Cost of Living Allowance

A cost of living allowance (COLA) is an adjustment in wages to make up for a change in purchasing power, in order to keep an employee at a certain standard of living or lifestyle. A change in purchasing power is determined with a measure of inflation, or rising prices, facing consumers over time or in different geographic areas, such as the U.S. Consumer Price Index (CPI). Employment contracts, pension benefits, and government entitlements, such as Social Security, often contain annual COLAs. Alternatively, COLAs may also be tied to a cost-of-living index that varies by geographic location if an employee temporarily relocates to a higher cost area within a particular country or to another country, including military personnel stationed overseas.

One controversy surrounding the COLA is that it often does not take into account the effect of higher taxes that must be paid if the recipient is pushed into a higher tax bracket. In that case, the COLA is not enough to keep the person “whole” or at the same after-tax salary level. In addition, the COLA is usually retroactive, or based on the inflation rate of the prior year, meaning recipients have difficulty keeping up with a higher cost of living. However, if the COLA is based on a measure of inflation that overestimates price increases facing consumers, then the recipient's purchasing power is increased rather than just maintained. Because the CPI did not take into account consumer substitution into cheaper goods or stores with better bargains, the U.S. Bureau of Labor Statistics created the Chained CPI to better reflect consumer adjustments and thus the cost of living.

COLAs were under scrutiny during the inflationary 1970s as a possible cause of cost-push inflation, a situation where the cost of production suddenly rises but the demand for the product or service remains the same. This additional cost must be passed on to the consumer in the form of price increases. Wage increases, along with increased costs of inputs, such as oil, were considered the primary culprits. However, further research indicates that sustained cost-push inflation can only occur with an increase in the money supply.