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Inflation’s Impact on State Spending

February 26, 2013 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis

With the latest state budget forecast due to be released on February 28, now is a good time to remind Minnesotans of a big flaw in the state's current forecast process.  For the last decade, the official forecast has failed to recognize the full impact of inflation on state expenditures, thereby increasing the chance that spending projections will be understated and also increasing the likelihood of future budget deficits. The folly of this approach has been discussed previously within the archives of Minnesota 2020 and elsewhere.

For those who want to restore reality to state forecasts by acknowledging the impact of inflation on state spending, but fear the resulting increase in the projected state budget deficit, there is some good news: the resulting increase in forecasted expenditures after adjusting for inflation might not be quite as large as commonly believed.

First, some background. It is not entirely accurate to say that inflation is completely ignored in the official state expenditure forecast. As a result of the soaring rate of inflation in health care costs, it was determined an expenditure forecast that ignored inflation in this area would be absurd. As a result, inflationary pressures in the health care portion of the state budget—equal to approximately 30 percent of all state general fund spending—are factored into the official state forecasts, statutory prohibitions notwithstanding. In addition, state debt service expenditures should not be adjusted for inflation.

Minnesota Management & Budget (MMB) does present an unofficial inflation-adjusted estimate of the future state spending. While the media and the public most commonly focus on the more prominently featured official spending projections, the inflation-adjusted amounts from MMB are cited by those who want a more reliable measure of future state spending.

However, the unofficial inflation-adjusted expenditure forecast reported by MMB is based on an abbreviated methodology that introduces a degree imprecision into the spending projections due to the following approaches:

  • All state expenditures are adjusted for inflation, including the portion of general fund spending that is already adjusted for inflation (specifically, health care costs) and the portion that should not be adjusted for inflation (specifically, debt service). The practice of adjusting for inflation expenditures that have already been adjusted, combined with adjusting for inflation in a category of spending that should not be adjusted, tends to overstate the impact of inflation on future state expenditures.
  • The inflation index that is applied to expenditure forecasts is the Consumer Price Index (CPI). According to the State Council of Economic Advisors, the Implicit Price Deflator for State and Local Government Purchases (S&L IPD) is a more appropriate inflation adjustment for state general fund spending. Insofar as CPI inflation is projected to be modestly lower than S&L IPD inflation over the last several years, the use of the CPI tends to understate future state expenditures.

The effect of the first approach is to overstate the impact of inflation on future state spending, while the effect of the second is to understate the impact of inflation. Because the effects of these two approaches partially offset each other, this abbreviated approach has been considered to be adequate for an unofficial inflation adjustment.

However, while these two approaches partially offset each other, they don’t fully offset. Under current circumstances, the overstatement of inflation-adjusted spending under the first approach is greater than the understatement resulting from the second, with the net result of modestly overstating the impact of inflation on future state spending.

The following is an illustration of the abbreviated methodology used by MMB to craft the unofficial FY 2014-15 inflation-adjusted expenditure forecast.

The total increase in projected FY 2014-15 spending resulting from the abbreviated inflation adjustment methodology is $890 million.

A more refined approach to estimating state spending forecasts would recognize that approximately 30 percent of the state spending is already adjusted for inflation and would use the S&L IPD, which is a more appropriate measure of inflation for general fund spending. An approximation of this more refined approach is illustrated below. Please note that a more rigorous application of this approach by the experts at MMB would likely yield a somewhat different and more accurate result, but the results below should be “in the ballpark.”

Based on the more refined approach, the total increase in projected FY 2014-15 spending resulting from the inflation adjustment is $767 million—or $123 million less than under the current abbreviated approach. If we look further ahead to FY 2016-17, the abbreviated approach for adjusting for inflation would add $2,362 to projected biennial spending, while the more refined approach would add $2,078 million.

The change in methodology discussed above would affect the projected size of the state budget deficit. By reducing projected state spending relative to the current abbreviated approach used by MMB, the refined inflation adjustment approach would reduce the size of the projected state budget deficit. For example, the projected state budget deficit for FY 2014-15 is $1,963 million using the abbreviated inflation adjustment method, compared to $1,840 million using the more refined approach. Meanwhile, the projected deficit for FY 2016-17 is $2,099 million under the abbreviated method, while the more refined approach would indicate a deficit of $1,815 million.

If state law were changed to recognize the effects of inflation in the official state budget forecast, MMB would likely use an approach closer to the more rigorous approach applied above. Under current conditions, this more rigorous approach would likely result in a lower estimate of inflation-adjusted state spending than the current abbreviated approach.

Ultimately, we deceive no one but ourselves when we choose to willfully ignore the impact of inflation on state expenditures; inflation will still occur, regardless of whether or not we choose to recognize it. However, under current conditions the abbreviated approach used to forecast the unofficial inflation-adjusted spending estimate appears to overstate state expenditures. A more rigorous method of estimating the effects of inflation will likely indicate a somewhat lower level of projected inflation-adjusted state spending and a somewhat smaller future deficit than does the current unofficial approach.

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