Australian CPI, Concepts, Sources and Methods
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Warning - this online document is now out of date. For the updated online version of this document see: Australian Consumer Price Index: Concepts, Sources and Methods - 2005 . For an acrobat version see Australian Consumer Price Index: Concepts, Sources and Methods (cat. no. 6461.0).
TAXES, LEVIES, CONCESSIONS AND SUBSIDIES 7.3 This section discusses the treatment of a number of government taxation, welfare and related policy measures (and some private sector actions) that affect the prices paid by households for their consumption purchases. The types of measures covered include taxes, levies, fees and charges, subsidies and concessions (referred to as ‘taxes and concessions’ from now on). The impact of government policy decisions on the CPI will depend on which of these measures is included and how each is measured in the CPI. Decisions on what measures are included depends on conceptual as well as practical issues. 7.4 An initial issue for determining if taxes and concessions are within scope of the CPI is the principal purpose of the index. In Chapter 4 it was noted that the domain of a CPI would vary according to the principal purpose and by implication so would the treatment of government taxes etc. It was argued that an index designed to measure changes in living standards should price items at their economic cost so that government subsidies would be excluded. It was also indicated that, in an index measuring price inflation, items with non-market prices (such as those items that are heavily subsidised) would be excluded from the domain. In practice, such items have not been excluded from the Australian CPI, as this would raise issues of public credibility of the index. 7.5 Accepting that the principal purpose of the CPI is to measure price inflation, any government charge or payment which is to be reflected in prices must be tied to the purchase of a specific consumer good or service (or the right to acquire some good or service). This criterion can be further tightened in the case of subsidies, to restrict them to those that are made directly by the government to the supplier of the good or service. If the subsidy or tax is not specific to a good or service then it can be regarded as an income transfer and the transfer may not necessarily be related to any purchase in the current period. Income taxes excluded 7.6 Income taxes are excluded from the CPI as the amount of tax paid bears no relationship to the household’s purchase of, or access to, any good or service (or a basket of goods and services). Similarly the Medicare levy and any income tax rebates or deductions are not included. An exception is the health insurance rebate. Households have the option of allowing the health fund to claim the rebate from the government at the time of paying the premium or paying the full premium and claiming the rebate when they lodge their tax return. Since the rebate is specific to health insurance, it is deducted from fund premiums in the CPI. Under the acquisitions approach, the timing of the receipt of the rebate is irrelevant. It is the timing of the acquisition of the right to a rebate that is relevant. In the case of health insurance, this right is obtained at the time of paying the premium. 7.7 It might be argued that a small number of eligible income tax deductions should be taken into account. (footnote 1) These include deductions for medical expenses when the net payment by households exceeds a dollar amount (set out in tax legislation) in the tax year. However, such deductions are small in terms of total household expenditure and the practical difficulties of estimating the effects of such deductions on the relevant medical prices are large. Therefore, this item and some similar deductions are ignored. Fees and charges included 7.8 On the other hand, various government fees and charges are included in the CPI because they are payments for a good or service or an inescapable cost arising from the purchase of a particular good or service. For example, a driver’s licence is a payment for the right to drive a vehicle on public roads. Similarly, vehicle registration is an inescapable cost of operating a motor vehicle and confers a legal right to use the vehicle on public roads. Local government rates and charges are viewed as an inescapable cost of home ownership. Water and sewerage charges are included as they represent payments for particular goods and services. Subsidies 7.9 Various subsidies are tied to the purchase of specific goods and thus the price measure used in the CPI is the subsidised price. Examples of this are the Pharmaceutical Benefits Scheme, Medicare bulk billing and public housing rents. In these examples the household is only charged the subsidised price. In the case of the PBS and bulk billing, the government pays the subsidy directly to the drug companies or medical professionals. Further information on the pricing of these items is in Chapter 8. 7.10 For some items it is less clear whether the subsidised price or the gross price should be used. Child-care subsidies and private rent subsidies are two such cases. 