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MN2020 - Taking the Spin out of Inflation Estimates
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Taking the Spin out of Inflation Estimates

September 09, 2008 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis

When expressing government revenue and spending in real (i.e., inflation-adjusted) dollars, Minnesota 2020 generally adjusts for inflation using the implicit price deflator of state and local government purchases.

The following 2008 article explains the rationale for using this particular index.

 

Whether it's a family or a Fortune 500 company, we all recognize that inflation drives costs up.  Government is no different. In assessing the impact of inflation upon state and local governments, Minnesota 2020 uses an inflation index known as the implicit price deflator for state and local government purchases (referred to hereafter as the S&L IPD). 

When most people think of inflation, the Consumer Price Index (CPI) usually comes to mind.  That's natural, considering that the CPI measures inflation for market basket of goods purchased by the typical household consumer.  This market basket consists of things like housing, food, health care, transportation costs, et cetera.

However, the "market basket of goods" purchased by state and local governments is driven largely by labor costs and is significantly different from the purchases of the typical household.  That's where the S&L IPD comes in.  The S&L IPD measures inflation for the types of goods purchased by state and local governments just as the CPI measures inflation for the types of goods purchased by the typical household.

It makes no sense to apply an inflation measure designed for ordinary consumer purchases (i.e., CPI) to state and local governments, just as it makes no sense to apply an inflation measure designed for state and local governments (i.e., the S&L IPD) to the typical household.  To apply an inflation index such as the CPI to a set of purchases for which it was not designed will only produce nonsensical and meaningless outcomes.

There is broad agreement across the ideological spectrum on the use of the S&L IPD as the appropriate measure of inflation for state and local government purchases.

For example, in each of last several legislative sessions, Governor Pawlenty has submitted levy limit proposals to the legislature designed to limit county and city budgets.  In each of these proposals, the Governor chose the S&L IPD, not the CPI, as the measure of inflation.

In an interview of Minnesota Public Radio, Pawlenty's then- Senior Policy Advisor, and now Economic Development Commissioner, Dan McElroy stated "I would urge people not to use the consumer price index to judge the cost of government.  There's a more complicated measure of inflation called the implicit price deflator for state and local government services [i.e., the S&L IPD]."  McElroy went on to note, "School districts and local units of government don't buy the same things that households buy.  They don't have quite the same pressure on food costs and on a variety of other things and so they have their own measure of inflation..."

In 2005, the legislature adopted the "supplemental truth-in-taxation" law which enables local governments to include additional explanatory information along with their truth-in-taxation mailing.  This law specifically requires local governments to use the S&L IPD, not the CPI, as the measure of inflation when preparing supplemental "truth-in-taxation" information.  When this measure was considered in the House Tax Committee, every member voted in favor, including then Committee Chair and current Taxpayers' League President Phil Krinkie.

There are few issues upon which the Pawlenty administration, conservative legislators, the Taxpayers' League president, and Minnesota 2020 agree, but there is at least one: the S&L IPD is the appropriate measure of inflation for state and local government purchases.

The use of the S&L IPD as the preferred measure of inflation for state government has been echoed by the Minnesota Council of Economic Advisors, a non-partisan group of economists which provides expertise to state government.  As noted in the November 2006 state budget forecast from the Minnesota Department of Finance:

The Council continues to believe that projecting future expenditures without making any allowance for inflation except where required under current law understates the severity of the financial problems the state will face in future biennia.  Council members also noted that use of the CPI understates the effect of inflation on the cost of providing state government services.  The Council suggested that the price deflator for state and local government services [i.e., the S&L IPD] was the appropriate price index to use.  [emphasis added]

It should also be noted that the House Research Department and the Office of Senate Council, Research and Fiscal Analysis-two non-partisan offices that provide analysis to the two chambers of the legislature-generally use the S&L IPD, not the CPI, when assessing the impact of inflation upon state and local government finances.

Some have incorrectly asserted that the difference between the CPI and the S&L IPD is driven by so-called "government inefficiency."  The difference between the two inflation measures is driven by differences in the type of goods purchased by state and local governments versus the ordinary consumer, not by the level of government efficiency.

Other detractors have argued that (1) the S&L IPD is always higher than the CPI and (2) the S&L IPD is used by progressives as a means of overstating the impact of inflation on government purchases.  The first assertion is conditionally true and the second is false.

Inflation as measured by the S&L IPD is currently higher than inflation as measured by the CPI, but this has not always been the case.  The graph below shows the difference between the annual rate of inflation as measured by the S&L IPD and the CPI since 1977.  The annual inflation rates beyond 2007 are based upon estimates from the most recent state budget forecast.

From 1977 to 1981, inflation as measured by S&L IPD was actually lower than inflation as measured by the CPI.  From 1982 to 1987, the reverse was true.  For most of the next decade (1988 to 1997), inflation based on S&L IPD was again lower than inflation based on the CPI.  Since 1998, inflation based on S&L IPD has been higher than inflation based on the CPI.

During the 1990s, I was a policy analyst for various groups of local governments.  During most of those years, it would have been to the advantage of local governments to use the CPI as the measure of inflation instead of the S&L IPD, since that would have reduced the inflation-adjusted growth in local government expenditures, thereby making local governments appear more frugal to legislators and the public.

However, that is not what I did.  Reasonable policy analysts-including not only myself, but non-partisan legislative staff-used the S&L IPD because that is the best measure of inflation for state and local government purchases.  The assertion that those involved in policy discourse cherry-pick the inflation measure they use in the service of "special interests" is false.

Common sense dictates that inflation adjustments be based upon an inflation index appropriate to the subject at hand.  Throughout recent history, responsible policy analysts of all ideological persuasions have used the S&L IPD as the best measure of inflation for state and local governments.  Minnesota 2020 will continue this practice.

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2 Comments:

  • Tom Lockhart says:

    October 20, 2013 at 4:46 pm

    Your explanation makes sense as far as it goes. However, if governments are purchasing primarily labor, and if government is overpaying for labor via poorly negotiated union contracts, then of course the IPD is going to be higher than the CPI.  This becomes self-justifying, as for example Hopkins School District is using the 10-year IPD of 42.86% to argue in favor of another increase in the operating levy. How do I know I’m not rewarding the schools for bad labor contracts that led to the high IPD?  The CPI-All Urban Consumer rate for the same period was 26.6%.  Although you carefully explain why IPD is the correct measure, such a huge gap is a red flag. Something’s not right.

    • Jeff Van Wychen says:

      October 21, 2013 at 7:26 am

      Tom: The Employment Cost Index (ECI) is a measure of the aggregate growth in wages and benefits paid to employees.  Over the last decade, growth in the public sector ECI has been running about the same as the private sector ECI (and somewhat less than the private sector ECI over the last few years), thereby showing the public sector wages and benefits were not growing faster than in the private sector.  Thus, the more rapid growth in the state and local IPD can’t be attributed to extraordinary growth in private sector wages and benefits.  The explanation is that the costs of state and local governments is more heavily weighted toward wages and benefits which have been growing rapidly (especially health care costs) for reasons that are beyond the control of state and local governments.  The S&L IPD is a better measure of inflation for state and local governments because—unlike the CPI—it is based on the mix of goods and services that state and local governments actually must purchase.