BLS WORKING PAPERS 

U.S. DEPARTMENT OF LABOR 

BUREAU OF LABOR STATISTICS 

OFFICE OF RESEARCH 

AND EVALUATION 

Escalation Measures: What is the Answer? 

What is the Question? 

By Jack E. Triplett 

Working Paper 132 

December 1982 

This paper is circulated for the information of members of the staff of the Bureau of Labor Statistics (BLS) and other professionals Interested in the 

work of the Bureau. It has not been cleared for publication and should not be quoted without the permission of the authors. The views expressed are 

those of the authors and do not reflect the policies of the BLS or the views of other BLS staff members. 
· .. 

ESCALATION MEASURES: WHAT IS THE ANSWER? 

WHAT IS THE QUESTION? 

BY JACK E. TRIPLETT* 

Introduction and Abstract 

Economists generally believe that a cost-of-living index is the 

appropriate measure for escalation purposes, a professional judgment that 

is documented in--to take examples covering a span of two plus decades--the 

1961 report of the Price Statistics Review Committee (Stigler Committee) 

and the 1982 Price Measurement Review Program Consultations Feedback Report 

of Statistics Canada. Economists who are specialists in index number 

theory as well as economists who are primarily users of index numbers for 

research and policy analysis share this opinion. 

This paper challenges this view. Escalation, whether in public or 

private sectors, seldom implies sets of circumstances that correspond to 

those on which the cost-of-living index has traditionally been defined. 

Section I reviews the cost-of-living index concept, emphasizing the 

multiplicity of measures that the general concept implies. The 

cost-of-living index is an answer to an economic question, of the general 

form: "What is the minimum change in an economic variable that would be 

required in order to leave a specified individual consuming unit 

indifferent between pre- and post-i nfl ati onary states?" It has sometimes 

not been recognized that the literature encompasses a whole family of 

cost-of-living indexes, which vary with the "economic variable" on which 
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the index is defined (e.g., "expenditure,1I IIpre-tax iflcome ll , IIwealthll). 

Each of these alternative definitions can be thought of as the answer to 

an economically meaningful question. Thus, there are many cost-of-living 

index answers to many cost-of-living questions. Each question can be 

thought of in terms of a compensation for inflation, and each cost-ofliving index is an answer that provides an appropriate measurement for some 

purpose. Section I of the paper discusses these alternative definitions of 

a cost-of-living index. 

Escal ati on of coll ecti ve' bargai ning agreements, di vorce settl ements, 

social security payments, and so forth is also frequently interpreted as 

requiring a measure that will compensate for inflation, and this interpretation is sometimes correct. Section II of the paper points out, however, 

that even when the escalation objective is inflation compensation, the 

question implied by escalation seldom corresponds to the compensation 

question that is inherent in any of the traditional cost-of-living index 

formulations. That is perhaps one reason why participants in escalation 

arrangements seem uninterested in the economists' concept of the cost-ofliving index. The paper develops one cost-of-living like price measure 

that is relevant to escalation, and discusses the problems of formulating 

and estimating an lIescalation index. 1I 

The final section of the paper notes that the objective sought in some 

prominent escalation situations, such as the escalation of social security 

payments in the U.S., has not been specified clearly. To put it another 

way, what is the precise question for which an answer is being sought? 

Because price measures have been employed for escalation, the presumption 

has been created that the objective of these escalation arrangements is 
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inflation-protection; yet, much of the public discussion of (one is tempted 

to say "public dissatisfaction with") the outcome of escalation suggests 

issues involving the determination of equity in real incomes. This implies 

alternative economic questions and alternative economic measurements to the 

cost-of-living index concept on which so much of the discussion has 

focussed. The final section of the paper discusses the formulation of 

escalation objectives and the specification of measures--primarily of wages 

and incomes--that would meet alternative objectives in escalation 

arrangements. 

I. Cost-of-Living Questions and Cost-of-Living Indexes. 

The development of the cost-of-living index concept occurred largely 

because of a need to make precise the questions that a price index was to 

answer. Starting with the original formulation by A. Konus in the 1920's, 

the idea has gradually spread to become a standard part of the economists' 

intellectual tool kit, and a favorite artifact of textbooks in 

microeconomic theory. 

The very universality of the COL concept, however, cloaks the fact 

that. economists use the term "cost-of-living index" (hereafter, "COL 

index") in slightly different way~. Until the last decade or so, most of 

the literature was written as if there were but one theoretical COL index 

and that it provided the "true" index against which approximations such as 

the Consumer Price Index (CPI) were to be assessed. On this view, if the 

usual textbook presentation--usually cast in an indifference curve-budget 

constraint diagram--was conceded to be oversimplified, removing the oversimplifications was still presumed to leave one generally accepted COL 

index definition. 
_ -- .- :-- '- - - -. ~ . .:.:. ~~.. .....,.-.............. '. . . _. --.-.. . - .... -....• _.-.!.. .,. _._ ..... .. . -...... _=--=- .. . 

- 4 -

The COL index concept is usefully thought of as framing an economic 

question (to which the COL index itself is the answer). That question is 

usually phrased in a manner similar to the following (the language is 

adapted from Samuelson and Swamy, 1974, page 567): "Whatis the ratio of 

the (minimum) costs of a given level of living in two price situations?" 