7.11 In the case of child care, and depending on the family’s circumstances, the subsidy is paid directly to the child-care centre. Since the subsidy is specific to child-care services, it is subtracted from the gross price to derive a net price measure for child care. 7.12 Private rent assistance is available to various welfare recipient households who rent in the private market and whose rent payments exceed prescribed levels. The subsidy is paid to the household as an income supplement and cannot be paid directly to the owner of the rented property. Therefore, it is considered to be an income transfer and not a price subsidy. Concession prices 7.13 For various commodities, concession prices are available to certain population subgroups. (footnote 2) These concessions are reflected in the actual prices paid by those population subgroups and should be taken into account in the CPI. Concessions can be provided by both the private and public sectors. Publicly funded concessions apply, for example, to phone line rentals by welfare recipients and self-funded retirees, public transport for school children and seniors, and local government rates for welfare recipients. Private sector concessions apply, for example, on admissions to movie theatres and other entertainment venues, transport and on a range of goods and services purchased by seniors’ card holders. 7.14 It is not practical or necessary to take all these concessions into account. Rather, the efforts of the CPI are directed at those concessions that are significant in terms of household expenditure and for those items actually priced in the CPI. For example, to the extent that any concession is expressed as a proportion of the ‘normal’ price and the proportion remains fixed over time, then the exclusion of the concession price will have no effect on the CPI outcome (until the proportion changes). 7.15 Some concessions, such as the Winter Energy Concession for eligible Victorian consumers, apply only at particular times of the year. In those cases the price included in the CPI falls during the relevant period and then rises again when the concession no longer applies. Other cases, however, are a fixed discount from an annual purchase. For example, with the now discontinued Victorian Winter Power Bonus consumers were given a discount of up to $60 off their September bill. If the September account was less than $60 then subsequent accounts were debited until the total reached $60. In these cases the concession is spread across the full year in which it applies. Taxes on business 7.16 A range of taxes applies on goods and services at various stages in the production and distribution chain before the point of purchase by households. These include customs and excise duty, wine equalisation tax and GST. Similarly, various taxes and charges are part of the costs of producers, distributors and retailers. These include pay-roll tax, company tax, and local government rates and charges. These taxes and charges all affect the final price paid by households and so affect the prices recorded in the CPI. There may be various lags before any change in these impositions is reflected in retail prices. Weights and prices 7.17 The weights in the CPI should be calculated on a basis that is consistent with the treatment of taxes on the items being priced. Thus if an item is priced at a subsidised price, it is important that the weight assigned to that item reflects expenditures valued at the subsidised price. SEASONAL GOODS 7.18 For many items of household consumption expenditure, purchases by consumers are spread reasonably evenly over the whole year. Their inclusion in a CPI basket is a relatively straightforward exercise, as they retain approximately the same relative share of household consumer expenditure over the year, and are available for obtaining price observations at any time. 7.19 The consumption of some goods and services is subject to seasonal influences. Consumption of these items may be negligible or zero at certain times of the year. Examples include varieties of fresh fruit and vegetables (e.g. peaches in winter months), seasonal clothing (e.g. summer and winter clothing), and ski lift tickets. 7.20 Seasonality in consumption and prices could lead to undesirable levels of volatility in the overall index. When availability of a seasonal item is low, its price may be high (if demand exceeds supply), or alternatively it could be zero (if there is no demand or the item is unavailable). Either situation will result in large price movements in response to seasonal changes. Appropriate weighting and pricing procedures can reduce such volatility. 7.21 In the Australian CPI, the use of a full-year weighting period is seen as substantially addressing the weighting issue. It ensures that expenditure on all seasonal items is included in the weights, maintaining the representativeness of the index. Alternative options are to either exclude seasonal items (thereby reducing representativeness), or to use more complicated methods such as seasonally adjusting prices, or changing weights. These alternatives are, however, likely to lead to bias in the index. 