indexation

A system under which contracts provide for regular revision of prices, wages, pensions, or rents in line with some chosen index of prices. The argument for indexation is that it offers stability of real incomes in times of inflation to workers or pensioners, and avoids the need for repeated ad hoc renegotiation of wages, etc. The disadvantage of widespread indexation is that if the various revisions are staggered over time, as seems inevitable, this gives rise to a wage–price spiral, making inflation extremely difficult to stop once it has started. There is also a political economy argument: without indexation, many people lose through inflation, and there is thus a great deal of political support for policies to control it. If most people are protected against inflation, in a political equilibrium there will be more inflation, which will injure the minority who are not protected by having their incomes indexed. Many countries have adopted some degree of indexation; in the UK, for example, pensions and other benefits are updated annually in line with the Retail Price Index.

Indexation is a technique to adjust income payments by means of a price index.

Applying a cost-of-living escalation COLA clause to a stream of periodic payments protects the real value of those payments and effectively transfers the risk of inflation from the payee to the payor, who must pay more each year to reflect the increases in prices. Using CPI as a COLA salary adjustment for taxable income fails to recognize that increases are generally taxed at the highest marginal tax rate whereas an individual's rising costs are paid with after-tax dollars - dollars commensurate with an individual's average after-tax level. Some countries have cut back significantly in the use of indexation and cost-of-living escalation clauses, first by applying only partial protection for price increases and eventually eliminating such protection altogether when inflation is brought down to single digits.

Protecting one of the parties from the risk of inflation means that the price risk must be shifted to another party. For example, if state pensions are adjusted for inflation, the price risk is passed from the pensioners to the taxpayers. But the taxpayers may be protected as well, if the income tax brackets are routinely adjusted upwards in order to keep from having to pay more taxes just because of inflation.