What a new inflation measure would mean for your wallet

'Chained CPI' explained
'Chained CPI' explained

President Obama put a new offer on the table in the fiscal cliff negotiations, and it includes a wonky change that may raise your taxes and reduce your Social Security benefits ... a little.

The proposal centers around how the U.S. government calculates inflation.

The government currently measures price increases using the Consumer Price Index, which tracks a broad basket of consumer goods. That measure is also used to determine increases in tax brackets and cost-of-living adjustments for retirees receiving Social Security benefits.

But some critics say the government is overstating inflation. In reality, when prices rise, consumers turn to alternatives instead of paying more. So for example, if prices rise significantly on beef, they may buy chicken instead.

Enter "chained CPI," a separate measure that accounts for such substitutions, and therefore paints what some call a more realistic picture of inflation's impact on consumers.

President Obama is proposing the government use chained CPI to calculate things like Social Security cost of living increases and income tax brackets.

The move could shave $236 billion off the federal budget over the next decade, according to estimates from the Committee for a Responsible Federal Budget, but could also have an effect on consumers' wallets.

How will it impact your Social Security benefits?

For Social Security beneficiaries, the effect would barely be felt in a one-year period. In most years, chained CPI differs from the other inflation measure very little -- only by about 0.3 percentage points, according to the Social Security Administration's chief actuary.

This year, for example, that would shave about $4 a month off the cost of living increase for the average Social Security recipient. Currently slated for a $21-dollar-a-month increase, the average Social Security recipient would instead receive a boost of only $17 a month.

"That's the funny thing about this policy. If we enacted it, nobody would notice," Marc Goldwein, senior policy director for the Committee for a Responsible Federal Budget, told CNN Radio's Lisa Desjardins.

But over time, the effect is compounded, and that has advocates for retirees up in arms.

Consider a person who retired at age 65 in 2000. If chained CPI had been used to calculate his annual cost of living adjustments, his monthly Social Security checks would total around $1,880 now, $106 less than under current law.

The longer a person lives, the larger the effect becomes. According to AARP, retirees lucky enough to live to 92 would lose a month's worth of benefits.

"It's a theory that may work when you're talking about buying chicken breasts instead of prime rib," AARP said in a statement. "But it's dubious for health care services, a very large expense for many who depend on Social Security, including older Americans and people with disabilities."

How will it affect your taxes?

Several elements of the tax code are indexed to inflation, including the income thresholds that define the tax brackets, the size of standard deductions and the size of tax-deductible contributions allowed in retirement accounts, such as 401(k) plans.

You're unlikely to notice a change in your taxes next year if chained CPI is used. But over a decade, the effect becomes slightly more pronounced, albeit still gradual.

Consider a typical household earning between $30,000 and $50,000. Ten years from now, a household with that same income would be paying about $125 more in federal taxes, according to calculations by the nonpartisan Tax Policy Center.

"I know that people have very strong emotions about this policy but if you look at it, it's frankly a very modest and gradual change, and it's a more accurate measure of inflation to boot," Goldwein said.

-- CNN's Lisa Desjardins contributed to this report.

Personal Finance


CNNMoney Sponsors