ECONOMICS:Basing spending rises on the EU harmonised consumer price index as opposed to CPI would benefit State coffers, writes PAT McARDLE

THERE WAS a time, not so long ago, when we were regularly accused of aping all things British.

More recently, the traffic was in the opposite direction and, in the past year, there were calls from Downing Street to Dublin as the UK began to grapple with the huge task of cutting public spending.

However, the traffic is not all one-way and we could usefully copy one recent UK initiative.

In 2003, the Blair government took the radical step of making the Bank of England independent and set it a target of keeping inflation below 2 per cent. Though the UK was not a member of the euro zone, the target was based, not on its domestic retail price index (RPI), but on the then relatively new harmonised index of consumer prices (HICP).

The HICP is the consumer price index as it is calculated in the European Union, according to a harmonised approach and a single set of definitions. While it grew out of the need for a common measure of inflation to be targeted by the ECB for those countries participating in the single currency, it is calculated for all 27 member states, including the UK. Confusingly, the UK did not want to use the HICP label so it renamed it the CPI for its particular needs but I shall refer to it as the HICP in the interests of clarity.

Consumer price indices measure changes in the prices paid for goods and services by households by comparing the cost of buying a “representative basket” of goods and services bought by an “average” household to the cost of a similar basket at an earlier period, typically a year ago. They are used for a wide variety of purposes, not just as a target for monetary policy but also for the indexation of commercial contracts, wage agreements, social welfare benefits and private sector pension schemes.

There are significant differences between the harmonised indices compiled by the European authorities and the old national measures such as the RPI in the UK and the consumer price index (CPI) here. By far the most significant of these is the omission from the HICP of a measure of the costs of owner-occupied housing.

Rises and falls in interest rates thus have no impact on the HICP, whereas they can have a major effect on both the RPI and the CPI. The differing treatment reflects lack of agreement as to how housing costs should be measured.

The new coalition government in the UK recently announced a further major change. From April 2011, benefits and tax credits, with the exception of the pension credit and the basic state pension, are to be uprated by reference to the HICP rather than the RPI. It is estimated that this move will save £6 billion (€7.06 billion) by 2014-2015, relative to maintaining the current system.

It should be noted that, unlike Ireland, the UK already links certain means-tested benefits such as jobseekers allowances and housing benefit to an ad hoc index that excludes certain housing costs and that typically lies in between the RPI and the HICP. The principle of differential treatment is, thus, already established but the latest proposals would push it much further.

In Ireland, nominal amounts are usually uprated by reference to the CPI. Last year’s reductions in social welfare benefits prompted a debate about the appropriate measure of inflation to be used. I took the view that, if social welfare rates were increased in line with inflation (or more) in good times, we should reduce them in line with the CPI when prices fell.

The Government did not agree and lowered social welfare rates, other than the State pension, by a lesser 4 per cent, arguing that many of those affected did not have mortgages and, thus, did not benefit from the falls in interest rates that caused the CPI to decline so sharply.

In effect, they switched horses from the CPI, which would have justified a larger reduction, to something closer to the HICP.

The question now arises as to whether we should formalise this and switch to the HICP, as the UK is doing.

In the long term, this would not make much difference. As the accompanying graph shows, the CPI is more volatile than the HICP, rising by more when interest rates are going up and vice versa. However, the differences tend to cancel out over time. In fact, the annual average difference between the two measures is only 0.1 per cent per annum or about 3.5 per cent in total over the 21-year period since 1989.

Why then switch to the CPI? Interest rates are now at abnormally low levels and will likely rise by several percentage points over the next five years, making this an ideal time to start from the perspective of saving money.

If key ECB rates were to rise from the current level of 1 per cent to what would be regarded as “normal” 4 per cent, this would add five percentage points to the CPI as mortgage rates went up. (The increase would be closer to five points but for the fact that recent rises in variable mortgage rates have had an overstated impact on the CPI due to the method of compilation, which needs to be reviewed). The HICP, by contrast, would not be affected.

The saving on gross current government spending, currently around €40 billion, would be of the order of €2 billion by comparison with a situation where spending grew in line with the CPI.

The public finances are in such a dire state that large savings will have to be made one way or another and irrespective of whether the indexation method is changed or not.

However, the announcement of a switch to the HICP at this stage would herald a longer-term structural change that would affect not just current government spending but tax receipts, pensions, wages and a range of contracts throughout the economy. It has the potential to improve our long-term competitiveness by several percentage points.

A good idea is always worth copying.