Indexation

What Is Indexation?

Indexation is a system or technique used by organizations or governments to connect prices and asset values. This is done by linking adjustments made to the value of a good, price of a service, or another specified value to a predetermined price or composite index. Indexation requires identifying a price index and determining whether linking the value to the price index will accomplish the organization's goals. Indexation is most commonly used with wages in a high-inflation environment. Indexation is also known as escalating.

Understanding Indexation

Indexing a given price or payment to other prices can serve two main purposes. It can be used either to maintain a stable relative price between two or more goods or services or to maintain a stable real price of a good or service relative to the purchasing power of a currency unit. Indexation is a pre-specified process, meaning that all parties involved are typically aware of how the link works.

In the first, and simpler, case, this is done by specifying the desired target ratio of two prices and adjusting one price when the other changes in order to maintain the ratio. For example, an ice cream stand might index the sale price of ice cream cones to the wholesale price that they pay for ice cream in order to maintain a steady profit margin by keeping the price of cones served constant, relative to the cost of bulk ice cream. That way if the wholesale price of the input doubles, so does the output price and the business remains profitable.

In the second case, a price or asset value is linked to a price level of a basket of goods, which is usually set equal to 100 at a given point in time. 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, meaning that an increase in the consumer price level over a period of time will lead to an increase in salary. This particular type of indexation is called a cost of living increase (COLA). 

In the above example, the use of indexation, in theory, can mitigate the impact of inflation against a worker's standard of living. Without this kind of indexation, most workers would effectively be getting a real wage cut each year as inflation cuts into the purchasing power of their nominal wages. 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 inflation can have on the recipients of transfer payments and entitlements. Social Security payments, for example, are indexed to the annual increase in the Consumer Price Index.

In addition to indexation over time, prices and wages can be indexed over different geographic areas. For example, because rents and costs of living vary from place to place, a company with employees in multiple states or cities might need to link compensation in different areas to local prices. This can be done either 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. For instance, it might be applied to debt mutual funds that have been held for a certain minimum amount of time before being sold. In such a case, 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 after the transaction for the seller of such assets.

Indexation might also be applied to pension funds to reassure participants that their assets will keep pace with inflation. That way, the value of those assets do not erode as time passes.

Life insurance companies might offer their clients policies that include terms for indexation, which may promise a payout that is adjusted for inflation. However, the premiums for such plans can be higher with annual increases. Such a product may raise concerns about consumers overspending on premiums, especially for periods when inflation is minimal and below the rate of increase that is charged for indexation.