Once attention is drawn to what one might call the "COL question," it 

is apparent that there is a family of precisely-stated questions, not just 

one. As there are many appropriate COL questions, there are in consequence 

many appropriate formulations of a COL index, not just a single one. In a 

way this is not surprising, for one of the oldest adages of index numbers 

holds that the design of the index depends on its purpose. One can 

distinguish at least the following family members. 

Expenditure-defined COL index. The most frequently used (and most 

straightforward) COL index is the formulation that answers the question: 

"What rati 0 of expenditures is requi red to maintain a fi xed 1 i ving standard 

in two pri ce regimes?" Thi s formul ati on may be termed the "expendituredefined" COL index. 

It is well known that the question underlying the expenditure-defined 

COL index can be framed from a variety of perspectives, according to which 

living standard is to be held fixed. What one might refer to as a 

"Laspeyres -perspecti veil expenditure-defi ned COL index takes as the basi s 

for forming the expenditure ratio the base, or "reference", period living 

standard--that is, following Pollak, 1971, the reference-period preference 

function and the indifference curve attained in that period. An alternative is the "Paasche-perspective" expenditure-defined COL index that is 

based on the current, or "comparison," period living standard. Pollak, 
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1971, points out that other living standards may also be relevant--e.g., 

the change in the cost of the 1972 living standard between the years 1979 

-

and 1982, or the cost of a U.S. living standard in Norway and Egypt. 

Because both intertemporal and interarea COL indexes are normally wanted 

for three or more periods or places, and not just for the two-period 

comparisons encountered in textbooks, this point has greater significance 

for price index theory than is sometimes recognized. 

Much of the content of traditional price index theory concerns the 

effects on the measurement of what the previous paragraph has termed the 

"perspective." As these topics are adequately treated elsewhere in this 

conference, there is no need to explore them here. Two points, only, must 

be made, not because either is new but only because they seem so widely 

misunderstood. 

First, various alternative perspectives all give equally valid 

measures. They deal with subtly different questions, and apply to subtly 

different uses. If one wants to compare (say) 1972 and 1982 prices, and if 

it were true (as often alleged) that the market basket for 1982 ;s far 

different from that of 1972, or that 1972 and 1982 correspond to different 

living standards, this would not automatically mean that the 1982 perspective was always preferred to the 1972 perspective--it depends on the 

uses and the questions asked. This point deserves emphasis because it has 

so frequently been misunderstood. 1 

Second, the "two price regimes" mentioned in the cost-of-living 

question consist of the relevant market prices prevailing in the two 

periods being compared, and not those of some other periods. That is, a 

COL index for the current month (or current year) depends on market prices 
-_ ...... .. _ .. -.-.--... . ---.-.. ; - .. -~ .......... ---.- .- ....::....- -. - - - - . - :.. .• - .• ---"._-. , ._ . .!-_-' 

- 6 -

prevailing this month (or this year), plus those of the reference period, 

and not those contracted for at some other period. The force of this part 

of the COL index definition applies mainly to durable goods. One often 

hears statements such as the "COL index for persons who own thei r own homes 

(or refrigerators or cars) would not reflect current house prices (or 

refrigerator prices or car prices), because current price movements do not 

affect that person's payments for durable goods acquired in some previous 

period" (for an example, see Kahn, 1980). Such statements reflect failure 

to recognize that it is the consumption of the services of durable goods 

that matters in a COL index, and not the acquisition of the durable good 

itself (a distinction that has prevailed in the analysis of consumer demand 

at least since the publication of Harberger 1960), combined with failure to 

understand that current opportunity cost, and not historical replacement . cost, defines the consumer's opportunity set (though there are, to be sure, 

ambiguities for the measurement of ~-period cost levels that are 

discussed in Muth 1974 and Pollak ~975a). 

The expenditure-defined COL index is the workhorse model for empirical 

estimates. The U.S. Consumer Price Index is an approximation to the 

expenditure-defined COL index.2 The expenditure-defined COL index is also 

the model that has been employed for all empirical COL indexes that have 

been based on estimated sets of consumer demand relations (see, for 

example, Braithwait 1980; Christensen and Manser, 1976; Manser, 1975; 

Goldberger and Gameletsos, 1971). 

Using the expenditure-defined COL model was a natural choice for 

empirical COL index estimation, since nearly all research in consumer 

demand systems has used total expenditures, rather than "income," as the 
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consumer's budget constraint (see the survey by Brown and Deaton, 1972, or 

Phl ips, 1974, or Deaton and Muellbauer, 1980). In part, this research 

strategy reflects a decision to avoid intertemporal decisions inherent when 

saving is admitted into the consumer's decision-making problem, complications that are usually deemed tangential when the research focus is on the 

allocation among goods for current consumption; and in part it reflects the 

reality that available survey data on expenditures are usually considered 

more- reliable than those on saving and income. These same considerations--

avoidance or minimization of certain technical difficulties, and the desire 

to erect the estimates on the firmer part of available consumption data--

lie behind the decision to employ the expenditure-based COL index model for 

the CPl. 

