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Right Time for Budget Reality

March 03, 2008 By Jeff Van Wychen, Fellow and Director of Tax Policy & Analysis

Every person, company, school district, county, and city government knows that their costs will change over time. Adjusting state expenditures for inflation provides a more accurate long-term picture of the spending demands the state will confront in future years. For several years, bi-partisan and non-partisan experts have agreed on this point. However, official state expenditure forecasts continue to ignore most of the effects of inflation.

Given the low rate of inflation projected for the next several years, now would be a good time to change this misguided policy and to take a modest yet important step toward fiscal responsibility.

When the rate of inflation is low, the impact of adjusting state expenditures for the effects of inflation shrinks.  For example, from the February 2008 forecast to the November 2008 forecast, the projected rate of inflation for the next biennium fell dramatically.  This resulted in a significant reduction in the projected increase in state expenditures due to inflation, as illustrated below.

From the end of the 2008 legislative session to the November forecast, the projected increase in FY 2010-11 biennium expenditures resulting from inflation fell by 47 percent.  This reduction is due to a rapid fall in the rate of inflation as projected for fiscal years 2010 and 2011.  As illustrated below, the rate of inflation is expected to continue to be low in FY 2012 and 2013 (the current planning horizon in state budget forecasts).

The average annual inflation rate in state and local government purchases from FY 2005 to 2009 was 5.2 percent.  The average annual rate of inflation for the next four years is projected to be just 1.7 percent, one-third of the rate in the preceding five years.  The projected reduction in inflation will mitigate the impact of adjusting state expenditures for inflation.

Projected state spending should be adjusted for inflation (or deflation) not just because the rate of inflation is currently low, but because it is the most realistic way to anticipate future spending levels based on current law.  The non-partisan State Budget Trends Study Commission and the State Council of Economic Advisors have both recommended adjusting state expenditure forecasts for inflation as a matter of good public policy.

However, the current low projected rates of inflation should make it easier for anti-tax activists, who fear increased pressure for a tax increase resulting from an inflation adjustment, to do the right thing.  For this reason, now is an opportune time to implement this forecasting reform.

The state should also consider reforms in how it projects the impact of inflation on state expenditures.  In a recent event sponsored by the Minnesota Budget Project, State Economist Tom Stinson noted that the unofficial adjustment for inflation made by Minnesota Management & Budget (formerly the Finance Department) is somewhat crude in that it applies a broad measure of inflation to the entire state budget, including those areas of the budget which already incorporate an inflation adjustment due to statutory requirements.  In the interest of greater accuracy, changes should be made in how we apply the inflation adjustment to state spending.

Inflation is a fact of the modern economic life.  Official forecasts of state revenues and expenditures must accurately recognize this reality.  The current low rate of inflation makes this overdue reform more politically palatable than in past years. Policymakers must put Minnesota and its inflation calculation back on the right track.

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