7.22 Determining out-of-season prices for seasonal items is addressed by using ‘imputation’, which is the construction of a price where an actual price observation does not exist. Two forms of imputation are commonly used in the Australian CPI. 7.23 One method of imputation is to hold the price constant at the level recorded when the item was last priced. This approach is most appropriate and used when items are unique (e.g. entry to sporting events such as football) and the movement in prices cannot be expected to be similar to that for other goods or services. This method is also used when prices, such as education fees, are only set annually. While these goods and services may not be seasonal in availability, the price setting procedures result in a seasonal impact on the index. 7.24 The second method of imputation is to use the price movements of similar or substitute items when the seasonal item is not available. This approach is most appropriate where the items are readily substitutable, for example fresh fruit and vegetables, and clothing. This is the normal and preferred method of imputation used within the CPI. Refer to the section on Temporarily missing price observations in Chapter 3. SECOND-HAND GOODS 7.25 Second-hand goods require special treatment in a CPI. While net purchases of second-hand goods by the reference population should be included in the basket just like any other good, any net sales of goods by the reference population should be treated as negative expenditures and deducted from the expenditure weights. This complicates the derivation of weights and prices. 7.26 Various situations arise requiring different approaches:
7.27 In practice it is not easy to identify all these flows. For example a reference population member might not know if the vehicle they purchased from a used car yard was previously owned by a non-reference population member (such as a business or government) or another reference population member. Therefore, simplifying assumptions are often made based on assessments of the likely significance of such flows and the ability to appropriately price such transactions. 7.28 As the 14th series CPI reference population includes all households (in the capital cities), the problem of second-hand goods is somewhat limited. If the reference population were confined to a narrow subset of households, then transfers of goods between the household types may need to be taken into account. The two commodities where transactions in second-hand goods between the reference population and other sectors are most significant are motor vehicles and house purchase. 7.29 In the case of motor vehicles, there is a substantial volume of transactions between households involving second-hand dealers and some purchases by the reference population of former government-owned vehicles. The expenditure weight for motor vehicles includes net purchases by the reference population while the price measure relates to new vehicles only. It is implicitly assumed that second-hand car dealer margins and second-hand car prices (in the case of cars purchased from other sectors) exhibit the same movements as new vehicle prices. For further discussion of motor vehicle pricing refer to the appropriate section of Chapter 8. 7.30 For house purchase, most transactions in established housing will be within the reference population, and hence the transactions will net to zero. However, there is a significant level of transactions between members of the reference population and other sectors. In particular, they include transactions involving the purchase of private rental dwellings and, to a lesser extent, purchase by members of the reference population of properties from the public sector. The approach used by the ABS to estimate net acquisitions of dwellings by the reference population effectively nets out such transfers. However, the Australian CPI does not include any dealer margin on transfers of properties between the reference and non-reference populations. Further discussion is in the appropriate section of Chapter 8. SERVICES 7.31 In principal, the treatment of services in a CPI is identical to that of goods. However, services pose pricing difficulties because often there is no clearly defined quantity for services like there is for goods. 7.32 All goods come in discrete quantities such as units, kilos, or litres. As such they are readily quantifiable and have an associated per unit price. Services on the other hand have no discrete physical quantity. They are usually specified in terms of outcomes and, ideally, price measures should be related to those outcomes. For example, consider the case of house cleaning services. One approach is simply to price such services for a set time period, say 2 hours of cleaning per week. Another, and the preferred, approach is to price a specified set of cleaning activities (e.g. cleaning a bathroom, vacuuming carpets) of specific homes. The latter approach has the advantage in that if there are any technological changes (better cleaning materials or methods) that might reduce the time or cost of cleaning then these would be reflected in a reduction in the price. Were a set amount of cleaning time specified, then any reductions in cleaning time to achieve the same outcome would not be reflected in the price except through an explicit adjustment in the cleaning time (e.g. from 2 hours to 1 hour and 55 minutes). Most services included in the Australian CPI are priced on an outcomes basis. 