This "defense" of the expenditure-defined COL index is necessary 

because it is plainly the most limiting of the family of COL indexes. That 

both economic researchers and statistical agencies have stuck with the 

expenditure-defined concept despit~ the attractiveness of the alternatives 

says a good deal about its homely virtues. 

Income-defined COL Index. This COL index gives the answer to the question: 

"What ratio of (pre-tax)3 incomes would be required to maintain a fixed 

standard of 1 i vi ng in two pri ce regimes?" As with the expenditure-defi ned 

COL, there are alternative perspectives corresponding to the living 

standard that is used for the comparison, and different perspectives may 

produce different measures. The income-defined COL also uses as data 

market prices for the two periods under consideration, as does the 

expenditure-defined COL. 

An income-defined COL index would differ from an expenditure-defined 
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COL index in a number of ways. One important difference is in the 

treatment of income and payroll taxes. In an expenditure-defined COL index 

(and in the CPI, which is its approximation) an increase in these taxes 

does not affect the index, though a change in excise or sales taxes does. 

This gives rise to anomalies if one form of tax is substituted for the 

other. The income-defined COL index has the advantage that it would not be 

affected by the mix of income and sales taxes, but only by their combined 

amount. 

An income-defined COL index has been considered preferable to an 

expenditure-defined index for many purposes. It has been argued, for 

example (see Cagan and Moore, 1981) that an income-defined COL is more 

appropriate for escalation use, on the grounds that the entity being 

escalated is an income source, and not a measure of consumer expenditure 

(in section II, we examine these grounds). 

However, the cpr's of most countries approximate an expendituredefined COL index and not an income-defined one. And even research 

estimates of an income-based COL index concept are infrequent (see the 

Gillingham and Greenlees paper presented at this conference). Two 

attributes of the income-defined COL account for its rarity. 

First, the income-based COL would rise with an increase in (say) 

individual Social Security payroll taxes, even if there were no change in 

any price in the economy. For some purposes, this would prove objectionable. Second, the concept of income, though seemingly simple at first 

glance, is notoriously difficult to define and measure in economic terms, 

and as a concept merges into lifetime wealth without a clear demarkation;4 

thus the greater apparent usefulness of the income-based COL is offset by 
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formidable measurement problems in practice. Additional discussion of the 

income-defined COL index is in Gillingham and Greenlees (1982). 

The Non-market Commodities COL index. Implicitly, the COL indexes 

discussed previously were defined on goods and services acquired through 

the market (or that could be acquired through markets--as for example, 

imputation in the U.S. CPI of the value of home-grown food, and beginning 

in 1983, of the rental value of owner-occupied housing). The standard of 

living may also depend on the level of services provided by the government, 

and on aspects of living such as pollution. Once this distinction is 

recognized, then the numerator of the expenditure-defined COL index 

discussed above should be re-phrased to answer the question: "What is the 

cost, at today's market prices, of a bundle of market-purchased goods and 

services equivalent to the bundle consumed in the base period?" Analogous 

re-phrasing can also be made for the income-defined COL index. 

The "non-market commodities COL indexll is a more comprehensive COL 

concept, dealing with the question: IIWhat change in cost (alternatively, 

what change in income) is required to maintain the base-period's living 

standard, considering privately-provided goods and services, and also free 

government services, the effects of pollution, and so forth?" As the 

alternative wording of the COL question makes clear, a complete taxonomy of 

the family of COL indexes would include both expenditure-defined and 

income-defined variants of the non-market commodities COL index, and the 

varying perspectives that were discussed in the previous sections also 

arise on this definition. 
_ •••• _ __ • __ __ _ M ___ • • ____ • • _ _ _ ....:~~ __ •••• __ ... _ ___ •• _ . ___ • • • _ .... . .. ... _ _ _ • __ __ •••• _ ____ • _ _ _ •• _. __ ~ __ , _ . _ . ... ~ 

- 10 -

Since the non-market commodities COL index encompasses on a more comprehensive set of consumption commodities than was the case for the regular 

expenditure-defined and income-defined COL indexes discussed earlier, each 

of the latter is a "sub-index" (in the sense of Pollak, 1975b) of the 

relevant version of the non-market commodities COL index. The theoretical 

discussion of sub-indexes (see also Blackorby and Russell, 1978) can be 

expected to apply to the relationship between the sub-indexes for marketpurchased commodities and the more comprehensive index. 

There can be no doubt of' the relevance and usefulness of the 

non-market commodities COL index. The empirical barriers to estimating it, 

however, are formidable, because it requires consumer valuations of 

non-market conmodities (the "value of clean air"). 

Some research on this topic has been carried out. Several years ago 

the BLS explored the possibilities in the "median-voter" literature and 

some alternative approaches, but we concluded that information that could 

be extracted from these approaches ~id not satisfy the requirements of a 

COL index (see Cobb, Barkume and Shapiro, 1978, and Shapiro and Smith, 

1981). I should note also that the extensive literature using hedonic 

methods to estimate the "demand" for neighborhood amenities (including 

pollution) is defective for our purposes (indeed, for most purposes), for 

the methodolo-gical reasons outlined in Brown, 1983 and Triplett, 1983. So 

far, empirical estimation of any form of the non-market commodities COL 

index has proven intractable. 

