Definition
Indexation is a financial technique used to adjust payments or income through a price index, to maintain its purchasing power against inflation. It involves linking taxes, benefits, or wages to a specific price index. Therefore, it protects the real value of such income from being eroded by inflation.
Key Takeaways
- Indexation is a technique used to adjust income payments by means of a price index to maintain the purchasing power of the public after inflation.
- It’s commonly used in adjusting the value of benefits paid under insurance policies or the amounts invested/distributed in financial instruments, such as mutual funds or bonds, to match changes in a cost-of-living index.
- Indexation can also be a means of tax adjustment so that taxpayers aren’t pushed into higher tax brackets when their income increases due to inflation rather than real gains.
Importance
Indexation is an important financial term as it plays a critical role in adjusting the value of money over time, mainly concerning inflation and its impacts.
It is a financial tactic used to adjust income payments by means of a price index, thereby safeguarding the real value of money in an inflationary period.
This is particularly crucial in long-term financial engagements such as pensions, taxes, or other long-term investments.
Through indexation, the purchasing power of money is conserved, ensuring that recipients are not disadvantaged by rising prices.
Therefore, indexation is essential in maintaining fiscal fairness, monetary stability, and encouraging long-term financial planning and investments.
Explanation
Indexation is a financial technique primarily used to adjust the value of money, such as incomes or savings, with changes in a specific price index, often to keep pace with the rising cost of living due to inflation. It serves to maintain the purchasing power of money over time by aligning it with an inflation index, such as the Consumer Price Index (CPI). Incomes that are indexed, for instance, will increase in tandem with inflation rates, allowing the purchasing power to remain relatively steady despite inflation.
Different countries may use different indexes, sometimes even multiple indexes simultaneously, for varied economic factors. This technique is frequently employed in various financial sectors like tax systems and pensions to safeguard income and wealth from the eroding effects of inflation.
For instance, taxpayers could observe the benefits of indexation as it prevents ‘bracket creep’, a situation where inflation pushes one’s income into a higher tax bracket, leading to an increase in taxes despite no change in real income or purchasing power. Thus, it’s utilized to ensure fairness and stability despite fluctuating economic conditions.
On a macroeconomic level, indexation helps in preserving economic equilibrium in the market. In essence, the key use of indexation is to ensure that individuals and institutions maintain the same standard of living and financial health, irrespective of economic inflations and deflations.
Examples of Indexation
Consumer Price Index (CPI): Indexation is applied frequently in the calculation of the Consumer Price Index. In this context, indexation computes and compares changes in the general price level of a basket of consumer goods and services over time. It is used to measure inflation and to adjust pensions or wages to maintain the purchasing power of the dollar amount over time.
Social Security Benefits: In the US, Social Security benefits are indexed to the CPI-W (Consumer Price Index for Urban Wage Earners and Clerical Workers). This means that the benefits are adjusted annually to account for the inflation that occurred over the previous year. This way, beneficiaries will receive a “cost of living adjustment” (COLA) that helps ensure that the purchasing power of their benefits keeps up with inflation.
Tax Brackets: Many governments, including the U.S., index tax brackets so they rise at the same rate as inflation. This prevents “bracket creep,” a situation where inflation pushes taxpayers into higher tax brackets even if their real income (income adjusted for inflation) has not changed. By keeping up with inflation, the government reduces the likelihood of this unfavorable outcome, making for a fairer tax system.
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FAQs on Indexation
What is Indexation?
Indexation is a technique to adjust income payments by means of a price index, in order to maintain the purchasing power of the public after inflation.
What is the purpose of Indexation?
Indexation serves the purpose of protecting the real value of incomes from the erosive effects of inflation.
How does Indexation work?
Indexation adjusts the value of an asset or an income payment, based on the changes in a price index, typically the consumer price index.
What are the benefits of Indexation?
Indexation helps in reducing the tax liability of investors when the assets are sold. It adjusts the buying price of the asset for inflation which results in lesser capital gains.
What are the limitations of Indexation?
One of the primary limitations of Indexation is that it can be complex to calculate for some investments. Also, the benefits of indexation apply only if the investments are held for a long-term.
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Related Entrepreneurship Terms
- Inflation
- Consumer Price Index (CPI)
- Cost of Living Adjustment (COLA)
- Real Value
- Purchasing Power
Sources for More Information
- Investopedia: A comprehensive online resource for finance and investment education.
- Corporate Finance Institute: Offers financial analyst training and certification programs in addition to providing extensive free resources for finance education.
- Khan Academy: A free online learning platform which provides courses on various topics including finance and economics.
- Bloomberg: A global leader in financial information, with news, analytics and other resources.
