(MONEY Magazine) – Does the consumer price index (CPI), the government's most widely used measure of inflation, actually overstate the true cost of living? That might not be the uppermost question in your mind as you pay for your groceries and fill your tank with gas. But it figures to be a prime topic of debate in Washington next year, and here's why: By making a small change in the inflation measure, lawmakers could cut the growth of Social Security expenditures and raise tax revenues--thereby taking a big bite out of the budget deficit--without having to vote for something as politically unpopular as a tax hike or a Social Security cut. But the result would be the same: less money in your pocket.

Let us explain. The federal government uses the consumer price index to calculate annual cost-of-living adjustments (COLAs) for Social Security recipients and to increase (or "index") the income thresholds for federal tax brackets. For example, the average monthly Social Security benefit rose from $720 in 1995 to $738 this year, in line with the 2.6% increase in the CPI from the third quarter of 1994 to the third quarter of 1995 (figures are rounded). Similarly, for 1996 the 28% federal tax rate won't kick in until your income exceeds $40,100 (for married couples filing jointly), up from $39,000 in 1995. Shrinking such annual adjustments would create huge savings for Uncle Sam. According to an estimate by the Congressional Budget Office, pegging federal tax brackets and Social Security COLAs and other federal payments to the CPI minus one percentage point--instead of the full CPI--would reduce the nation's debt by more than $600 billion over the next 10 years.

And Congress, desperately seeking ways to close the budget gap, has already begun to lay the groundwork for such a move. Last year, the Senate Finance Committee appointed a panel of experts to study the CPI. Dubbed the Boskin commission, after its chairman Michael Boskin, a Stanford University professor and the top economist in the Bush Administration, the panel won't issue its findings until December. But it is clear where the experts are heading: An interim report released last year estimates that the CPI overstates the cost-of-living increase by one percentage point annually. The final report may provide lawmakers the theoretical ammunition they need to justify altering the yardstick. "It's very likely Congress will act," says Stephen Moore, director of fiscal policy studies at the Cato Institute, a Washington think tank.

To help you understand how a change in Social Security COLAs and the indexing of tax brackets would affect you, MONEY asked Bruce Schobel, a vice president and actuary at New York Life in New York City, to calculate the impact of "CPI minus one" on two typical couples: one retired, one working. For these illustrations, Schobel used the inflation rates projected in the 1996 annual report of the Social Security trustees--an average of 3.33% through 2002, 4% thereafter--and assumed, as the report did, that wages would go up by one percentage point more than the inflation rate each year.

Here's what he found. Bob L'Heureux, 75, and his wife Claire, 68 (pictured at right), of Harvard, Mass., now receive combined Social Security benefits of $18,720 a year. Under present law, COLAs would boost their annual take to $21,216 in the year 2000. If COLAs were pegged to CPI minus one percentage point, however, their benefit in 2000 would be just $20,412, for a cumulative loss over the five-year period of $1,978. By 2005 their benefit would be $23,448, vs. $25,584 under the current system, and their total loss by year-end would be $9,858. By 2010, the couple would be out a steep $25,786, with an annual benefit of $27,168, compared with $31,128 under current law. "We could endure the cuts now," says Claire. "But unfortunately, the biggest expenses of our retirement--medical costs and long-term care--may still be ahead of us. So as we age, the cuts could really hurt."

Couples with higher benefits would stand to lose more. A 65-year-old couple going on Social Security this year and earning the current maximum of $30,000 annually, for example, would receive $34,008 in the year 2000 under present law, vs. $32,712 if COLAs were pegged to CPI minus one--a cumulative loss of $3,163. Ten years later, their income from Social Security would be $43,584, vs. $49,896 under today's formula. The high-earning couple's total loss, however, would be a whopping $41,296.

