why indexation is necessary
the use of indexation can theoretically mitigate the impact of inflation on a worker s standard of living most workers would effectively be getting a real wage cut each year as inflation cuts into the purchasing power of their nominal wages but 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 are indexed to the annual increase in the consumer price index 1types of indexationprices and wages can be indexed over different geographic areas a company with employees in multiple states or cities might want to link compensation in other areas to local prices because rents and costs of living vary from place to place this can be accomplished 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 it can be applied to debt mutual funds that have been held for a certain minimum amount of time before being sold 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 for the seller after the transaction indexation might also be applied to pension funds to reassure participants that their assets will keep pace with inflation the value of those assets won t erode as time passes life insurance companies might offer their clients policies that include terms for indexation they might promise a payout that s adjusted for inflation the premiums for such plans can be higher with annual increases however such a product might raise concerns about consumers overspending on premiums especially during periods when inflation is minimal and below the rate of increase that s charged for indexation 2