Q. You have recommended the Vanguard Inflation Protected Securities Mutual Fund instead of the Vanguard Total Bond Market Index Fund because of its inflation-indexed securities.   Recent articles by Bill Gross and others show that the CPI inaccurately calculates Americans' real cost of living.   The CPI does not include food and gas prices!   Do you know when food and gas prices were removed from the CPI?   It also used hedonic adjustments, quality improvements that transform into price declines.   How can Inflation Protected Securities Mutual Funds protect you from inflation when the CPI is flawed?

---S.R., by e-mail


A. We live in a world of argument and imperfection. Bill Gross believes the CPI understates inflation, largely due to the use of hedonic measurements--- adjustments for quality, durability, features, etc. Respected analysts like Steven Leuthold, Jim Grant, and others share his view.

A belief is not a fact.

Still others believe that hedonic measurements don't go far enough to adjust for changes in the quality of goods produced.   And others will point out that no one actually spends their money exactly as the Consumer Price Index is constructed--- so it doesn't reflect the actual experience of many people.

The elderly are particularly vocal about this due to their larger spending on health care. (In the construction of the CPI, for instance, health care carries a weight of only 6.2 percent. That's less than half the 14 percent of Gross Domestic Product consumed by health care.)

But let's back up a bit.

The regular CPI does include food and energy prices. It is also calculated as a "core" rate without food and energy because both are volatile. The CPI used for Treasury Inflation Protected Securitys is the full index, including food and energy.

A larger issue with the CPI is the measurement of housing costs. For many years the Bureau of Labor Statistics has been weighting housing at 42.1 percent of the CPI. It has also used a "rental equivalent" calculation instead of a home price index. The result is major smoothing of the impact of rising home prices. The practice is defensible because no one buys a new house every year--- but it could introduce a significant inaccuracy over a period of time.

All arguments about the index aside, an imperfect adjustment for inflation is better than no adjustment for inflation. TIPS adjust for inflation and work to protect your purchasing power better than conventional fixed coupon obligations.


Q. Considering recent comments about eliminating the present tax code and moving to other taxing procedures such as a national sales tax, what effect would a national sales tax have on our short and long-term deficit?

---A.P., by e-mail from Dallas


A. A recent paper by Edward C. Prescott, winner of this year's Nobel Prize in economics, provides an interesting answer to your question. In "Why Do Americans Work So Much More Than Europeans?" he finds that the primary difference over the last 30 years is that Europeans have much higher marginal tax rates (The marginal rate is the tax rate on their highest dollar of income.) than Americans.

Therefore, he says, Europeans are less inclined to work. A reduction in the rate at which labor income is taxed would broadly increase the supply of work in Europe, he believes. In this country the impact of lower tax rates would be significant but smaller because we're starting from a lower rate.

A national sales tax that replaced the employment tax, the corporate income tax, and the personal income tax--- as proposed by Fair Tax, a tax reform group in Houston--- would eliminate the tax on labor income. It would also eliminate the highly regressive employment tax.

And talk about magnificent side effects: replacing our complex tax system with a simple sales tax would eliminate the primary tool Democrats and Republicans use to extort contributions from special interest groups.

The same paper also suggests that a lower tax rate on labor would improve the funding of the Social Security system by improving the ratio of workers to retirees. The paper estimates lower marginal taxes on labor would improve broad lifetime consumption by 9 percent.

On the web:

The BLS Consumer Price Index Home Page

Why Do Americans Work So Much More Than Europeans?