What is Cost Of Living?

The cost of living is the cost of maintaining a certain standard of living over time. A cost-of-living index, such as the United States Consumer Price Index is a price index that conceptually measures relative cost of living. Such indexes are constructed to have a value of 100 in a given year (or period, or place), the base. Other values of the Consumer Price Index are relative to the base year. An index value of 110 indicates that the cost of living is ten percent higher than in the base year. Thus, the index provides a unit-free measure of the change in the cost of living. Cost-of-living indexes are also available that allow for substitution among items as relative prices change.

Another kind of cost-of-living index compares the cost of living not across time but across locations, such as metropolitan areas. A value of 100 for the index would indicate which areas had a cost of living above or below that level.

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.

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.

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.)

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.

References

External links

• Cost-of-Living Calculator from American Institute for Economic Research (AIER)

Internationally recognised cost of living index by Mercer Human Resource Consulting: [1]