An automatic cost-of-living adjustment, or CoLA, is effectively a system of wage indexation designed to address inflation, yet there is no universal application nor a unified model for its implementation.

The majority of European Union countries rely on collective agreements for wage settlements, which usually take inflation into consideration, but not through an automatic or institutionalised process.

A smaller number of nations implement indexation strictly for the minimum wage rather than for all wages. Those few countries that implement universal wage indexation do not follow a monolithic model. Rather, they differ significantly in the income brackets they cover and the modes used to calculate cost-of-living adjustments.

If the primary policy objective is real wage stability and the reduction of income disparities, universal CoLA systems are often counterproductive. To be effective for these purposes, a CoLA system would need to restrict benefits for higher incomes while allocating them fully to lower incomes.

From this perspective, the recent CoLA agreement in Cyprus, brokered between labour unions and employer organisations, represents more of a failure than a success. It applies to less than half of the working population and, where applicable, takes the form of universal full wage indexation with some caveats built in. T

his model fractures the labour market, creating a divide between those who are eligible and those who are not. It exacerbates inequalities between high and low earners within eligible groups, and endangers the economy by potentially entrenching inflationary pressures and creating fiscal bottlenecks. A more productive alternative would be a capped system, a solution that the negotiations failed to acknowledge.

Pros and cons 

The positive aspect of CoLAs is their ability to preserve living standards and combat poverty to a large extent. According to economic theory, the downside is that they can suppress employment by keeping real wages artificially high. Under certain conditions, they can also entail the risk of a ‘wage-price spiral’. This is a vicious cycle in which inflation and CoLAs push wages higher, forcing companies to pass on these increased costs to consumers through higher prices, which in turn fuels further inflation and COLA adjustments. However, wage-price spirals are not an automatic consequence of COLAs, but rather a serious conditional risk. Whether or not this occurs depends heavily on other factors, such as inflation expectations, central bank credibility, the specific type of COLA and the sources of inflation. The risk of a spiral is highest when inflation expectations become ‘unanchored’, central banks lose credibility and inflation is demand-driven rather than supply-driven. During the period of pandemic-related inflation from 2021 to 2022, the main drivers were fiscal policies, such as pandemic-related payments, alongside supply shocks, primarily in the energy sector. To a certain extent, there was a ‘profit-price spiral’ rather than a ‘wage-price spiral’.

Implementation perspectives 

Even with accurate measurement, countries implement CoLAs in very different ways, ranging from comprehensive systems to limited benefits. Countries such as Belgium and Luxembourg utilise mandatory, economy-wide mechanisms where full wage indexation covers all workers. In contrast, France and Slovenia tie automatic CoLAs exclusively to the national minimum wage. Other countries, such as the United States and Canada, do not have automatic, economy-wide wage indexation. Instead, CoLAs are applied annually to social security or retirement benefits.

Malta is an interesting case because its CoLA system is unique within the European Union. It is a universal, fixed-euro adjustment applied annually. Unlike percentage-based systems in most other countries, Malta’s model is highly compressive, meaning it provides a much larger percentage increase for low-income earners than for high-income earners, thereby reducing relative income inequality. This standard, flat-rate COLA is mandatory and paid to all workers, while a separate, state-financed ‘Additional Cost of Living Benefit’ is paid to low- and medium-income households to provide extra support.

The case of Cyprus 

The new CoLA agreement in Cyprus stands in sharp contrast to these targeted models. It provides for the gradual restoration of full indexation for workers and the introduction of new economic safeguards for employers. The transition from the current level of two-thirds of inflation to full indexation will be completed by July 2027. The framework introduces three major economic conditions designed to protect national competitiveness: an inflation cap, whereby the adjustment is calculated on inflation up to 4 per cent; an economic growth link, whereby the CoLA is activated only if there is positive real economic growth; and a crisis clause, whereby the Labour Advisory Body is empowered to modify or suspend the CoLA during economic crises.

Crucially, the CoLA amount will also be officially incorporated into the national minimum wage. This measure is expected to benefit over 55,000 low-wage earners who were previously excluded, although the adjustment will be implemented biennially rather than annually. Yet more than half of the working population will still be excluded from the system.

Worsening income inequalities 

In addition to the coverage issue, the agreed CoLA system will exacerbate income disparities because wage indexation and inequality are directly related. It is therefore necessary to distinguish between ‘relative inequality’, which is a ratio, and ‘absolute inequality’, which is a monetary gap. Full, percentage-based wage indexation is mathematically neutral with regard to relative inequality; it simply preserves the existing income structure in real terms. However, it exacerbates absolute inequality, which is important where there are large differences between high and low earners, as there are here.

A typical measure of income inequality is the ratio of the income of the top 20 per cent of earners to that of the bottom 20 per cent. If the bottom 20 per cent earns an average of €20,000 per year and the top 20 per cent earns €100,000, the relative ratio is five times, which is close to the actual ratio in Cyprus. In this example, the absolute monetary gap is €80,000. If all incomes are adjusted for 5 per cent inflation, the average income of the bottom tier rises to €21,000, while that of the top tier rises to €105,000. While the relative ratio remains at five times, the absolute income gap widens from €80,000 to €84,000. This concept was also discussed in an article published in April 2023: ‘Wages, inflation and automatic cost-of-living adjustments’.  

Reducing inequality 

If the policy goal is to reduce inequality or protect low-income earners, a universal, percentage-based CoLA is not the right approach. Policymakers seeking to combat inequality during inflation should use compressive CoLA mechanisms. The most common alternatives are a flat-rate CoLA , a capped CoLA or a targeted COLA.

A flat-rate CoLA , such as that in Malta, provides all workers with the same monetary compensation, thereby reducing the relative gap. A targeted CoLA only applies to the minimum wage or social benefits, thereby protecting the most vulnerable while leaving other wages to market forces.

A capped CoLA is a hybrid: it applies the inflation-related percentage increase only up to a certain income level, such as the national median or average income. For instance, if the cap were set at €50,000, an employee earning €20,000 would receive the full adjustment, whereas an employee earning €100,000 would only receive the adjustment on the first €50,000.

The choice of mechanism directly reflects policy goals. A capped CoLA is favoured by those focused on social equity and government finances. It reduces relative inequality by ‘compressing’ the wage scale, acting as a targeted social programme that delivers 100 per cent of the benefit to those with the least bargaining power. Furthermore, it ensures fiscal sustainability. However, universal, full-indexation CoLA could inject a significant amount of new money into the economy, which could potentially fuel the very inflation it aims to combat. While a capped system protects low incomes and reduces relative inequality, it does not reduce absolute income inequality; it only moderates it.

In conclusion 

Ultimately, the saga of CoLA negotiations in Cyprus ended in farce. The final agreement restores full wage indexation for public sector workers and unionised employees, with a provision for the minimum wage. This effectively leaves out more than half of the working population, who may need wage protection the most. This half-baked agreement prioritises the already privileged while exacerbating income disparities, all with the signature of the President himself, and fails to address the structural inequalities of the broader economy.

Ioannis Tirkides is an economist and president of the Cyprus Economic Society. Views expressed are personal. The article is republished from the blog of the Cyprus Economic Society.