What Is a Cost-of-Living Salary Increase?

Inflation reduces the purchasing power of an employee's salary over time.
Inflation reduces the purchasing power of an employee's salary over time. (Image: Comstock Images/Comstock/Getty Images)

Every household spends money on taxes, food, energy, transportation, housing and consumer goods and services to attain a standard of living. The amount of money a household spends on these items is the cost of living. The cost of living varies from time to time depending on how much a household needs to spend to maintain its standard of living. Inflation is the result of sustained increases in the cost of living.

Impact of Inflation on Salaries

U.S. inflation has risen steadily since 1952, according to Charles R. Nelson in his book "Macroeconomics: An Introduction." As inflation rises, the purchasing power of a dollar falls. If a salary remains static and never increases, it will have less purchasing power over time, leaving the individual unable to maintain her standard of living. Employees and unions prefer contracts of employment to include a clause guaranteeing a cost-of-living pay increase each year.

Consumer Price Index

Since it is not possible to track the variations in cost of living for every household, the U.S. Department of Labor's Bureau of Labor Statistics tracks inflation using the Consumer Price Index. The index is not exactly the same of cost of living as it does not include the impact of taxes and variations in purchasing behavior resulting from inflation. However, many employers and unions use the index as the basis for cost-of-living pay increases.

Annual Salary Reviews

Most employers review salaries annually. They may grant a pay increase following this review, but they are not obliged to do so unless it in a union contract or an individual employee's contract. Employers examine several factors to determine whether, and by how much, they will raise salaries. Employers want their pay levels to be competitive as this helps them to recruit and retain skilled workers. Local labor market conditions and increases granted by other local companies may encourage an employer to raise salaries or risk losing employees. An employer's ability to pay is also a key factor as the business must remain profitable.

Escalator Clauses

As employers have no legal obligation to increase an employer's salary, employees and unions prefer to include an escalator clause in the employment contract. An escalator clause provides for an annual salary increase based on an external measurement, usually CPI. While an escalator clause tied to inflation will protect an employee's current standard of living, a salary increase must exceed inflation if it to increase an employee's spending power.

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