7.33 A problem with some services is that they are not charged separately. For example, the price of a new tyre for a car typically includes the cost of fitting, while a restaurant meal includes both food and table service. For these items it is not necessary for the good and service to be separated, as both are jointly consumed. However, for some items such as insurance services, it is important that the service component be separately identified and priced in a CPI measuring price inflation. This is discussed further in the section on insurance services later in this Chapter. 7.34 Some services are not priced as a unit for some overall outcome but are priced individually for each sub-service component of the required outcome. Medical services represent a good example of this class of service. Take a surgical operation, for instance. Separate invoices will be received from each provider of an input service as part of an operation (i.e. surgeon’s fee, anaesthetist’s fee, hospital theatre charges and hospital accommodation charges). Pricing such outcomes requires that prices for each sub-service must be collected. QUALITY 7.35 The objective of the CPI is to measure pure price change over time so identical goods and services should be priced from one period to the next. This practice is called pricing to constant quality. In reality, over time new products appear in the market and replace older products with the new products possessing different attributes (or quality). For price index purposes it is necessary to measure these changes in quality and to remove any change in price attributable purely to the change in quality from the inflationary movement in the price. 7.36 The concept of quality used in the Australian CPI is based on the notion of consumer utility. Quality change is measured by reference to the expected value to the consumer of the changes. While it is not always possible to achieve this in practice, it is the principal guideline in making decisions concerning quality change. 7.37 The term ‘quality’ embraces all those characteristics in a good or a service that a household values or from which it derives utility. Thus the problem is to identify those characteristics that households value, to make an estimate of the value of those characteristics and to measure the change in those characteristics embodied in the good or service so that its effect can be removed when calculating price movements. When used in this context, ‘ quality’ encompasses all attributes of a product, including quantity. 7.38 In some cases the adjustment for quality change is relatively simple. A common case, as demonstrated in the following example, is when only the volume or weight of an item changes. (footnote 3) 7.39 Suppose there is a price sample for medium sized tins of tomato soup from three respondents, comprising the most popular selling brand each respondent sells. Now suppose in the current period the size of the can of soup sold by respondent A drops from 440 g to 400 g with no change in the sizes of the cans sold by the other respondents. The price data and index calculations for this elementary aggregate are shown in table 7.1. TABLE 7.1: PRICE ADJUSTMENT FOR CHANGE IN QUANTITY
7.40 If no allowance was made for the smaller can size in the current period, the price of the can from respondent A would show a fall of 2.9 per cent ((1.70-1.75)/1.75x100). What is required for the base and previous periods are the prices that would have been paid in those periods for the identical item that was priced in the current period. These are estimated by multiplying the base and previous period prices by the ratio of the current period quality (can size of 400 g) to the previous period quality (can size of 440 g). The ultimate result is that the geometric mean of the price relatives is 1.178 in the current period once allowance is made for the quality change, and not 1.141. 7.41 Similar adjustment procedures can be adopted for other quality changes, the only issue being how to determine a suitable quality measure. For example, changes in the alcohol content of spirits could be allowed for simply by adjusting the price proportionally for the change in the alcohol content. More problematic would be the handling of changes in the meat content of sausages or the salt content of margarine. 7.42 Of course there are limits to the application of this approach. For example it would be inappropriate to replace a medium sized can of tomato soup (say 500 g) with a large (say 1 kg) or small size (say 100 g) can since price typically falls per unit of weight with significant increases in the container size. Rather, different elementary aggregates should exist for any significantly different container sizes. 7.43 The situation becomes more complicated when there are technical changes to goods and with changes in services. Consider the case of an improvement in the fuel economy of a motor vehicle brought about by, say, some modification to the engine. If there were no other changes in the vehicle (its power, speed capabilities etc.), then an estimate could be made of the fuel cost savings that would accrue over the effective life of the vehicle and the vehicle’s price adjusted accordingly. It is implicitly assumed that the household values the saving of $1 in fuel cost as much as they do $1 of income which is available for spending on any other item. 7.44 In some cases there may be overlapping prices for the item with the quality change and the item it replaces. For example suppose in period t there are price observations on a standard resolution TV that is included in the TV price sample, and a comparable TV with a higher screen resolution. The standard resolution TV ceases to be available in period t +1. Suppose the price observations are as follows:
7.45 A price for the standard TV in the price sample in period t+1 can be imputed by using the price movement of the high resolution TV, that is $440 ($400×550/500). 7.46 This approach to quality adjustment is suitable so long as the price difference between the TVs in period t is representative of the difference in utility households derive from the two TVs. This could be expected in a competitive market and where the ‘ better’ feature has been available for some time. It would not be appropriate if the price of the item, which is phased out in period t+1, is not a ‘normal’ price (e.g. it could be a run-out special). It also may not be appropriate if the feature is new, raising the possibility that households’ perception of the utility derived from the feature may not have ‘settled down’ or the manufacturer is trying to extract a price premium for the new feature. 7.47 If there are no overlapping prices or those prices are not ‘normal’ then quality adjustment becomes more problematical. It might be possible to use the last available price of the replaced item or to use estimates of differences in manufacturing costs. Again, using manufacturing costs will only be appropriate if costs broadly correlate with consumer utility. 7.48 There are other circumstances where use of price differentials as indicators of quality differentials may not be appropriate. Examples include items that are heavily subsidised or regulated, such as public education and pharmaceuticals. 7.49 For more complex quality adjustment needs, statistical techniques such as ‘hedonics’ may be used. The hedonic technique involves the use of a regression equation, the 'hedonic function', in which prices from an array of different varieties of a product are the dependent variables and the characteristics of that product are the independent, or explanatory, variables. The estimated parameters from the regression provide implicit prices for each of the price-determining characteristics of the good. In more simplistic terms, hedonic modelling involves dividing a good or service into its component characteristics and using these characteristics as explanatory variables for the price. (footnote 4) 7.50 While this form of modelling is appealing, it is clear that vast amounts of data and calculations are required for the application of hedonic models. Hence, the development of a hedonic model would necessitate considerable expenditure of time and resources. An additional problem is that hedonic techniques are not readily able to deal with quality changes that are not easily quantifiable, such as the handling characteristics of a car, the quality of medical care, or whether a variety of clothing is in or out of fashion. 7.51 For some types of quality change it is doubtful that any accurate measurement of the change can be calculated. For example, consider changes in passenger vehicles in areas such as road holding, passenger safety, cabin space, and type of wheels. In the case of services, how would the value of improved medical operating procedures (e.g. keyhole surgery) that involve less pain and a speedier recovery be evaluated? Has the quality of education services changed with greater use of computers? In these cases it may be necessary to make subjective adjustments or no quality adjustment at all. 7.52 One important area of quality change is that arising from government regulations. It is ABS practice that, unless such changes clearly affect the level of utility of households, then they are not treated as quality changes. An example of this practice is that any higher price of motor vehicles occasioned by mandatory pollution requirements is regarded as a price increase, not a quality improvement. 7.53 An important issue is whether an item should be regarded as a quality change to an existing item or whether it should be treated as a ‘new’ item. The simplest approach is to assume the item is new and to splice it into an existing price sample. However, a splice implicitly assumes that the difference in quality (footnote 5) is equivalent to the price difference. Clearly, if it is assessed that a price differential is not a reliable indicator of quality or household utility differentials then some other appropriate quality adjustment should be made. INSURANCE SERVICES (NON-LIFE) 7.54 For insurance services in a CPI designed to measure price inflation, the ideal is to measure price changes for the provision of services by the insurer. This has implications for both the weights and price measures used in the Australian CPI. 7.55 What is the value of services provided by (non-life) insurance providers? The treatment of insurance services in an acquisitions CPI is similar to that accorded to insurance in the System of National Accounts 1993 (SNA93) (footnote 6) . Insurance may be described as a process where households can gain financial protection against often expensive but infrequent and non-predictable events. For a scheduled fee (premium or contribution) an insurer will cover part or all of the expense imposed on the household should a nominated event(s) occur to the policyholder. The alternative to buying insurance is to self-insure, the household thus incurring the full expense should the event occur. The risk for the household of not buying insurance is that the event may occur at a time when they are financially unable to endure it. By purchasing insurance, a household can pass these risks on to an insurance company. 