the extent the government uses the CPI for significant purposes as if it were a cost-of-living index, we believe there is fundamental soundness to the principle of an index matching its purposes.

Summary:
Why GAO Did This Study

Pursuant to a congressional request, GAO determined: (1) whether changes made to the housing component of the consumer price index (CPI) made it more or less suitable as a cost-of-living measure; and (2) the advantages and disadvantages of changing the current measurement of medical care costs to a cost of living measurement.

What GAO Found

GAO found that: (1) the CPI is not a cost-of-living index, but a measure of the change in prices paid for a fixed market of goods and services; (2) a comprehensive cost-of-living index is broader in coverage than an index based on consumer expenditures and budgets; (3) the Bureau of Labor Statistics (BLS) uses the rental equivalence method to better measure housing costs within the CPI structure; (4) this method has made the CPI more suitable for measuring cost of living; (5) two-thirds of medical care expenses are excluded from the CPI, since they are paid by third parties payers; (6) including third-party payments in the CPI would move the CPI towards a cost-of-living index; (7) BLS excludes third-party payments from the CPI to better represent direct expenditures by consumers; (8) changing the medical care component of CPI would improve the formulation of health-care-specific policies and macroeconomic policies, but there is little technical feasibility in making such changes; (9) the Stigler committee believes that CPI should better reflect the cost-of-living index; (10) it is difficult to design a cost-of-living index for the federal government because of the additional uses of CPI; and (11) policymakers need to consider how the CPI will be affected by changing the medical care component and whether any single price index can account for such cost-of-living measurements.