The narrower COL indexes (as, for example, the expenditure-defined COL 

index) may pick up some of the consumer costs of changes in non-market 

commodities. For example, if an increase in air pollution causes an 
- 11 -

increase in medical expenditures because of respiratory illness, part of 

the consequences of air pollution would Show up in the normal 

expenditure-defined COL index. But for this measure to provide a correct 

estimate of the value of the non-market commodities COL index would be 

fortuitous and unlikely. Similarly, it has sometimes been argued that the 

cost of putting smog control devices on automobiles (which has clearly 

increased the price of cars and the cost of automobile transportation, and 

therefore the expenditure-defined COL index) ought to be adjusted out of a 

COL index because the value of cleaner air provides an offset to the 

increased private cost of transportation. Note that this suggestion is 

incorrect if the expenditure-defined COL index is the subject of 

discussion; and if the non-market commodities COL index is the one that is 

wanted, then the proposal will approximate the correct movement in that 

index only if smog regulations are chosen so that the marginal cost of smog 

abatement equals the incremental valuation on clean air. That this is an 

appropriate principle for regulation does not mean that it has been met in 

practi ceo 

The preceding was somewhat of a digression from the main line of the 

argument, and was intended to illustrate the formidable information 

requirements of the non-market commodities COL index, and clarify the 

relations among the various COL index concepts (on which there has been 

much confusion). At present, I know of no empirical estimate of a COL 

index including non-market commodities. 

Wealth-defined COL index. A COL index based on a wealth measure has been 

suggested by Alchian and Klein (1971), the objective being to bring assets 

and changes in asset values into the COL analysis. This idea seems 
- 12 -

appealing; for one thing, permanent income is a wealth concept, and other 

income concepts prove slippery or not economically relevant. Explicitly 

defining the COL index measurement on wealth is a way of cutting through 

to the essentials. In addition, the wealth concept gets away from the 

one-period decision-making mode that underlies other COL indexes. 

An alternative approach to 'introducing inter-tE!l1'Poral decision-making 

into the theory of the COL index is Pollak (1975a). Pollak's approach 

shQols that, far from making the measurement easier, moving to a I1lJltiperiod setting makes it far .more difficult. Discussion of these problems 

in the present paper takes us too far afield. 

Partial-income COL index. $0 far, each successive member of the family of 

COL indexes has widened the variable on which the index is defined. One 

can also usefully consider going the other way. This approach is inspired 

by Pencavel (1977), who sought to determi ne the mi nil1lJm change ina single 

price in the consumer demand system that would be sufficient to compensate 

for the net effect of changes in the other prices. Pencavel's objective 

was to make the analysis apply to an individual who was a consumer of all 

commodities, but a seller of one. 

For present purposes, we can alter this approach a bit by supposing 

only that an individual has two (or more) sources of income (IT= IA + I

B). 

Then we may ask the question: "What change in IA is required to achieve 

a total income (IT) that maintains the base-period living standard?" The 

resulting "partial-income COL index," being the escalation of IA required 

to hold utility constant, obviously depends on what has happened to lB' 

This measure woul d probably not normally be properly thought of as a COL 

index at all, but it does provide a form of escalator, which is one use 
- 13 -

often proposed for a COL index. The partial-income COL index is the 

appropriate escalator for situations in which only a portion of income is 

escalated and the purpose of the escalation is to maintain living 

standards. We return to this measurement concept in Part II. 

Summary. This taxonomy of COL indexes is doubtless not complete, but that 

is not the intention. The variety of COL indexes that can be produced 

(expenditure-defined, income-defined, non-market commodities, 

wealth-defined, and partial-income were the names given to the five 

concepts discussed) correspond to different versions of the question for 

which the COL index is conceived as the answer. Though some of these 

questions are more interesting and meaningful than others, there is 

generally a trade-off between comprehensiveness and practicality in making 

a COL index measurement. The following sections consider the use of the 

COL index concepts discussed in this section as escalation measures. 

Comment. It is often said that the CPI "is not a COL index" because the 

latter would account for factors such as income taxes, pollution and 

government services and so forth that are omitted from the CPI (see, for 

one such statement, Cagan and Moore, 1981, page I). The discussion in this 

section specifies the precise sense that such statements are true: They 

are correct if the broader definitions of a COL index (the income-defined 

COL index or the non-market commodities COL index) are meant. However, the 

CPI is not deficient in these elements with respect to the expendituredefined COL index, which provides its theoretical underpinnings. A more 

precise and less confusing way of putting the matter would be to say that 

an expenditure-defined COL index omits factors such as income taxes, 
.- -. _ .. _ •. -- ... -------- .. --- .......... ...... _.-'-------- ,_ ...... _. -- .. ...; - .... ..: .~ ...... ~ 

- 14 -

government services and so forth, whose inclusion in a COL index would be 

useful for many purposes. Because I believe the expenditure-defined COL 

index is also relevant and useful for some purposes (especially as a design 

for an analytic inflation measure--but that is beyond the scope of the 

present paper), one should avoid confusing the choice of the COL question 

that one wants to answer (which implies the definition of the COL index 

that one wants to compute) with the issue of how well the CPI approximates 

its own COL index concept. Both are important matters; but they are 

distinctly different ones. 

