What is Indexation?

Indexation is the means by which the value of a financial item, usually entitlement payments or taxes, is linked to the value of another, usually a price index. When the linked-to value rises or falls, the amount of the payment is automatically changed to reflect that rise or fall. Indexation is intended to minimize or eliminate the impact of inflation on those receiving or making these payments.

There is a wide variety of indexation techniques, but all involve comparing current values against historical values. In some cases, current values are compared with those from years ago; in others, the comparison is month-to-month, quarter-to-quarter, year-to-year, or the current period with the corresponding period from one year earlier. In the United States, the most commonly used measure of inflation is the Consumer Price Index (CPI), which is the change in the value of an average “market basket” of universally-needed goods and services including such things as groceries, housing, transportation and health care. The value of the market basket is compared with earlier values, and the ratio of change is the actual index amount.

The most widely-known payments that are subject to indexation are those made to retirees. The underlying logic for indexing retirement payments is that since inflation is almost unavoidable, retirees' pensions would automatically lose their purchasing power over time because they aren't eligible for the wage or salary increases available to active workers. In the US, Social Security benefit payments to retirees are subject to an annual Cost of Living Adjustment (COLA), so that retirees don't suffer a significant loss of their benefits' purchasing power to inflation. In addition, American income tax brackets are indexed to offset the effect of inflation, thus protecting taxpayers from a phenomenon known as “bracket creep,” which is the increase in the income tax rate that results from the worker earning more money, even as the purchasing power of that additional income is declining. Both of these indexation adjustments are based on the change in the CPI, although no adjustment is made if the change is negative.

Indexation can be a controversial issue because it influences the amount of taxes paid by individual taxpayers, the amounts paid out of the public treasury, and the amounts received by retirees and others. When Social Security COLA adjustments are announced in the US, for instance, retirees will generally complain that the adjustment isn't enough to meet the effects of inflation and claim that the CPI is an inaccurate measure of inflation.