Cost-of-Living Adjustment (COLA)

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

A cost-of-living adjustment is an increase in income to offset the effects of inflation on the cost of goods and services, ensuring that purchasing power remains stable over time. A COLA is common in long-term contracts and is frequently referred to as a cost-of-living allowance. 

Detailed Explanation:

Many elderly people live on a fixed income, and inflation reduces their purchasing power. Before 1975, Social Security payments in the United States were fixed. Recognizing the financial strain caused by inflation, Congress introduced a Cost of Living Adjustment (COLA), tying Social Security payments to inflation. Now, recipients can expect their income to increase at the same rate as inflation. For instance, if the cost of living rises by 4% due to inflation, a 4% COLA would increase an individual’s income by the same percentage to help maintain their standard of living.

Similarly, many long-term employment contracts include a COLA to protect employees from inflation. Businesses may also negotiate COLAs with suppliers if they fear inflation could impact costs. Some jobs offer a COLA when employees are temporarily relocated to areas with a higher cost of living. 

A cost-of-living adjustment (COLA) can also be applied to the amount of taxes a family pays. Before 1985, taxpayers were subject to a “hidden tax.” While incomes rose with inflation, tax brackets were not adjusted, leading to “bracket creep,” where taxpayers would move into higher tax brackets and pay more in taxes even though their purchasing power had not increased. A taxpayer could pay higher taxes on an income increase that was less than the inflation rate. President Reagan’s Economic Recovery Tax Act of 1981 introduced the indexing of tax brackets to address this issue, which began in 1985. This change helped reduce the impact of inflation on taxpayers by adjusting tax brackets in line with inflation.

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