II. Escalation or "Indexing" Issues and Escalation Measures. 

In 1970, benefits of programs that accounted for roughly 3 percent of 

U.S. Federal government outlays were tied to the Consumer Price Index. 

During the following decade more and more government programs were 

"indexed", and by 1980 this proportion had risen to 30 percent. It should 

be noted that this great percentage increase reflects not so much growth in 

programs that are indexed (though that has occurred) but rather growth in 

the number of programs that make use of indexing (see appendix A of 

DeMilner, 1981, or Table 4 of Goldfeld-Ooms, 1981). In Canada [insert 

material here]. 

Private sector use of the Consumer Price Index as an escalator in 

collective bargaining agreements has fluctuated with the rate of inflation 

in the post-war period; in the 1970's, the number of workers covered by 

escalator clauses expanded as the rate of inflation increased. Few private 
- ----.--- -. ---- - ---- ~- - _. _ _ . - . - -. ~ '- ' ~ ... - • ••• < • ••• _- • .••• ~ •• - ." , .- < .: • • --•• - - --• •• --- - - ....: . '-

- 15 -

sector collective bargaining agreements provide for 100 percent escalation, 

and the data available suggest that the escalator yield as a proportion of 

the cpr is an inverse function of the CPI's rate of change (see Cagan and 

Moore, 1981, Table 2). One should note that at least one collective 

bargaining agreement (that of the United Auto Workers) uses an average of 

the U.S. and Canadian CPI's. 

Outside the traditional collective bargaining use, escalation in 

private sector agreements has also grown greatly in recent years. Though I 

know of no concrete data to indicate the degree of usage, fragmentary 

information in the BLS (frequently, a letter of inquiry occasioned by a 

dispute in interpreting an often unclearly written agreement) indicates 

that divorce settlements, rental agreements, and so forth have increasingly 

been tied to the Consumer Price Index. A novel and perplexing use of the 

CPI was the U.S. Financial Accounting Board's decision that the index 

should be used for deflating data in corporate financial statements in 

order to get a profit measure that was not distorted by inflation. 

[Insert material on private sector uses in Canada.] 

What is the purpose of escalation or indexing of income payments in 

private contracts and government transfer programs? What is the 

appropriate measure for use in such arrangements? 

In response to the first question, most people would answer that the 

objective was to protect workers and benefit recipients from inflation. 

And given the answer to the first question, economists invariably respond 

that the cost-of-living index is the appropriate measure for that purpose. 
- 16 -

Considering particular cases of escalation leads me to challenge that 

"inflation protection" answer to the first question. The answers that 

people give to questions about the motivation of their economic behavior 

characteristically suggests behavior different from what is actually 

observed. I believe the "inflation protection" answer is, though not 

necessarily wrong, quite incomplete. 

But let me put aside the first question until Section III, and 

consider for the moment only the second question C'What is the appropriate 

escalation measure?"), as if 'the answer to the first question were indeed 

only "inflation protection." "Protection" against inflation implies 

compensation. The COL question can be thought of in similar terms--i.e., 

What change in some economic variable is necessary to compensate for 

inflation? The issue, then, is whether the variable that is being 

escalated corresponds to the variable on which some member of the family of 

COL indexes is defined. 

Of the list of COL indexes described in Section I, it is immediately 

evident that most are defined on variables that differ from the ones chosen 

for actual escalation situations. We have already noted Cagan and Moore's 

contention that the expenditure-defined COL index (or its CPI approximation) is inappropriate for escalation because no known escalator is applied 

to consumer expenditures: "It [the index] covers only consumption 

expenditures and not the part of income that is taxed or saved, whereas 

escalation is directed to income without regard to its disposition" (Cagan 

and Moore, 1981, p. 1). 

But do we in many actual situations escalate income? There may be a 

few cases in which this is done, but the most prominent escalation cases 

";" •• .,." ...... # 
___ • ____ _ _ _ ~ _ __ • _ _ . _. _ _ -'~""" _. . _ _ • .1 _ . : • • 

- 17 -

cannot be so interpreted. For example, the average (or "representative", 

to follow the conventions of price index theory) Social Security recipient 

- has some form of income other than Social Security payments. That means we 

are escalating a portion of income, and not all of it. And perhaps some 

workers who are covered by cost-of-living escalator clauses under 

collective bargaining agreements have only income from wage and salary 

earnings under those agreements. But not all do, and a very large 

proportion of workers do not fall in the single-source-of-income class if 

we consider how conventional it is to view owner-occupied housing as 

producing an imputed income in kind. In all these cases total income is 

not the variable being escalated, and therefore the income-defined COL 

index is not the escalator that will leave the individual exactly 

compensated for inflation. That is, if the income-defined COL were applied 

as an escalator to a particular payment stream, the resulting total income 

would not in general equal the income that would keep the individual 

consuming unit on a fixed indifference curve. 

When the particular stream of payments being escalated is only a 

portion of income, and the objective of escalation is to protect the real 

living standard, then the partial-income COL index is the appropriate 

escalator. This index would escalate (say) Social Security benefits by an 

amount just sufficient to maintain the total real income of the average 

recipient, after accounting for changes in the recipient's other sources 

of income (including imputed income from owner-occupied hOUSing). 

