When U.S. President Obama released his 2014 budget proposal last month, many Americans who paid attention to the details needed a measurement he used – "chained CPI" – explained.
That's because President Obama used chained CPI (consumer price index) to help shave off more than $1 trillion from spending on government programs.
While that sounds like a good thing – it comes at a price.
This budget calculation adjustment could affect your money, since many parts of our tax code, like the size of the standard deduction – that flat dollar amount that reduces taxable income – and the income thresholds for tax brackets are recalculated every year for inflation.
And adding chained CPI to the budget alters those calculations.
What is Chained CPI?
The consumer price index – or CPI for short – is an economic measure used to figure out the rate of inflation and changes in price levels. It takes a virtual "basket" of consumer goods, including groceries, housing, gasoline and clothing, and tracks the average prices of the basket's components over time.
For example, at the end of 2012, the CPI measure made the assumption that the typical household contributed about 41% of its spending toward housing, 15% for food, and 17% went toward transportation. Within these broad categories are smaller sub-divisions with even more breakdowns.
If there is an overall rise in the cost of the basket, we have inflation. And at the heart of the matter is that our government uses CPI to index benefits like Social Security payments and determine income tax brackets.
Chained CPI is an abbreviation for "Chained Consumer Price Index for All Urban Consumers." It's referred to as "chained" because it takes into account a phenomenon in economics known as "substitution bias."
It goes like this: If the prices for certain items rise, rather than pay the higher price, consumers would purchase cheaper substitutions instead.
Here's a perfect example of chained CPI explained:
"If, for example, the price of canned salmon goes up, many consumers will simply switch to the less-expensive canned tuna, rather than buying less salmon or going without. This type of substitution lessens the impact of inflation on consumers. Chained CPI attempts to address this economic reality."
On average, the measure of chained CPI is going to be smaller than regular CPI somewhere in the range of 0.25 to 0.3 percentage points. It seems to be a pretty insignificant difference – but its impact on hot-button issues has the bases of each party drawing lines in the sand.
The Heart of the Chained CPI Debate
The concept of chained CPI is not new and has been proposed before as a means of deficit reduction. And for different reasons, both sides of the aisle aren't particularly fond of it.
The Moment of Truth project found that the federal government could save about $300 billion over the next decade by implementing "chained CPI."
That should be a good thing.
However, it would do this by reducing future Social Security payments and pension payments to federal retirees.
Democrats not happy.
But, neither are Republicans.
On one hand you have the idea that current cost of living adjustments don't accurately reflect rising prices. So now the government wants to create a larger deficit between the two.
On the other hand is a stronger argument – that seniors have a different basket of goods and services with no means for substitution. Larger portions of seniors' expenditures are and will be more heavily weighted to healthcare.
Since chained CPI is a slower rate of inflation, it would also cause a slower rise for the standard deduction. Tax bracket income cutoffs would also slow. This phenomenon would push more taxpayers into higher tax brackets. That would result in new tax revenue that strikes at the heart of the GOP.
President Obama used chained CPI as an olive branch to Republicans: "I'll put entitlement reform on the table if you discuss new revenue."
But if it works, and sticks around, be prepared.
For more on what the Obama budget and things like chained CPI could do to your money, check this out: Obama Budget 2014 Busts Open the Middle-Class Piggy Bank