Taxpayers would also be hurt by a shift to CPI minus one, though not nearly as much as Social Security recipients. Silver Spring, Md. residents Kelli Potter, 28, a schoolteacher, and her husband Jeff, 29 (pictured on page 94), who owns a landscaping company, expect to have a taxable income of $41,780 this year, about the same as last year. Assuming that their taxable income grows by one percentage point more than inflation thereafter, the Potters would pay an extra $94 in taxes next year under a CPI minus one scenario; over five years their added burden would total $1,220. (Schobel believes it's unreasonable to estimate the tax impact over periods longer than five years because of the likelihood that tax laws will change.) "If the extra taxes were used to reduce the deficit, it would be okay," says Jeff. "But I'd be upset if the change went through and there wasn't real progress on the deficit."

To estimate the effect on high earners, Schobel computed the tax bill of a hypothetical couple with $100,000 of taxable income. Through the year 2001, the couple would pay an extra $1,733 in taxes--$513 more than the Potters.

The economic effects of CPI minus one would go far beyond Social Security checks and tax bills, of course. Presumably, reducing federal spending and increasing tax revenues would lower the budget deficit, leading in turn to lower interest rates and, eventually, a stronger economy. Mark Lasky, a senior economist at DRI/McGraw Hill in Lexington, Mass., figures that switching to CPI minus one starting in 1997 would knock half a percentage point off long-term interest rates by 2005.

But not all Americans would share equally in the benefits of such a decline. Lower interest rates would help borrowers, such as home buyers. For example, if a middle-income family like the Potters bought a house in 2005, a half-point reduction in their interest rate would save some $12,000 over the life of a 30-year fixed-rate $100,000 mortgage. But lower rates would further pinch seniors like the L'Heureuxs if they keep a lot of their money in fixed-income investments, such as CDs or money-market funds. An exception: Seniors who keep their portfolio in bonds would get a kick, since bond prices would rise as interest rates fall. Overall, however, "retirees would simply have less money than they otherwise would have, so they'd be worse off," says Lasky.

And while lower budget deficits would help spur economic growth in the long run, at first they could have the opposite effect. That's because with higher taxes and smaller Social Security checks, people would have less money in their pockets, and consumer spending accounts for roughly two-thirds of the nation's economic activity. Running the figures through his computer, Lasky estimates that the economy would produce 370,000 fewer jobs under CPI minus one by 2005. Eventually, lower interest rates would stimulate economic growth, but Lasky figures it would take 20 years for job creation under CPI minus one to catch up to what it would be under the current system.

Now let's get back to the original question. Does the CPI overstate the cost of living? Many esteemed economists contend that it does. The CPI, compiled by the Department of Labor's Bureau of Labor Statistics, measures the average price change over time of a fixed market basket containing more than 200 goods and services in seven broad groups--everything from bananas and haircuts to VCRs and college tuition. One key criticism is that since the market basket is fixed, the CPI fails to capture the savings that occur when penny-wise consumers substitute cheaper goods for items that have gone up in price; nor does it fully reflect the lower prices shoppers enjoy on everyday items at discounters such as Wal-Mart. Also, many critics say the CPI doesn't adequately account for improvements in the quality of goods we buy.

On the other hand, when it comes to measuring the cost of living for America's seniors, the CPI may understate inflation. That's mainly because older people are big consumers of health care, and medical costs have been rising faster than other prices. For example, the Bureau of Labor Statistics has devised an experimental price index (known as CPI-E) to track inflation for people age 62 and older. In the 13-year period from December 1982 through December 1995, the CPI-E rose 62.4%, vs. 57.3% for the CPI. The retirees' higher medical expenses accounted for most of the difference (BLS researchers stress that the experimental index does not conclusively prove that seniors face higher living costs).

In the end, a decision to shrink the inflation yardstick will hinge on political considerations more than anything else. Boskin commission member Zvi Griliches, a Harvard economist, says many lawmakers want to use a CPI change as "a fig leaf" to cover efforts to slow the growth of entitlements and raise taxes. So now you know that when Congress starts debating the seemingly abstract question of whether the CPI accurately measures the cost of living, a lot more than economic theory is at stake.