Yet, there is something unsatisfactory about proposing the. 

partial-income COL index as an escalator. It seems doubtful if Congress, 
.- .- -~ ----- --.. -----~- .. ~ .. - -- - -. .. - -"",-- .. -. ,- .' . . 

- 18 -

employers, workers or Social Security recipients would find satisfacto~ an 

escalator that made compensation for services under collective bargaining 

contracts, or the level of Social Security benefits, depend on what happens 

to other income sources--as does the partial-income COL index. Though the 

partial-income COL index gives the precise answer to the relevant 

compensation question, perhaps this degree of precision is not what was 

wanted or is not understood. As Paul Samuelson and S. Swamy (1974, p. 587) 

remarked in a similar context, "Probably, though, one should not try to 

read anything so definite intopeople's vague notions of equity." 

And one should also recognize that it is not always certain that 

"ma intaining living standards II is pr~cisely the meaning of "inflation 

protection. II One frequently hears statements such as: liThe purpose of 

escalating benefits is to maintain the purchasing power of benefit 

payments, or to maintain the standard of living," where it is clear from 

the context that the speaker is under the presumption that these are 

alternative expressions for the same thing. Where full income is being 

escalated, they of course are. But where the benefit payment is only a 

portion of total income, "maintaining the purchasing power of benefits" is 

not the same thing as "maintaining the standard of living"--they are 

different objectives, they imply different escalators, and a choice must be 

made between them. 

In the case under discussion, "maintaining the standard of living" is 

a precisely-defined objective that implies the use of the partial-income 

COL index. "Maintaining the purchasing power of benefit payments" 

presumably implies that the benefits being escalated should command a 
• -.... _ ____ ___ . • _ ~ . .. ___ _ ~_ .. ___ __. _ .;. ... . '1~ .. _ •• A,.. _._.-... _ .. _ ."_." 

- 19 -

constant level of real goods and services--presumably consumption, but 

sometimes this is not entirely clear--irrespective of the command over 

- goods and services that accrues to total income. For "maintaining 

purchasing power," the expenditures-defined COL index, its fixed-weight 

approximation, or some other measure, may be suitable. It is evident that 

the partial-income COL index, reflecting as it does the movement of other 

income sources, could hardly be interpreted as "maintaining the purchasing 

power of benefits." 

In summary, the COL index concept, seemingly so precise and 

theoretically appropriate, does not in any of its several forms 

match the variables that are known to be escalated in actual situations, 

save for the one version (the partial-income COL index) whose properties 

(mainly, its dependence on other income sources)make it fairly clear, I 

think, that this is not generally what is wanted. That brings us back to 

the question that led off this section: What is the purpose of 

escalation? We turn to this matter in Section III. 

Before leaving the present topic, however, it is advisable to consider 

briefly one or two arguments that have been raised in the context of 

escalators as inflation protection. [Add material on the arguments (1) 

that escalator measures should reflect only inflation "caused" by monetary 

policy and not that "caused" by relative price changes and (2) that they 

shou1 d measure only inf1 at i on "caused" by domesti c sources and not 

inflation that ;s imported.] 

..... 
- 20 -

III. Matching the Purpose of Escalation with the Design of an Escalator 

We now consider the logically prior question: "What is the purpose of 

escalation?" I freely concede that I do not know the answer to this 

question with any degree of certainty. This section does not so much propose an answer or answers, but seeks to highlight the question. Much of 

the recent search for "answers" to the problems posed by "indexing" (of 

Social Security payments, for example) has taken place without sufficient 

attention to the questions f~r which answers are being sought. 

It is clear that whatever the purpose people had in mind in entering 

into escalation arrangements, much dissatisfaction with the results 

developed during the peak inflation years of 1979-1980. Escalation and 

indexing arrangements were felt to cost too much, and indeed payments under 

escalators did rise steeply and in many cases unexpectedly. Not surprisingly, the situation led many to challenge the validity of the price 

measure (usually the CPI) used as an escalator--see for example, U.S. 

Congress, Hearings, 1980, or Statistics Canada Price Measurement Consultation Feedback Report, 1982. The accuracy of the CPI as an inflation 

measure, or as an approximation to a cost-of-living index, is of course a 

legitimate question, but one that will not be considered in the present 

paper, because the issues have been adequately covered elsewhere {in 

Triplett 1982 I reviewed three studies of the U.S. CPI that were 

commissioned at the height of concern over indexing}. 

But even though much of the dissatisfaction with the outcome of 

indexing has been directed toward the escalating index, many of the 
- 2.1 -

issues raised suggest that the sp~aker has in mind an objective that does 

not match the purposes of the CPI or of a cost-of-living index. Examining 

carefully some of these complaints, even though perhaps misdirected, can 

tell us a good deal about what is desired in the situations for which 

indexing has been employed, and thereby lead to better specifications for 

measurement. 

