Cost of living is the cost of maintaining a certain standard of living. Changes in the cost of living over time are often operationalized in a cost of living index. Cost of living calculations are also used to compare the cost of maintaining a certain standard of living in different geographic areas. Geographic differences in cost of living can be measured in terms of purchasing power parity rates.

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. 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)^[1]

• Federal Employees Retirement System (FERS)^[1]

Pensions in Canada with a COLA include:

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

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.

See also

• Price index
• Consumer Price Index
• Inflation
• List of most expensive cities for expatriate employees

References

External links

• Real Cost-of-Living Calculator from Leaving the Folks
• Cost-of-Living Calculator from American Institute for Economic Research (AIER)
• US Consumer Price Index FAQ

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