The Forecast Inflation Debate: There’s More Here Than Meets the Eye

It has come back, like it always does.  Age-old migration patterns predict its return to legislative hearing rooms at the beginning of every session when the economic forecast is not yet available to legislators for decision-making purposes so the inputs underlying the forecast go under the microscope.  The “it” is the debate on whether or not to formally include spending inflation in the state’s economic forecast.  

A MinnPost article asks, "why is the DFL so riled up over inflation?"  One answer to that question was communicated in the House Ways and Means committee's informational hearing on a bill to formally include inflation in the spending side of the state's economic forecast.  Ignoring the existence of inflation, it was argued, is a disservice to responsible state budgeting and makes our fiscal situation look much rosier than it is.  The administration's comments accompanying last week's release of the February forecast emphasized this same point.  Excluding expenditure inflation has been called a misrepresentation of reality.   And that has been one of the kindest descriptions used over the years to describe this practice.   Proponents of the bill ask, how we can possibly have a responsible state budget without acknowledging the reality of inflation?

The answer is: you can’t.  That’s why the reality of inflation (or MMB’s best estimate of it) is there in the forecast in black and white.  The just-released February economic forecast has it on page 7 for all to see: $1.119 billion for FY 22-23.  Just how that number is derived and the logic of what it includes and excludes is certainly fair game for discussion and debate.  But thanks to our economic forecast, legislators should never have to look back with regret on budget actions they take and say, “oh, if only somebody had given us some indication of inflation's potential impact.” 

The debate, of course, is “how” it’s recognized.  We might think our lawmakers would have the sensibility to take the reality of inflation and this helpful estimate into consideration in their tax and spending decisions.   But proponents argue that is not sufficient.  Instead, they insist the state formally bake it into the spending side of the economic forecast, thus indemnifying about two-thirds of what government currently does and how it does it.  And this is where a different type of budgeting reality arises, masked in the pursuit of fiscal responsibility.

It revolves around the claim that the economic forecast is "just" a planning tool, merely a reference document for responsible budget decision making.    That’s true but only when you leave forecast spending inflation out.  When you bake it in, it becomes something much more --  a potent budgeting tool as well.  As a House Fiscal brief from 2002 on planning estimate inflation noted:

“Planning estimate inflation has also been a tool to provide more flexibility for a Governor and Legislature in assembling a new budget. The inflation creates a cushion of several hundred million dollars that is already counted as spending in the budget forecast.”

Today's inflation estimate creates a very luxurious $1.1 billion budget cushion.  If inflation were formally included in the forecast it wouldn't commit the state to $1.1 billion of additional spending in the next biennium, nor would it commit the state to holding all existing government spending harmless from inflationary effects.  What a $1.1 billion cushion would do when the next biennial budget cycle rolls around is give new government spending “cover” in the state budget since some or all of the cost would already be booked.  Politically, anyone suggesting higher spending than the previous biennium but lower spending than forecast would be accused of budget cuts.  And any dollars diverted to new programming rather than covering the higher costs of existing programming may themselves have tails that then boost inflationary projections going forward.  The result is a bias in what should be a neutral budget process.

It's also important to observe that one of the more influential talking points surrounding this debate  -- the supposed imbalance of including inflation's influence on the revenue side but excluding it on the spending side -- has a serious conceptual problem.   At the Ways and Means hearing one testifier argued that if we don’t include expenditure inflation, balance would demand that removing it from the revenue side.  It’s a dubious premise for reasons discussed here, but nevertheless it sets up an interesting thought experiment.  

Since the rationale for reducing revenues would only be to "balance" the lack of inflation in government spending, “balance” would require removing only those additional revenues the state would forego if government spending did not rise with inflation.  For example, since compensation is by far the largest component of government spending, establishing balance in the forecast would mean removing inflationary growth in income tax revenues from government employees only.  One could remove sales tax revenues due to lower spending by government employees using only their non-inflated income, etc.

Such adjustments would be minor.  The last time we checked state and local government employees earned about 9% of total compensation in Minnesota.  Removing a 3% increase in compensation from 9% of the workforce would reduce revenues by about 0.25%  -- barely measurable in forecasted revenues.  Government is an important part of the state economy but a relatively small player when it comes to the inflation-related contributions to state revenues.  In short, this illustrates the “lack of balance” argument conflicts with a definitely “unbalanced” reality.

None of this diminishes the legitimacy and importance of a high-quality inflation estimate in the economic forecast.  In fact, we would argue its profile needs to be elevated in forecast documents.  In some respects, the importance of the topic is done a disservice by limiting it to just a number and a passing footnote.  A fuller description of how the number is derived and more detail on what MMB believes should be included and excluded and why would help lawmakers in their budget deliberations. 

And while this goes far beyond the responsibilities of MMB’s forecast group, what would be really helpful would be an analysis of where the greatest inflationary pressures reside in state government, and an inventory and examination of the state statutes and other limitations that reduce government’s ability and flexibility to respond to inflationary pressures in government inputs: human resource management,  purchasing, outsourcing and any other areas that could be targeted for improvements in government productivity.

We would hope this type of consideration of government inflation would be as welcome.