Indexation is a system used to make adjustments to prices, wages, or asset values over time to lessen the impact of inflation.
It involves establishing a point of comparison — usually either a period of time or a price level — and making changes relative to it. The U.S. government uses indexation to make policy and regulate the economy.
What is Indexation?
Indexation is the process of adjusting prices, wages, or asset values, usually in accordance with changes in the general cost of living. It’s often used by governments to keep the effects of inflation to a minimum and therefore maintain consumer purchasing power.
For example, the U.S. tax system uses automatic inflation indexing to avoid “bracket creep,” according to the Tax Foundation. Tax provisions that are tied to a specific dollar amount, such as standard deductions, Social Security payments, and income tax brackets, increase annually when cost of living goes up. More than 60 tax provisions were adjusted for 2022.
Without indexation, you might end up paying higher taxes on the same amount of income, even if tax rates haven’t changed. The adjustments are usually minor from one year to the next, but can be significant over several years.
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How Does Indexation Work?
One type of indexation requires establishing a benchmark, or base year. This is used as a point of comparison and usually has a value of 100.
With two or more index values, you can compare the change — usually expressed as a percent — over time.
For example, let’s say the index value for the price of a basket of goods in 2005 was 200 and in 2010 was 230 (both values were calculated using a base of 100). The index point change is 30. Divide the index point change by the earlier year and then multiply that by 100 to find the percent increase.
230 – 200 = 30
[30 / 200] x 100 = 15%
In this example, the price of a basket of goods increased by 15% between 2005 and 2010.
Alternatively, indexation can be used to maintain a price ratio between at least two items when a producer wants to keep profits stable. For instance, a baker may index the price of a muffin to the cost of flour so that they maintain a ratio of two to one. That is, when the cost of flour goes up 5%, they increase the price of a muffin by 5%. This maintains their profit margin.
Some indexation systems lead to automatic adjustments, like the U.S. tax code. Other indexation systems are simply signals for policymakers, employers, and the Federal Reserve to implement changes to budgets, interest rates, and employee wages.
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Types of Indexation
Below are a few common indices used in the U.S.
Consumer Price Index
The Consumer Price Index (CPI) is one of the most well-known indices in economics. It measures how prices of a specific group of goods and services commonly purchased by U.S. households, including imported products, change over time.
The Bureau of Labor Statistics (BLS) uses the years 1982 to 1984 to represent the base period for CPI. A 7% increase in prices from that base period to the year 1990, for example, would bring the index from 100 to 107. Variations of the index measure changes on a monthly, quarterly, and semiannual basis, or for a certain geographical area.
CPI can be used to find the difference between nominal wages and real wages, or the amount a worker is actually getting paid after factoring in inflation.
Producer Price Index
The Producer Price Index (PPI) goes back one step and tracks the prices that U.S.-based manufacturers pay to produce their goods and services, such as the price of flour for a baker or steel for a car maker. An increase in the PPI usually indicates a future increase in the CPI, since many businesses pass the cost of production on to consumers.
Employment Cost Index
The Employment Cost Index (ECI) is a business planning tool that measures the cost of labor for employers in various industries. It tracks both wages (salary and hourly pay) and benefits (health insurance and retirement plans) through surveys of employers. The BLS releases this data quarterly and uses a base year index of 100.
GDP Price Index
The Gross Domestic Product (GDP) Price Index measures the prices of goods and services that are produced in the U.S. and purchased by domestic consumers, businesses, and the government, as well as foreign buyers.
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The Bottom Line
Indexation is a system that helps governments and businesses make adjustments to the cost or value of something relative to a specific benchmark. If you have indexed pay, for example, that means your salary or hourly rate is tied to inflation — when general prices go up, your pay does too so that you don’t lose purchasing power.
Indexation isn’t a cure-all for inflation because most types of indexation don’t lead to automatic adjustments. Policymakers and businesses have to evaluate different indices and make decisions on their own time, considering not only inflation, but other economic factors.
Author is not a client of Personal Capital Advisors Corporation and is compensated as a freelance writer.
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