What is Chain-Weighted CPI?

Chain-weighted CPI is an alternative measurement for the Consumer Price Index (CPI) that considers product substitutions made by consumers and other changes in their spending habits. The chain-weighted CPI is therefore considered to be a more accurate inflation gauge than the traditional fixed-weighted CPI. This is simply because it accounts for the fact that consumers’ purchasing decisions change along with changes in prices as opposed to merely measuring periodic changes in the price of a fixed basket of goods.

Key Takeaways

  • Chain-weighted CPI takes real-word purchasing decisions into account to provide a more accurate picture of inflation.
  • Chain-weighted CPI can capture substitution effects and is therefore the preferred measure of inflation.
  • In 2017, chain-weighted CPI was substituted for regular CPI in setting tax brackets. This change is expected to result in higher tax revenues over time as the bracket adjustments will be smaller, potentially leading to more bracket creep.

Understanding Chain-Weighted CPI

The U.S. Bureau of Labor Statistics also maintains that the chain-weighted CPI is a closer approximation to a cost-of-living index than other CPI measures. This is because the fixed-weighted CPI may consistently overstate inflation by ignoring the disinflationary effect of quality improvements and new technology, in addition to the substitution effect.

For example, consider the impact of two similar and substitutable products—beef and chicken—in the shopping basket of Mrs. Smith, a typical consumer. (Let’s ignore for the moment the fact that the core inflation rate ignores food and energy prices because they are too volatile.) Mrs. Smith buys two pounds of beef at $4 / lb. and two pounds of chicken at $3 / lb. A year later, the price of beef has risen to $5 / lb. while the price of chicken is unchanged at $3 / lb. Mrs. Smith, therefore, adjusts her spending pattern because of the higher price of beef and buys three pounds of chicken but only one pound of beef.

The fixed-weighted CPI measure would assume that the composition of Mrs. Smith’s shopping basket is unchanged from a year earlier, and would compute the inflation rate as 14.3% (i.e. the difference between the total price of $14 and $16 paid for two pounds of beef and chicken a year apart). The chain-weighted CPI measure would, however, consider the effect of Mrs. Smith substituting a pound of beef with a pound of chicken because of its lower price, and would compute the inflation rate as zero (because the total amount spent is unchanged at $14).

Chain-Weighted CPI and Taxation

A federal law passed in 2017 applied the chain-weighted CPI instead of primary CPI for adjusting the incremental increases in income tax brackets. By switching to this metric, the increases on tax bracket adjustments will be comparatively smaller each year. This move to chain-weighted CPI is expected to push more citizens into higher tax brackets over time, thereby increasing the taxes they owe and, in turn, increasing the tax revenue collected by the Internal Revenue Service.

The year-over-year change will likely be a percentage or less over a given year, but there is a significant difference over time. For example, between 2000 and 2017, primary CPI increased by 45.7 percent, but chain-weighted CPI only increased by 39.7 percent. For taxpayers with raises indexed to primary CPI, this change may eventually result in them paying more tax in a higher bracket despite not feeling significantly more wealthy.