Lowering Contracting Costs. It has become a commonplace observation that 

when Congress tied U.S. Social Security benefits to the CPI, its objective 

was to lower the rate of increase in per person benefits. The evidence 

suggests that it succeeded. Goldfeld-Ooms {1981} present data indicating 

that the increase in Social Security benefits per recipient rose more 

rapidly than the CPI in the decade before "indexing" was adopted in 1975; 

but per recipient benefits have risen more slowly than the CPI since that 

time, so that real benefits per recipient dropped 5 percent between 1975 

and 1981. 5 A major objective behin~ the decision to use escalation in 

Social Security benefits was to get an emotional and politically explosive 

issue out of the legislative arena. 

A similar point can be made about collective bargaining agreements. 

Are employers and unions attempting only to assure that workers' real 

incomes are precisely protected from inflation? Or is the foremost objective to remove from the collective bargaining table an emotionally-loaded 

and difficult and expensive-to-negotiate issue?6 Reducing the cost of 

bargaining may be as strong a motivation as the explicit and exact 

protection of the workers' standards of living. This in turns suggests 
- 22 -

that because there are multiple objectives to be met in an escalator 

clause, precise definition of the cost-of-living index to be used in the 

contract becomes of second-order importance. 

Of course, one might object that the workers would only agree to 

remove the inflation issue from the bargaining table if they were fully 

protected; but even if this were true of workers, an escalator clause puts 

management in the position of speculating on the course of the CPl. 

Putting an upper limit on losses from such speculation is one reason why 

collective bargaining agreements typically do not provide 100 percent pass 

through of the cpr rate of change. It may also be one reason why no party 

to a contract agreement, so far as I can determine, has ever specified that 

the economist's concept of a COL index is wanted, even when the distinction 

between a fixed-weight price index and a COL index has been described to 

them--and the workers, judging from positions taken by their representatives, strongly dissent from the idea that any COL index is relevant to 

collective bargaining (see Oswa1dJ 1980). Unless contracting parties are 

not acting in their own interests (which I doubt), we should probably pay 

more attention to what motivates the adoption of an escalator clause in 

determining the statistical formulation that is appropriate. 7 

Income-Eguity Issues. One characteristic of recent criticism of indexing 

is its focus on what has happened to the incomes of the population that 

receives indexed payments. As Cagan and Moore, 1981, put it, the indexed 

population is insulated from "price changes that reflect a change in the 

standard of living of the entire population" (p.3). Thus, if a price 

increase in imported oil leads to a fall in national income, the larger is 

the protected, indexed part of the population, the larger the decline in 
~ 23 -

real income that must be taken by the non-indexed population. Of course, 

if the entire population were indexed, the situation would be disastrous. 8 

Reaction to what many thought was "petro-inflation" in the U.S. and 

Canada has resulted in suggestions for a measure of IIdomestic inflation" as 

a remedy for what many people regard as the over-adjustment of recipient 

incomes from use of presently available price measures (see the Statistics 

Canada Price Measurement Consultation Feedback Report). Cagan and Moore, 

1981, propose (page 3) that the CPI be adjusted by the ratio of U.S. export 

and import prices, so long as the rate of price change exceeds the rate 

wage change. 

I have reservations about whether one can really distinguish 

"imported" and "domestic" inflation. Aside from this, however, is a more 

basic reservation: The problem complained of concerns equity in the 

distribution of real income. If distributional equity is the goal that is 

not being met, the solution is to assure that the incomes of the recipient 

population change with the incomes "of the remainder of the population 

(e.g., for Social Security beneficiaries, to tie benefits to a measure of 

wages). Trying to pursue equity in the distribution of real income by 

devising some adjustment to the deflator for income (the CPI) is not only 

an exceedingly cumbersome approach, it confuses the objective of equitable 

growth in real income with that of inflation protection (which means 

constant rea 1 income )--these 'are two different objecti ves that cannot be 

met with the same indexing arrangements. 9 

On the other hand, linking growth in individual retired incomes to the 

growth in per-capita incomes of workers may well be infeasible if the 

proportion of beneficiaries in the population rises. This is a very real 
threat to the U.S. retirement system because of the population bulge of 

30-40 year old workers now moving its way through the demographic 

structure. This suggests a different objective: That the share of 

national income going to the total beneficiary population be limited at 

some level, lest the tax burden ~n the working population reduce incentives 

to the point that it affects productivity growth. Alternatively, if the 

rationale underlying a Social Security system that pays out to the average 

beneficiary more than the ac~ uarial value of his payments into the fund 

is that such a system shares current productivity gains with the retired 

population, then one cannot tolerate a beneficiary scheme that threatens 

these productivity gains. 

Either way of looking at the problem suggest an alternative scheme in 

place of current indexing methods--an indexing proposal that constrains 

payments to beneficiaries so that the share of national income to Social 

Security recipients be held below some ceiling, perhaps by a formula that 

sets payments to each beneficiary on the basis of wages, adjusted by the 

share of the per capita productivity dividend that is to be allocated to 

the total retired population (and the latter could produce a negative 

adjustment for individual retirees payments if the growth rate of the 

retired population exceeds the growth rate of productivity). 

