Developing a municipal price index.

• Author: Walters, Patrick

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Governments are under considerable pressure to relate their spending and taxation levels to cost inflation, yet each local government's experience with inflation can differ greatly from a national average. The City of Calgary, Alberta, has responded by developing a municipal price index (MPI) to improve the accuracy by which its local government costs can be projected. Calgary's work has emphasized the need for governments to revisit their selected inflation measures for accuracy and to communicate broadly about how inflation measures correspond to local government needs.

The most widely applied measure of inflation is the Consumer Price Index (CPI). Given its pervasive use in setting cost-of-living adjustments, it can be the appropriate metric when calculating the rate of consumer inflation at the national level. Major components within the CPI include housing, food, and transportation. It is often used in inflation calculations such as Social Security payments, labor agreements, service contracts, and retirement benefits. The CPI is a useful proxy for cost inflation in general because it is well-known statistic, it is produced monthly by an independent source, and it is available free of charge.

Extending the use of the CPI into discussions about the appropriate level of tax and fee rate increases becomes problematic, however, because a government's actual experience with inflation can differ greatly from the CPI. This is because the largest expenditures for governments are typically labor, materials, and contractual services--different factors than those found in the CPI.

Local governments would benefit from having a well-constructed index reflecting the changing costs of providing municipal services, but few cities have attempted to build and effectively use such a measure. The City of Calgary is now doing so. This article reviews some of the options available for constructing indexes of municipal costs, and then focuses on the Calgary experience, with some practical tips for creating an MPI and for dealing with some of the criticisms inherent in developing a cost index from scratch.

MEASURES OF COST INFLATION

Governments budget for expenditures on a variety of goods and services, and as the average price of that basket of purchases changes, so too does the purchasing power of local governments. Price indexes are the most commonly used tool for measuring changes in price levels, and thus purchasing power. A price index measures the change in the costs of purchasing a fixed basket of goods and services in the current period, compared to a base period, typically month-over-month or year-over-year.

The key issue in calculating price changes has always been defining the contents of the basket of purchases. The nature of the price index is determined by the composition of the specific basket--how spending is distributed among the components of the basket. Some of the more common price indexes are:

* The Consumer Price Index (CPI), which measures the price changes for common household purchases. It focuses on expenditures for food, shelter, clothing and footwear, household operations, and furnishings.

* The Producer's Price Index (PPI),which measures the price changes of commodities at different stages of processing;

* The Gross Domestic Product (GDP) deflator, mostly used in national accounts. It is designed to reflect current expenditure patterns in an economy and therefore focuses on new domestically produced final goods and services.

Other price indexes measure changes in specific sectors of the economy. The Construction Price Index, used by the U.S. Department of Commerce, reflects the changes in the cost of construction materials and skilled and unskilled labor. It is a composite derived from separate indexes for construction of commercial facilities, residential housing, utilities, highways and general construction, as well as other construction contract indexes. Statistics Canada, a federal government agency, compiles the Canada CPI and has developed a similar index for non-residential building construction. Statistics Canada has also...