The Minister for Social Protection wants to index many social protection payments to a cost of living index as an anti-poverty measure. This makes sense on the face of it, as long as that cost of living index is going up, and as long as the level of benefits fall when the cost of living falls. It’s also worth thinking about the virtues of indexation, as this was one of the main criticisms IFAC had of the fiscal space calculations during the last election.
Let’s say you index benefits to the consumer price measure of inflation.
Here’s what happened to that reading over the longer run.
Just messing about with the idea a little more, imagine we ‘begin’ the Irish economy in year 1 with a CPI reading of 100, and grant benefits of €100. Then we can add in (say) the last 20 years of real CPI data from 1995 to 2015 to get a sense of what would have happened to benefits in a year-on-year basis as a result.
The line is the increase in benefits as a result of the indexation, and the bars are the changes in euros to the benefits as a result of the cost of living increase or decrease, measured on the right hand axis. The excel sheet I used to knock this up is here.
Hopefully you can see two things. First, the measure is highly pro cyclical. Precisely when we want benefits to decrease a bit, because the economy is growing strongly, they go up, and when we want benefits to increase a bit to cover the cost of living during a crash, they go down. Second, in recent years inflation has either stagnated, or fallen, so you wouldn’t see a huge increase or decrease in benefits either way. Now you could smooth out some of these effects out with a moving average of, say, 3 years, but this little exercise shows, I think, that it’s worth looking carefully at indexation proposals.
(Updated with thanks to commenter Tony_Eire.)