Does CPI reflect the inflation experiences of benefit recipients?

19 August 2015

The Summer Budget announced many working-age benefits will be frozen in nominal terms until 2020. The Government has indicated the Consumer Price Index (CPI) will be used to uprate benefits when the freeze is lifted. However concerns are growing about the relevance of this measure to the price experiences of benefit recipients.

Historically, benefits have been pegged to an index measuring general changes in the price of goods and services. RPI was the favoured measure until the Rossi and New Rossi Indexes were introduced in the 1980s. In 2010, George Osborne announced the majority of benefits would be uprated in line with CPI.

The Chancellor’s rationale was clear: CPI best reflects the price experiences of social security recipients, be they pensioners, the unemployed or the disabled. Unlike RPI, CPI excludes the housing costs that many social security beneficiaries do not face thanks to Housing Benefit. By taking into account the fact that individuals substitute away from expensive goods, CPI was also deemed a better model of consumer behavior.

Yet issues remain. An individual’s experience of changing prices is determined by their consumption habits. If these deviate from the average used to construct CPI, the headline measure will not reflect the price changes faced by that individual. All price indexes suffer from this problem of aggregation – no household is exactly representative. However evidence from both the UK and abroad suggests social security beneficiaries depart from the expenditure patterns of average households.

Take pensioners in the UK. The ONS recently calculated a CPI index based on the expenditure patterns of retired household. Since 2002, pensioners have seen prices rise by 3.7 per cent more than non-pensioner households. This gap has been consistent and growing.

Cumulative and yearly price changes for retired and non-retired households, CPI

In Australia we find a similar picture emerging. Those in receipt of social security transfers have seen their cost of living increase by 5 per cent more than those in employment since 2000. In contrast to the UK, however, these trends were largely driven in the wake of the financial crisis. This area of investigation is recent, so empirical evidence on the question of whether social security beneficiaries will experience higher inflation in the long run is limited.

Australia: annual inflation rates by household type, cumulative and annual percentage change

What we do know, however, is that the cost of fuel, energy, and food – goods that beneficiaries consume proportionately more of due to their low incomes – has been both higher and more volatile than other bundles of goods in the CPI. When these products are excluded from the CPI, the price index grows at a considerably slower pace.

CPI and core CPI inflation

Yet even if these issues are temporary, policymakers should take note. Using a price index that does not reflect the short-term experiences of beneficiary households could result in temporary declines in the purchasing power of some of society’s most vulnerable individuals. The lack of evidence prevents policymakers from assessing whether interventions are needed to resolve these discrepancies. Remedying this gap in our understanding should be a priority for policymakers in the run up to the removal of the benefit freeze in 2020.

William Mosseri-Marlio, Researcher, Reform

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