Price Adjustment (Indices)
Introduction
Indexation is a technique for adjusting income payments using a price index, to maintain the purchasing power of the public after inflation, while deindexation is the cancellation of indexation.
Overview
From a macroeconomic point of view, there are four main categories of indexation: wage indexation, financial instrument rate indexation, tax rate indexation, and exchange rate indexation. The first three are indexed for inflation. The latter is usually indexed to a foreign currency, primarily the US dollar. Any of these different types of indexing can be reversed (deindexed).
Applying a COLA to a stream of periodic payments protects the real value of those payments and effectively transfers inflation risk from the beneficiary to the payer, who must pay more each year to reflect price increases. Therefore, inflation indexation is often applied to pension payments, rents, and other situations that are not subject to market repricing.
COLA is not CPI, which is an aggregate indicator. Using the CPI as a COLA wage adjustment for taxable income fails to recognize that increases are generally taxed at the highest marginal tax rate, while an individual's increasing costs are paid for with money left after taxes are paid. Tax brackets do not address this fundamental issue, but they effectively eliminate bracket-creep.
Indexation has been very important in high inflation environments, and was known as monetary correction "correção monetária" in Brazil from 1964 to 1994. Some countries have significantly reduced the use of indexation and cost-of-living increase clauses, first applying only partial protection for price increases and eventually removing such protection entirely when inflation falls to single digits.
Protecting one party from inflation risk means that price risk must be transferred to another party. For example, if state pensions are adjusted for inflation, price risk shifts from pensioners to taxpayers.
Salaries
When a government decides to index the salaries of government employees to inflation, it is transferring the risk of inflation from government workers to the government itself. This policy aims to try to reduce inflationary expectations and, in turn, inflation when it is rising rapidly. Economists' research is ambivalent about the success of such policies. It has been considered a success by some, including Friedman (1974), Gray (1976), and Fischer (1977). Others have considered it less successful, noting that indexation creates inflationary inertia (a reduction in the government's and central bank's effort to combat inflation, leading to the inflation rate remaining higher than expected). This perspective is supported by Bonomo and García (1994).