These are intended as illustrative examples, and not a thorough 

analysis. They do illustrate the proposition that thinking through the 

goals to be met by a situation in which indexing is proposed leads to a 

more precise definition of the question that indexing is to answer. Once 

the question has been refined, the development of a measure that would 

answer the question is a technical task. To be sure, the formulation of 
- 25 -

objectives· is by far the most difficult task, and it is not entirely an 

economic one. Much of the recent debat~ over indexing seems preoccupied 

with finding some narrow technical measure that would obviate the necessity 

for making the difficult choices that society must make. This is, of 

course, impossi bl e. And the very search for a narrow techni cal lIanswerll is 

counterproductive and postpones work on the real task: What is the 

question? 
__ _ • ~" _ ~ . ........ .,. _ _ . .... ~ __ .... __ d ._--""'-__ • _ _ ~ ___ '._ • • _ _ • ..- .... _ " _ _ ..... _ •• 

- 26 -

Footnotes 

*Office of Research and Evaluation, U.S. Bureau of Labor Statistics. 

The views expressed in this paper do not represent an official position of 

the Bureau of Labor Statistics. 

The present paper is a revision and extension of an earlier paper 

entitled "Cost of Living Questions and Cost of Living Indexes," which 

received limited circulation and has been cited by that name. I appreciate 

helpful comments from Robert A. Pollak. 

1 This paragraph shou1d ~ot be construed as a reference to Fisher and 

Shell's (1972) argument that in the presence of taste change between two 

periods using the Paasche-perspective index can permit framing a meaningful 

question (whereas economists have conventionally disclaimed the possibility 

of making comparisons that bridge taste change, the COL index being defined 

on an unchanging preference map). 

2 See Gillingham 1974 for a discussion of the ways that the theory of 

the cost-of-living index has guided · decision-making in the construction of 

the U. S • CP I • 

30 ne might distinguish between pre-tax income and after-tax income in 

computing this member of the COL index fami1y--that is, a complete taxonomY 

of the COL index family tree would do so--but the more interesting case is 

the index involving pre-tax income, so that is the income definition that 

should be understood for the present discussion. 

4Insight into the difficulties of defining a meaningful concept of 

income and its measurement is contained in Friedman's Theory of the 

Consumption Function. 
·. T~ ~~---- --~ ••. ~ •• . -_~,;,-:"~ ,, . _____ ....= . ..-.-;o _ _ • • _.~ ._ . .!.. ;,:..- :~w _ ~ • ",_~_ _ .. ___ ~-:_ c. ~ __ .... -.: ____ __ 4- ... ~ __ ....-!' _. 

- 27-

5This estimate is based on my own updating of Goldfeld-Ooms Table 2 

(which shows a 3 per cent fall in real benefits between 1975 and 1980). 

Both estimates use the official CPI, so the decline would be less if real 

benefits were computed by use of a price index that treated housing from a 

flow-of-services approach (such as Gillingham, 1981). 

6In this regard, I have observed that groups of union members 

generally think that their own inflationary experience exceeds that 

measured by the CPl. National opinion polls suggest that a large part of 

the public in the U.S. holds a similar belief, at least for recent 

periods. Thus, when inflation "catch-up" or inflation expectations become 

a factor at the bargaining table, differing perceptions of the facts can 

extend negotiations. 

70 uring the past several years, statistical agencies have often been 

criticized for not providing guidelines for writing escalator clauses, or 

for their failure to tell the parties how escalator clauses should be 

written or what measurements should be used. Much of this criticism 

stemmed from the belief that the CPI was an independent contributor to 

inflationary pressure (an "engine of inflation," Alfred Kahn called it) and 

that changing the index or the way it was used could somehow moderate 

inflation in the private sector. This criticism is misguided. Parties to 

a collection bargaining agreement will determine what they believe is 

appropriate. No government agency, and certainly not a statistical agency, 

has a role in this decision. Moreover, it is naive to believe that 
- -=- ---=- ., .. -- --- ~- . '--.. - - .... -. ---...:..~ -- --'- - - .-•• --- ..-.- -.~ .• ·.to ...... _ .• _ • _ • _ ___ __ ~" . _. 0 _. 00 _ __ '-"_ • •• _ .. ;... _ ... _ 

- 28 -

I 

changing the numbers used in an escalator clause formula will have any but 

the most transitory and ephemeral effects on the course of money wages or 

inflation. 

8It seems such a short time ago that many economists argued that the 

cost of inflation could be mitigated, provided all portions of the 

population were indexed, and some of them pointed, paradoxically, to hyper 

inflations such as Brazil and Israel as examples of how indexing might 

work! 

9A frequently heard objection to the use of a wage measure for 

indexing purposes is that a wage measure would share gains in productivity 

with the retired population, which, it is alleged, does not contribute to 

productivity gain. Stepping for the moment into a normative mode, this 

proposal seems predicated on a false premise. The current level of 

productivity depends on the contributions of past generations, and some 

part of the current capital stock, both physical and human capital, was 

accumulated by current retirees. Unless retirees have already appropriated 

the returns from all the social investments they may have undertaken in 

their working lifetime, a system, such as the U.S. Social Security system, 

that makes the pension depend on the current social dividend as well as the 

pensioner's own contribution to the account has much to recommend it on 

equity grounds. 
.-- -~ .. -- . - .. _---- .- ~ .. ~ .. '- .~ -..... -.. -....... ~-

- 29. ~ 

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