Last week, the U.S. Bureau of Economic Analysis announced the latest Personal Consumption Expenditures (PCE) Price Index. The Fed’s preferred barometer for inflation policy hit a forty-year high, with a 6.4% annualized rate since last February that doesn’t fully capture the recent spike in gasoline prices.

The impact of inflation on household budgets is obvious every time we refill our tanks or stock up on groceries. Cost increases and supply chain issues are affecting businesses as well, compounded by a tight labor market. But in terms of Indiana’s fiscal outlook, how might inflation influence state and local revenues and spending capacity on priorities like education and infrastructure?

A revenue windfall?

As a recent S&P Global commentary notes, inflation will affect states differently. Some states will experience “revenue windfalls” as wage inflation floats taxpayers into higher brackets without increasing real buying power. The majority of states with graduated systems index brackets and/or exemptions to inflation to mitigate such stealth tax increases.

Indiana has a flat rate and standard exemption, so earnings growth will be consistently reflected in taxable income – adding to income tax collections, though not at a ‘windfall’ level.

Three months of data under the latest state revenue forecast shows income tax withholdings $41.5 million above estimates, which could be partially attributable to this wage inflation effect (along with falling unemployment).

Sales tax revenue, on the other hand, is $16 million below estimates from December through February. What does the future hold for the state’s largest source of general fund revenue in an inflationary economy?

Sales taxes and school budgets:

We might expect rising prices to boost sales taxes even more directly than other revenue streams. However, Indiana’s tax base excludes many necessities – such as grocery items – that are leading the surge of consumer inflation, leaving less discretionary income to spend on taxable goods. (Since last April, Hoosier spending on grocery items has increased at twice the rate of overall personal spending, according to analysis by Opportunity Insights/Harvard.)

Consumer spending rose 0.2% in March, less than half what economists expected. Sales tax revenue was already expected to flatline in 2023 as Hoosier spending habits shift back to services, resuming a pre-COVID pattern.

Persistent inflation could make this trend even more pronounced, if consumers curtail spending altogether as Indiana begins a seven-year schedule of income tax cuts (HB1002) that further shifts our reliance towards the sales tax.

Any complication in future revenues is a matter of concern for school corporations, which depend on state aid for all ‘education fund’ operating budgets, including teacher pay.

Local schools receive $16 billion in enrollment-based tuition support in the current biennium, with a legislative directive to use at least 45% of their state funding for educator salaries. But inflation is already eroding the impact of K-12 budget increases meant to close the gaps identified by the Governor’s Teacher Pay Commission. Renewed concerns over recruitment, retention and compensation keeping pace with cost of living will likely greet lawmakers in January as they begin negotiating appropriations for FY2024 and 2025.

Despite these issues, Indiana’s healthy budget surplus provides some insulation against inflation, at least for the near term. Local governments are more vulnerable to elevated costs lingering into next year.

Local revenues – back to the future:

Food and beverage, innkeepers and other minor local revenue sources face the same consumer headwinds as the sales tax. But inflation also creates a broader structural challenge in the local tax system (specifically in the timing of taxation, collections and distributions).

At the state level, budgets are crafted using forecasts of general fund revenues, matching collections and expenses over a biennium. But the two primary sources of county and municipal revenue are based on past economic conditions even as inflation raises costs in real time.

Property tax bills are based on assessments from the previous year, and total collections can only grow as fast as the six-year average of statewide non-farm personal income (the Maximum Levy Growth Quotient, or MLGQ).

Local income taxes are collected by the state and redistributed to counties based on past collections, calculated from prior-year tax returns. (For more on the challenges this creates during periods of expansion and recession, see IFPI’s 2021 study of Indiana’s local income tax structure.)

So more than 80% of local revenues are based on real estate activity and earnings one to two years (or more) removed from the current budget.

There are a few factors easing the local tax climate. Federal relief and a faster-than-expected economic recovery kept personal income growing through 2020 and 2021, and home prices have risen rapidly over the same timeframe. This will keep property tax assessments and levies rising, with an MLGQ over 4.5% (still below the current rate of inflation).

After a slight dip this year, local income tax distributions should also rebound for the 2023 budget year.

Finally, the U.S. Treasury recently granted more flexibility on local uses of American Rescue Plan funds, which could offer temporary budget relief.

Cost challenges building:

With revenue uncertainty on one side of the ledger, cost challenges are rising for all levels of government. Again, localities have limited flexibility within already-lean budgets. Adjusted for inflation, Indiana’s average county and municipal spending was growing about 2% annually over the five years leading into the pandemic. PCE inflation is now rising more than three times that rate.

Pressures on payroll expenses extend beyond Indiana’s 60,000+ public school teachers. Recruiting and retaining public sector employees in competition with the private sector is an ongoing issue; add fifty-year low unemployment in tandem with forty-year high inflation, and labor costs are an issue for most Indiana governmental units and agencies.

State and local governments also share the costs of infrastructure, dividing proceeds of the gasoline use tax to support a significant share of road and highway budgets.

Monthly revenue reports haven’t captured the recent high prices at the pump, but it’s unlikely that higher per gallon tax collections at current consumption levels will generate revenues sufficient to keep up with continued inflation, as construction costs have consistently soared beyond the consumer price index.

Nonresidential material prices are rising at an annualized rate of 21%, according to the Associated General Contractors of America (AGC). The Highway Construction Cost Index rose nearly 13% in 2018 and is in the midst of another double-digit spike since late 2020.

Parting thoughts:

Inflation doesn’t represent a budgetary crisis for Indiana, but its continuation will eventually begin to chip away at the state’s strong position and historic reserves emerging from COVID. On the other hand, moves by the Federal Reserve to bring inflation back to the 2-3% range by the end of this year will raise the cost of public debt and pose a different set of risks to revenues if the economy slows.

Either way, early optimism that this inflation could be transitory without Fed action has faded. Scenarios of elevated costs and unsettled revenues extending into 2023 (and beyond) have to be factored into the local budget process this summer, the state’s management of FY2023 finances and fiscal assumptions as policymakers begin planning for the next biennium.

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