Un-COLA: Why Have Cost-of-Living Clauses Disappeared from Union Contracts and Will They Return?

• Author: Ragan Jr., James F.
• Position: Cost-of-living adjustment clauses

James F. Ragan, Jr. [*]

Bernt Bratsberg [+]

For more than 20 years, unions have been trading cost-of-living adjustment clauses (COLAs) for other forms of compensation. Various explanations have been offered for the erosion of COLA coverage--including reduced inflationary uncertainty, lower union power, and structural shifts in the economy--but the relative importance of these and competing hypotheses remains untested. We investigate the reasons for the decline in COLA coverage using a pooled cross-sectional, time-series model that accounts for industry fixed effects and recognizes the multiyear nature of most union contracts. After assessing the relative importance of alternative hypotheses, we conclude with a discussion of the potential for a rebound in COLA rates.

1. Introduction

   One of the major changes in collective bargaining in recent decades has been the gradual elimination of cost-of-living adjustments (COLAs) from union contracts. In 1976, 61% of union workers covered by major collective bargaining contracts had COLA provisions, but by the end of 1995, when the U.S. Bureau of Labor Statistics stopped collecting data on collective bargaining settlements, COLA coverage had fallen to 22%. [1] Although the decline in COLA rates has been studied extensively, there is no agreement as to which factors are primarily responsible for this decline. One view attributes the elimination of COLAs, or escalator clauses, to declines in inflationary uncertainty; a second view emphasizes the erosion of union power; yet another view focuses on structural shifts in the U.S. economy. Previous research has not determined the relative importance of these and other hypotheses.

   Another reason to reassess COLA determination is that the economy has changed since the early research was completed. The bulk of studies to examine COLA incidence statistically have relied on sample periods that end in 1982 or earlier. [2] Since then, there have been major changes in union strength, inflationary uncertainty, and other potential determinants of wage indexation, including deregulation of certain industries. In addition, more than 90% of the decline in COLA rates has occurred since 1982. It is worthwhile to determine whether the factors deemed to be important in the early studies are still important.

   We provide a comparison with previous research, formally assess the contributions of various factors to the erosion of COLA rates, and provide insights as to likely changes in COLA coverage in the future. If inflation picks up, and with it inflationary uncertainty, [3] will COLA rates rise to levels not seen since the 1970s? What would be the consequences of a rebound in union power, of further economic deregulation, of likely industrial and demographic shifts in the economy? Once the major causes of past changes in COLA coverage are understood, it becomes possible to project the consequences of changes in key economic variables. Given the concern in macroeconomics with wage indexation and the linkage between wages and prices (Gray 1976; Fischer 1986; Ball and Cecchetti 1991; Schiller 1997), the extent to which COLA coverage responds to economic factors has important implications for the economy.

   Underlying the empirical analysis is a pooled cross-sectional, time-series model of COLA incidence that accounts for industry fixed effects. To estimate the model, we assemble a panel data set of COLA coverage and an array of characteristics for 32 private-sector industries over a 22-year period. Because COLA clauses are multiyear in nature, the model also recognizes that the percentage of workers covered by COLA clauses in a particular year depends on conditions in both the current year and previous years.

   Previewing results, we find that the major cause of the decline in COLA coverage has been the reduction in inflationary uncertainty. Second in importance has been the erosion of union power. Both the percentage of the industry's workforce that is unionized and the estimated union wage premium in the industry are highly significant determinants of COLA coverage. But because the union wage premium has remained largely intact in most industries, changes in the premium are much less important than losses in unionization in explaining the overall decline in COLA provisions. Economic deregulation, industrial shifts, and an increased presence of women in the workforce have had modest effects on COLA rates. On the basis of our findings, a rebound in inflationary uncertainty to the levels experienced in the 1970s would raise COLA coverage by 10 percentage points.

2. Background

   For workers in long-term contracts, COLAs provide at least partial protection from the consequences of unexpected inflation. For the employer, however, COLAs increase rigidity of real wages and relative wages. Whether or not a given union contract contains an escalator clause depends on the valuation of such a provision by both workers and the employer and, in turn, on risk preferences of the two parties.

