Cost of living

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For other uses, see The Cost of Living.

Cost of living is the cost of maintaining a certain standard of living. A cost-of-living index is a price index that measures relative cost of living over time. Such indexes are constructed to have a value of 100 in a given year (or period or place), called the base. An index value of 110 means that the current cost of living is ten percent higher than in the base year. Because the index provides measure of the change in the cost of living, it has no units.

There are many different methodologies that have been developed to calculate cost-of-living indexes, including methods that allow for substitution among items as relative prices change.

1 Variations
2 Uses of cost of living indexes
- 2.1 Cost-of-living allowances (COLA)
3 Other uses of the term "cost-of-living allowance"
4 See also
5 References
6 External links

[edit] Variations

There exist cost-of-living comparison calculators which compare the cost of living at different locations (such as cities) rather than in different years. A value of 100 for the index would indicate a place with equal overall costs as the base location. A value of 200 would indicate a place where the overall cost of living is double that of the base location.

A Konüs index is a type of cost-of-living index that uses an expenditure function such as one used in assessing expected compensating variation. The expected indirect utility is equated in both periods. This method can be used to introduce risk aversion into cost-of-living indexes.

The United States Consumer Price Index [CPI] is a price index that is often referred to as a cost-of-living index. The two are related but not exactly interchangeable, however. The US Department of Labor's Bureau of Labor Statistics [BLS] explains the difference:

"The CPI frequently is called a cost-of-living index, but it differs in important ways from a complete cost-of-living measure. BLS has for some time used a cost-of-living framework in making practical decisions about questions that arise in constructing the CPI. A cost-of-living index is a conceptual measurement goal, however, not a straightforward alternative to the CPI. A cost-of-living index would measure changes over time in the amount that consumers need to spend to reach a certain utility level or standard of living. Both the CPI and a cost-of-living index would reflect changes in the prices of goods and services, such as food and clothing that are directly purchased in the marketplace; but a complete cost-of-living index would go beyond this to also take into account changes in other governmental or environmental factors that affect consumers' well-being. It is very difficult to determine the proper treatment of public goods, such as safety and education, and other broad concerns, such as health, water quality, and crime that would constitute a complete cost-of-living framework."^[1]

[edit] Uses of cost of living indexes

A cost-of-living index is a useful way to consider welfare changes caused by changes in factors exogenous to the individual household, such as inflation, and the monetary, fiscal, and trade policies of governments. One drawback to simple price change measurement is a difficulty in measuring changes in the quality of goods.

[edit] Cost-of-living allowances (COLA)

Employment contracts, pension benefits, and government entitlements (such as Social Security) can be tied to a cost-of-living index, typically to the consumer price index (though such CPI increases may not meet the "indifference" objective if the increase is then reduced by income taxes). A cost-of-living allowance (COLA) adjusts salaries based on changes in a cost-of-living index. Salaries are typically adjusted annually. They may also be tied to a cost-of-living index that varies by geographic location if the employee moves.

Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments or cost-of-living increases because of their similarity to increases tied to externally-determined indexes. Most economists and compensation analysts would consider the idea of predetermined future "cost of living increases" to be misleading for two reasons: (1) For most recent periods in the industrialized world, average wages have actually increased faster than most calculated cost-of-living indexes, reflecting the influence of rising productivity and worker bargaining power rather than simply living costs, and (2) most cost-of-living indexes (see above) are not forward-looking, but instead compare current or historical data. Additionally, simple arithmetic requires that any increase subject to income tax will necessarily have to exceed the inflation rate to result in an inflation adjusted after-tax salary level. Thus for real purchasing power (or any after-tax income) to merely keep up with inflation, gross income must increase faster than cost-of-living indexes.

Consequently, where using CPI as a proxy for a Cost-of-Living index may fall short is in accounting for subsequent income taxes on COLA increases. As a means for adjusting gross wages/salaries/incomes CPI calculations may fail to gross-up for 'progressive rate marginal taxes'. Indexed increases are generally taxed at the highest marginal tax rate, whereas the consumer expenditure market basket corresponds to the consumer's generally lower average tax rate. The widely recognized problem known as bracket-creep can also occur in countries where the marginal tax brackets themselves are not indexed - COLA increases simply place more dollars into higher tax rate brackets. (Only under a flat-rate tax system would a percentage gain on gross income translate into a comparable inflation-offsetting gain at the after tax level.)

Some salaries and pensions in the U.S. with a COLAs (they vary by type) include:

Social Security
Civil Service Retirement System (CSRS)^[2]
Federal Employees Retirement System (FERS)^[2]

Pensions in Canada with a COLA include:

Canadian Auto Workers union (CAW) Local 200 (Ontario)

[edit] Other uses of the term "cost-of-living allowance"

Stipends or extra pay provided to employees who are being temporarily relocated may also be called cost-of-living adjustments or cost-of-living allowances. Such adjustments are intended to offset changes in welfare due to geographic differences in the cost of living. Such adjustments might more accurately be described as a per diem allowance or tied to a specific item, as with housing allowances. Employees who are being permanently relocated are less likely to receive such allowances, but may receive a base salary adjustment to reflect local market conditions.

A cost-of-living allowance is frequently given to members of the U.S. military stationed at overseas bases. For example, service members stationed in Japan receive a cost of living allowance of between $300 and $700 per month (depending on pay grade), in addition to their base pay.