Cost-of-Living Adjustment (COLA)

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Definition of Cost-of-Living Adjustment (COLA):

Cost-of-living adjustments are common in long-term contracts where one party could be hurt by rising prices. The adjustment is intended to reduce the harmful effects of inflation. The cost-of-living adjustment is frequently referred to as a cost of living allowance. 

Detailed Explanation:

Many elderly people receive a fixed income. Inflation reduces their buying power. Social Security payments were fixed In the United States prior to 1975. Congress, recognizing the hardship caused by inflation tied payments to a COLA. Now recipients can expect their income to increase at the rate of inflation. Many long-term employment contracts have a COLA to protect the beneficiaries against inflation. Businesses may negotiate a COLA with suppliers if they fear inflation could hurt them. Some jobs have a cost-of-living adjustment when an employee is temporarily sent to an area with a higher cost of living. 

A cost-of-living adjustment can also be used to adjust the amount of taxes a family pays. Prior to 1985 taxpayers paid a “hidden tax”. Incomes increased with inflation, but the tax tables were not adjusted. This resulted in a taxpayer moving to a higher tax bracket (paying more in taxes) following an increase in the taxpayer’s nominal income. In other words, it was possible for a taxpayer to pay a higher tax following an increase in income that was less than the inflation rate. Economists refer to this as “bracket creep”. President Reagan’s Economic Recovery Tax Act was passed in 1981 and started indexing the tax tables in 1985 to reduce the impact of inflation on the taxpayer.

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