Cost of Living Adjustments Fuel Inflation

COLAs are an Inflationary Device and Should be Changed

Oct 8, 2009 Nelson Acquilano

Cost of Living Adjustments were designed to help protect individuals against inflation. In reality, it has a paradoxical effect which actually drives inflation higher.

The cost of living is the projected cost for maintaining a certain standard of living. With inflation the cost for maintaining a certain standard of living does increase. As such, both the public and private sectors generally allow a cost-of-living adjustment (COLA) to adjust a salary to equalize changes projected from a cost-of-living index- most usually the Consumer Price Index (CPI). Both government salaries and salaries in private corporations are typically adjusted annually to reflect these changes. Again, the intent is to maintain one’s standard of living- not to improve upon it.

COLA Legislation

According to the Social Security Administration, legislation was enacted in 1973 that provides for automatic cost-of-living adjustments, or COLAs for Social Security and Supplemental Security Income (SSI) benefits to keep pace with inflation. For instance, in 2008 the COLA was computed from the Consumer Price Index, and indexed (projected) to be a 5.8 percent raise for SS and SSI beneficiaries. This adjustment is important to help those on a fixed and restrictive income. With high inflation in the 1970s, COLAs became popular in both the public and private sectors to protect against inflation.

The Inflation Factor

As salaries increase to meet prices, however, corporations raise their prices to pay for the higher wages. Governments raise taxes or increase fees to pay for the higher wages. The end result is that cost of living adjustments “create a perpetual inflation machine.” In the article “Inflation’s COLA Cure” (Time Magazine, July 28, 1980), it was pointed out that state and county budgets are “becoming disenchanted with the salary escalator ride.”

States and counties are cash strapped and can no longer turn to taxes and traditional revenue sources for additional monies to balance budgets. The results are huge, unmanageable deficits with high levels of layoffs, closings of necessary services, overcrowding of prisons and jails, and even catastrophic consequences such as the state of California running out of money entirely.

For example, assume one city school district negotiates a COLA salary adjustment of 4% each year for a three year contract. That one school district has 2,500 teachers, averaging a salary of $47,000 each. The school would need to budget $4.7 million in additional wages the first year of the contract, 4.9 million the second year, and 5.1 million the third year. Future labor contracts would then demand COLAs based on top of this new salary level. This level of COLA places a tremendous strain upon the local economy and results in many other inflationary sequences.

Opponents of COLAs say that cost of living adjustments fuel higher inflation rather than just help people keep up with past price hikes. With COLAs, cost increases begin to progress geometrically and without corresponding matching revenue. And COLAs have crept into virtually every other arena as well as salaries: rent payments, divorce settlements, income taxes, retirement systems, and even college tuition. Often COLAs are granted even when the Consumer Price Index drops- another example of how the COLA mechanism has been counterproductive.

Economics- Fiscal Restraint for a Better Labor Wage System than COLA

Serious thought should be given to the replacement of a percentage-based COLA mechanism with a flat adjustment mechanism. For instance, every year as a worker is more skilled and productive, that worker would be granted a $500 or $1,000 increase. A worker would continue to build a salary over a 25 year work history, yet, the adjustment would be both predictable and more manageable than a percentage base COLA. In this same example above, if the school district granted a flat “COLA” it would total $2.5 million per year, and yield a total savings of $7.2 million over the life of the three year contract. This is far less of an inflationary device, and one which government and industry may wish to seriously investigate.

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