   In the efficient-contract model of Ehrenberg, Danziger, and San (1984), the union and the employer jointly maximize the weighted average of expected utility of the representative union member and expected profits, with weights based on the relative bargaining power of the two parties. In addition to determining whether or not the contract contains a COLA clause, a companion issue is the degree to which any COLA clause is indexed, where [epsilon], the elasticity of indexation, measures the extent to which higher prices translate into higher nominal wages. Ehrenberg, Danziger, and San show that the optimal elasticity of indexation depends on the risk preferences of workers and of the employer.

   Workers are assumed to be risk averse. If the employer is risk neutral and if there are no costs of COLA provisions (administrative or otherwise), then all contracts contain COLA clauses and these contracts are fully indexed ([epsilon] = 1). When the employer is also risk averse, the degree of indexing depends on relative risk aversion. The greater the risk aversion of workers relative to the employer, the closer [epsilon] is to 1. [4]

   Including COLA clauses in contracts is likely to entail costs. Once these costs are recognized, the probability that a contract contains a COLA clause depends on the costs of COLA as well as the benefits. As Ehrenberg, Danziger, and San observe, an increase in costs reduces the likelihood that a contract will contain a COLA clause. Another conclusion of their model is that increased risk aversion of workers increases the probability of a COLA. Finally, the model implies that "given that workers are risk averse, the more uncertain inflation is the greater is the gain to them of indexation and thus the greater is the likelihood of indexation" (p. 16). Consistent with this prediction, most studies find a strong positive relationship between inflationary uncertainty and COLA coverage (Cousineau, Lacroix, and Bilodeau 1983; Hendricks and Kahn 1983, 1985; Holland 1984, 1986; Prescott and Wilton 1992; Weiner 1993).

   Figure 1 depicts movements in inflationary uncertainty, as proxied by the standard deviation of inflation forecasts from the Livingston Survey, and aggregate COLA coverage. Although movements in the standard deviation of inflation forecasts are more erratic, the two series display broadly similar patterns (the simple correlation coefficient is 0.73). When inflationary uncertainty picked up in the 1970s, so did the incidence of indexation. More recently, both series have declined. In light of the previously cited studies, it is likely that at least part of the erosion in wage indexation can be traced to the reduction in inflationary uncertainty.

   The model of Ehrenberg, Danziger, and San does not explicitly consider how union bargaining power affects the decision of whether or not to index a contract. When Hendricks and Kahn (1985) recast the model so that bargaining power enters the solution for the optimal degree of indexation, they show that "higher bargaining power raises the incidence of indexation when [epsilon] [less than] 1" (p. 145). Because data in both Hendricks and Kahn and in Card (1986) indicate that [epsilon] tends to be less than 1, the implication is that greater union bargaining power can be expected to increase the likelihood of COLA coverage. Empirical evidence supportive of this proposition has been uncovered by Hendricks and Kahn (1983, 1985), Prescott and Wilton (1992), and Weiner (1993).

   Another issue concerns the extent to which trends in aggregate COLA coverage result from changes in employment patterns across industries, rather than from trends in industry COLA rates. Devine (1996, p. 25) notes that union employment has declined faster in "the more COLA-prevalent manufacturing sector" than in nonmanufacturing, though she does not attempt to quantify the effect of changing employment patterns on overall COLA coverage. Davis et al. (1990) go further, asserting that shifts in employment patterns are the principal cause of declines in the aggregate COLA rate:

   The proportion of workers with COLA coverage ... declined slowly from the end of 1976 through 1984 largely because of employment losses in industries in which COLA clauses were common. (p. 7)

   Unfortunately, the study provides no empirical evidence to support its claim.

   Lending credence to this view, however, are two earlier studies. Examining the modest two percentage point decline in COLA coverage between 1979 and 1984, Mitchell (1985, p. 595) finds that "changes in industry mix account for almost all of the change." Studying a longer time period, 1977 to 1986, Weiner (1986) reaches an apparently similar conclusion:

   On net, 2.5 million workers lost their COLAs. Sixty-nine percent of this decline was attributable to employment shifts while 31 percent was attributable to COLA eliminations. (p. 15)

   But unlike the Davis and Mitchell studies, Weiner focuses on the change in...