7.56 Insurers spread the risks over the entire population of policyholders. An insurer will set (gross) premiums at a level to cover expected claims, its administrative costs and a profit. Consequently, an insurance company is able to accumulate reserves which it will invest to help meet the cost of future claims (the earnings on reserves can be regarded as additional premium contributions by policy holders). In addition, the total cost to policyholders typically includes stamp duty and, at times, other charges such as levies for fire brigade and other emergency services. In effect the value of the service provided by insurers is only the costs and profit arising from their risk pooling activities through the collection of premiums and paying claims. (The claims payments themselves are simply a return of the ‘savings’ of policyholders.) These components should then determine the weight for insurance services in the index, and it should also be the basis of the price measure. A price measure for this activity would be a net premium, defined as a gross premium less the provision for claims. As taxes and levies are an inescapable cost of insurance, these should also be included in the CPI. Ideally such imposts should be shown as separate expenditure items. 7.57 The 14th series CPI attempts to approach the theoretical ideal for the measurement of non-life and non-medical insurance services. However, practical difficulties have meant that gross rather than net premiums have had to be used as the price measure that is applied to the expenditure weight calculated on the basis of net premiums. Taxes and other charges tied to the premium are included in the price and weight for insurance. For weighting purposes, expenditures on items funded by insurance claims are included in the appropriate item expenditure classes. For example, the purchase of a new car funded by an insurance claim is included in the motor vehicles expenditure class. Thus these insurance services are priced on a gross basis, insurance weights are on a net basis, and the weights for goods and services are on a gross basis. Life insurance is excluded from the 14th series CPI as it largely represents a financial investment. Medical insurance has both expenditure and price measured on a gross basis. Refer to paragraph 6.27 for more detail on medical insurance pricing. 7.58 An illustrative example of the calculation of the price index for insurance services is provided below. 7.2 CALCULATING A PRICE INDEX FOR INSURANCE
7.59 Note that from paragraph 7.54, the ideal is to measure price changes for the provision of services by the insurer, the ‘insurance service charge’. In the case of no premium supplements and no actuarial reserves, the insurance charge is obtained simply as gross premiums less claims. 7.60 Suppose that the only change between periods 1 and 2 is a change in the tax rate from 5% of premiums to 15%. Under this scenario it is clear that the insurance service charge has increased from $45 to $55 (an increase of 22.2%) whereas gross premiums have increased by only 9.5 per cent. 7.61 In an inflation index, insurance services would have a weight based on the value of the insurance charge ($45) and show a price change of 22.2 per cent. Note that in a living cost index, insurance would have a weight based on the value of gross premiums ($105) and show a price change of 9.5 per cent. Footnotes 1. The items for which tax deductions are allowable has been reduced over the years. For example, deductions were once available for expenditures on local government rates, water and sewerage. < Back 2. The expansion of the population group from wage and salary earners to all private households with the introduction of the 13th series CPI meant that a wider range of such concessions needs to be included. < Back 3. This approach to quality adjustment in retail prices appears to have been first formalised by Hofsten (1952). < Back 4. For example, Moulton (1995) showed how a hedonic model could be used to explain the cost of shelter. He suggested 33 explanatory variables, 15 of which were related to the actual housing unit, such as age, number of bedrooms, bathrooms and other rooms, and dummy variables for type of heating/air conditioning and kitchen facilities available. Other independent variables covered characteristics of the neighbourhood in which the housing unit was located, and conditions of the rental contract (where applicable). < Back 5. See Hofsten (1952, pp. 49–50). < Back 6. Refer to United Nations (1993). < Back
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