Michael Hicks: Figuring out inflation, money illusion and state budgets

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One revelation from this bout of inflation is that many folks, from all walks of life, have no idea what is happening. In turn, they have little idea what to do, or how to think about the future. Nowhere is this more telling than in the way in which taxes and budgets are debated.

Indiana has collected large sums of additional taxes through the past year. This has prompted Gov. Eric Holcomb to claim that is due to Indiana’s rapidly growing economy. That is most certainly not the case. The last 12 months for which we have data show Indiana’s GDP growing at a moribund 2.1%, and has only outperformed the U.S economy in two of the past eight quarters.

This slow growth is both surprising and alarming. The COVID pandemic shifted household and business spending into Indiana’s major industrial sectors. We should be robustly outperforming the other 50 states. We are not. The surplus isn’t due to a fast growing economy. Instead, Indiana’s tax coffers have been filled by inflation. In fact, after adjusting for inflation, the state’s tax collections are weaker than we should expect. A little math helps explain this.

Calculations

Indiana’s tax collections in the last year were about 9% above the level collected last year. That would seem to make sense, because inflation is running at about 9.1%. But, Indiana has a state tax system that is the fourth most ‘elastic’ in the nation. That means that as the tax base rises, either due to inflation or economic growth, the taxes collected grow much faster. Indeed, according to the most recent estimates, a 1% increase in personal income would lead to between 1.8 and 2.4% increase in personal income taxes.

Over the past 12 months of the fiscal year, Indiana’s personal income rose by 14% in a combination of inflation and stimulus payments. That means income tax revenues last year should’ve increased by 25 to 34%. We don’t have state data, but national consumption rose by almost 28% over the past 12 months. In normal times, that would translate into a 20% increase in Indiana sales tax revenues. Given the heavy consumption of taxable items, like RVs and restaurants, that is a low estimate.

The huge budget surplus and growth of tax revenues aren’t from economic growth, but are due to inflation. Economists have a term for the inability to perceive inflation and consider it when making budget decisions. It is called ‘money illusion’ and is taught in Standard 5 of Indiana’s high school economics curriculum. This year will provide the single best textbook example of this in the past half century.

Impact on schools

Inflation is tough on everyone. But it is particularly damaging to employers who cannot themselves raise prices for the goods or services they provide. The most obvious example of these are public schools. Here in Indiana, the 2022-3 state budget raised school funding by 2.1%, but overall inflation last year was 9.1%. Teachers in Indiana are today experiencing a 7% pay cut right now.

This is more than twice the private sector wage pain caused by inflation. Without budget action, expect 2022-23 to be the year of teacher shortages, cramped classrooms and frustrated parents. It need not be this way if the special session of the General Assembly was really focused on long term issues. But, alas, that is not the case.

Even an optimistic forecast will have high inflation continuing through much of the next year. At the same time, the economy will slow, perhaps sliding into a recession. There will be no federal stimulus to inject cash into Indiana’s economy and buoy our tax revenues. Indiana will enter the legislative budget year facing a double digit gap in school funding.

Many folks have thoughts about how to spend the budget surplus. Some of these, such as what I call the billion-dollar Hoosier Stimulus or Gas Tax cuts will simply fuel more inflation, and extend price level increases in Indiana by several months. However, none of these proposals wrestles effectively with the effects of inflation on the most fundamental public services in the state.

Indiana entered the pandemic with a sizable educational deficit, in both funding and achievement. It has worsened substantially since 2019. Poor and weakening educational outcomes are the states Achilles heel, and cause of our ailing economy. That needs to be our focus.

Michael Hicks is the director of the Center for Business and Economic Research and an associate professor of economics in the Miller College of Business at Ball State University. This commentary previously was published on indianacapitalchronicle.com.

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