Do State and Local Governments Need to Worry About Inflation?

Wall Street is abuzz about inflation. Recent Consumer Price Index data showing a 4.2 percent rise from a year ago spooked investors briefly as costs spiked for food, energy, used cars and commodities ranging from microprocessors to lumber. But one or two hot readouts alone do not signal persistent inflation — or at least that is what White House and Federal Reserve officials are preaching. Should state and local leaders brace for something worse?

Let’s be optimistic and assume that Congress eventually passes some kind of physical infrastructure bill paid for with tax increases and user charges. That’s unlikely to stir up inflation by itself. But the remainder of the Biden agenda, which includes “soft” infrastructure and the American Family Plan’s social spending, seems unlikely to secure enough votes for offsetting tax increases to avoid yet more deficit spending. Add to that the certainty that a big blue health-care bill will surface next year, and the recipe for inflationary deficits is bubbling in the federal fiscal kitchen.

Some economists, along with progressive politicians bedazzled by Modern Monetary Theory, argue that inflation won’t result from a multitrillion-dollar surge in deficit spending, and that offsetting taxes can come later if it does. Maybe they are right, but what if they are not? If inflation returns at levels well above the comfortable rate of 2 percent that Federal Reserve officials are targeting as optimal in the long run, how would that impact states and local governments? Admittedly, it’s a speculative question at this point, but governors, city and county executives, and school superintendents need to think ahead for what might happen to avoid policy errors that could result in the coming decade from assuming that we will never see a replay of the messy 1970s inflation and stagflation.

The good news is that most state and local revenues do have inflation elasticity. Income and sales tax receipts will generally increase if inflation returns, so most states are likely to see their revenues keep pace with moderate inflation. The major exception to this rule is if inflation invokes higher interest rates that cause the bond and stock markets to plunge in value as they did in 1973, when energy and food inflation were gaining steam. If that happens, states that thrive on capital gains taxes will suffer a revenue slump. These states’ rainy-day funds need to be rebuilt quickly and not frittered away with runaway spending proposals that resurface whenever the financial markets are frothy.

At the local government level, the fiscal picture is more nuanced. Many states share some of their revenues with their local governments, sometimes by formula, so that component of the local budgets’ revenue base is similarly prone to keep pace with increasing prices. Where it gets trickier is with the property tax. Right now we have a nationwide surge in single-family housing prices, so property assessors are marking up the valuations, which oddly provides an industry-specific inflation windfall to many local governments.

The obvious exception to that rule is states that impose property tax limitations. Where assessed values or property tax increases are capped, as with California’s Prop. 13 and its cousins across the country, the only way those jurisdictions can keep up with inflation is if enough properties are sold at prices so far above their tax-limited valuations that they can compensate for all of the others capped by the general ceiling. Right now, that is the prevailing scenario, but if inflation starts to run hotter than 3 percent annually, the statewide revenue caps will begin to bite. Then public pressure mounts to install new property tax caps where they don’t now exist, especially for retirees.

Fortunately, the budget and finance staffs at larger local governments are well-equipped to model the various revenue scenarios described above, so the contingency planning on the revenue side can be based on fairly reliable estimates. The problem, therefore, is what happens on the expense side. As with many post-industrial companies, state and local governments are largely service organizations. The inflation ghouls in government hang out in their operating budgets, and most particularly in their payrolls. If wages start going up more than 3 percent annually, then a wage-price inflation spiral will set in, and that is problematic for governmental budgets.

Recent labor-market reports show the largest quarterly wage increase in 18 years, the result of worker shortages and pressure on employers to catch up from the pay freezes and layoffs they deployed to survive the COVID-19 recession. If that trend continues, it won’t be too long before public-sector labor unions will begin to demand contractual pay increases to catch up with their private-sector counterparts. The American Rescue Plan gave states and localities enough federal cash to eliminate their ability to claim poverty with their workers and unions, so the leverage is now strongest on labor’s side of the bargaining table. Don’t be surprised to see “CPI-plus” language in new labor agreements.

As long as inflation remains modest and not runaway — somewhere below 3 percent annually — the two sides of most state and local budgets can be balanced without crisis implications. But above that, a second shoe will drop: Pension funds will be crushed by actuarial shortfalls. Suddenly, their current benign assumptions of 2 percent inflation will fall short of actual wage increases, which immediately creates new unfunded liabilities. Meanwhile, unfunded COLA increases for retirees will burn up reserves. If lofty stock market earnings fall short of their expected returns, as they did throughout the stagflationary 1970s, then today’s underfunded public pensions could become a worsening nightmare for public budgets.

So before they agree to any salary increases that exceed their pension system’s actuarial inflation assumptions, public-sector labor negotiators need to secure an estimate of the future costs and pension deficits that could result from what naively appears on the surface to be an affordable settlement. Salary increases may be just the tip of the iceberg.

I’m not here to scaremonger or preach doomsday. None of this is inevitable. But good risk management policies must include an identification of a potential danger that mounting inflation could bring to public-sector fiscal structures that are not prudently designed. State and local leaders who take multiple inflation scenarios into account in their strategic planning will do all their stakeholders a true public service.

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