Table of Contents
- What Is Indexation?
- Key Takeaways
- Understanding Indexation
- Two or More Goods or Services
- Purchasing Power of a Currency
- Why Indexation Is Necessary
- Important Note on Social Security
- Types of Indexation
- How Does the IRS Use Indexation?
- What Are the Signs of Inflation?
- What Is the Consumer Price Index?
- The Bottom Line
What Is Indexation?
Let me explain indexation to you directly: it's a system or technique that organizations or governments use to connect prices and asset values. You accomplish this by linking adjustments to the value of a good, the price of a service, or another specified value to a predetermined price or composite index.
Indexation requires you to identify a price index and determine whether linking the value to that index will meet your organization's goals. I see it most commonly used with wages in high-inflation environments. You might also hear it called escalating.
Key Takeaways
Indexation means adjusting a price, wage, or other value based on changes in another price or composite indicator of prices. You can do this to adjust for the effects of inflation, cost of living, or input prices over time. It can also adjust for different prices and costs in different geographic areas. Indexation is often used to escalate wages in inflationary environments where failing to negotiate regular wage increases would lead to ongoing real wage cuts for workers.
Understanding Indexation
Indexing a given price or payment to other prices can serve two main purposes, and it's a pre-specified process where all parties involved are typically aware of how the link works.
Two or More Goods or Services
You can use indexation to maintain a stable relative price between two or more goods or services. This is done by specifying the desired target ratio of two prices and adjusting one price when the other changes to maintain the ratio.
Consider an ice cream stand that indexes the sale price of ice cream cones to the wholesale price they pay for ice cream. This maintains a steady profit margin by keeping the price of the cones constant relative to the cost of bulk ice cream. If the wholesale price of the input doubles, the output price adjusts, and the business remains profitable.
Purchasing Power of a Currency
Indexation can also maintain a stable real price of a good or service relative to the purchasing power of a currency unit.
You link a price or asset value to the price level of a basket of goods, which is usually set equal to 100. Price indexes are commonly published by official government agencies, often for the specific purpose of convenient use in the indexation of prices, wages, and transfer payments.
Businesses may use this type of indexation to match an employee's salary increases to the inflation rate. If the consumer price level increases over time, that leads to an increase in salary. This particular type of indexation is called a cost-of-living adjustment (COLA).
Why Indexation Is Necessary
The use of indexation can theoretically mitigate the impact of inflation on a worker's standard of living. Most workers would effectively be getting a real wage cut each year as inflation cuts into the purchasing power of their nominal wages. But there are still possibilities for economic changes to force some disparity between salaries and the pace of inflation.
Governments might similarly use indexation as a way to potentially alleviate the negative effects that inflation can have on the recipients of transfer payments and entitlements.
Important Note on Social Security
Social Security payments are indexed to the annual increase in the Consumer Price Index. The Social Security Administration plans a 2.5% cost-of-living adjustment for 2025.
Types of Indexation
Prices and wages can be indexed over different geographic areas. If you're a company with employees in multiple states or cities, you might want to link compensation in other areas to local prices because rents and costs of living vary from place to place. You can accomplish this by indexing pay to the prevailing wages paid by other businesses in those areas or by using an index such as the Regional Price Parities published by the Bureau of Economic Analysis.
Various assets and values might be subject to indexation. Some countries might apply indexation on certain types of tax payments at varying periods. It can be applied to debt mutual funds that have been held for a certain minimum amount of time before being sold. The original purchase price is adjusted for inflation when calculating long-term capital gains that will be taxed when those debt funds are sold. This can lead to a discount on taxes for the seller after the transaction.
Indexation might also be applied to pension funds to reassure participants that their assets will keep pace with inflation. The value of those assets won't erode as time passes.
Life insurance companies might offer their clients policies that include terms for indexation. They might promise a payout that's adjusted for inflation. The premiums for such plans can be higher with annual increases, however. Such a product might raise concerns about consumers overspending on premiums, especially during periods when inflation is minimal and below the rate of increase that's charged for indexation.
How Does the IRS Use Indexation?
The Internal Revenue Service (IRS) says that it makes tax inflation adjustments annually to prevent taxpayers from losing the value of various benefits. An example is the standard deduction for single filers that increased by $750 from the 2023 tax year to 2024. The Earned Income Tax Credit is indexed for inflation, as are numerous other credits, tax breaks, and income spans for tax brackets.
What Are the Signs of Inflation?
The primary sign of inflation is the steadily increasing costs of many goods and services over time. A carton of eggs might cost $1.85 in June and hover in that area for the next several months. That's not inflation. But inflation might exist if the price increases to $2.00 in July and to $2.10 in August and if the cost of many other products and services climb as well.
What Is the Consumer Price Index?
The U.S. Bureau of Labor Statistics defines the Consumer Price Index (CPI) as a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Indexes are broken down into food costs, energy costs, and all costs. The overall index increased by 3.4% from April 2023 through April 2024.
The Bottom Line
The term indexation essentially translates to adjustment in terms of the values of goods and services commonly purchased by businesses and consumers. Adjustments are based on changes in various price data and ideally keep pace with the effects of inflation over time. This can mean taking actions such as increasing the minimum wage when the costs of groceries are climbing.
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