The "Real" Story Behind State and Local Government Inflation

When measuring changes over time in income, wages, revenue, spending, or just about anything else that is measured in dollars, amounts are commonly adjusted for the decline in the purchasing power of the dollar due to inflation. Without inflation adjustments, we have no idea of the real purchasing power of the dollars being earned, collected, or spent. For example, in nominal dollars (i.e., dollars not adjusted for inflation), U.S. median household has income has increased by 28 percent so far this century; however, in real dollars (i.e., adjusted for inflation), it has declined by seven percent. In other words, the real purchasing power of the median household income has fallen by seven percent since 2000.

The precise index used to make inflation adjustments depends on what is being adjusted. Inflation adjustments to household incomes are based on an index that measures inflation in the types of goods and services typically purchased by households, known as the Consumer Price Index (CPI). Because state and local governments purchase items that are quite different from those purchased by ordinary consumers, a different inflation index—the Implicit Price Deflator for State & Local Government Purchases (S&L IPD)—is used to adjust for the impact of inflation on total state and local government revenues and expenditures.

Over the course of most—though not all—of recent history, the price of the goods and services typically purchased by state and local governments has increased more rapidly than the price of the goods and services typically purchased by ordinary consumers. Consequently, inflation as measured by the S&L IPD has been running higher than inflation as measured by the CPI. For example, the rate of inflation from 2006 to 2015 as measured by the S&L IPD has been 26.8 percent, compared to just 19.0 percent based on the CPI—a difference of 7.8 percent.

Some advocacy groups have challenged the propriety of using the S&L IPD as an inflation adjustment for state and local government purchases. The challenge is based on the allegation that inflation as measured by the S&L IPD is high largely because state and local governments have chosen to provide liberal increases in employee compensation; growth in pension and other post-employment benefit costs are pointed to as an especially significant culprit. As the argument goes, growth in the S&L IPD is not driven so much by growth in the items that state and local governments must purchase, but by the generous compensation packages that state and local officials choose to provide to employees; proponents of this view contend that the use of the S&L IPD overstates the impact of inflation on state and local finances by conflating inflation with the impact of discretionary acts of policymakers.

One might argue that growth in employee compensation—be it in the public or private sector—should be regarded as a positive development, given the wage stagnation and erosion in middle-class purchasing power that has plagued the economy for decades. Setting this issue aside, how valid is the critique that the more rapid growth in inflation as measured by the S&L IPD relative to the CPI is driven largely by discretionary state and local decisions to increase public employee compensation?

It is true that over the span from 2006 to 2015, state and local government employee compensation has grown 2.5 percent more rapidly than private sector compensation. This conclusion is based on Employment Cost Index (ECI) data compiled by the Bureau of Labor Statistics, which measures growth in the cost of employee compensation, including benefits, per hour worked. (ECI analysis in this article is based on data beginning in 2006 because, according to the Bureau of Labor Statistics, ECI estimates prior to 2006 “are not official” and “are presented only to aid users in interpreting the industry and occupational classification systems that were introduced in March 2006.”)

However, this 2.5 percent disparity is nowhere near large enough to explain the 7.8 percent disparity between the rate of inflation as measured by the S&L IPD versus the CPI, especially considering that approximately 40 percent of the value of the S&L IPD is driven by factors other than employee compensation.

Furthermore, the 2.5 percent disparity between the state and local versus private sector ECI growth over the last nine years should not be attributed entirely to more generous compensation packages provided by state and local governments relative to the private sector. Private sector employment is more heavily weighted toward service occupations, which have tended to have a lower rate of compensation growth than other occupations based on the ECI. If we look at similar classes of occupations, much the disparity between private sector versus state and local ECI growth disappears. For example, the ECI growth over the last nine years among state and local government “management, professional and related occupations” is nearly the same as in the private sector.

A further indication that state and local employee compensation growth is not a principal cause of the more rapid growth in the S&L IPD relative to the CPI is that the S&L IPD continues to grow more rapidly than the CPI even during periods when state and local employee compensation grows less rapidly than private sector compensation. For example, from 2009 to 2015 the rate of inflation as measured by the S&L IPD was 2.4 percent greater than inflation as measured by the CPI, despite the fact that the state and local ECI grew 1.6 percent less rapidly than the private sector ECI. It becomes difficult to argue that state and local government employee compensation costs are driving the more rapid rate of growth in the S&L IPD when the S&L IPD continues to grow more rapidly than the CPI even when state and local compensation costs are growing less rapidly than those of the private sector.

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So if growth in state and local government employee compensation is not the driving force behind the more rapid rate of growth in the S&L IPD, what is? The most likely single culprit is soaring healthcare costs. Healthcare costs impact state and local governments through employee healthcare benefits and through medical assistance programs; in fact, it is widely acknowledged that healthcare costs impact state and local government budgets more than they do the budgets of typical consumers.

As a result, escalating healthcare costs have greater impact on the S&L IPD than on the CPI. A statistical analysis based on data from the last fifteen years shows that the annual differential between the S&L IPD and the CPI is highly correlated with the annual rate of inflation in the cost of medical care. (The relationship is statistically significant at the 0.05 level.) In other words, the greater the rate of inflation in healthcare, the larger the disparity between the S&L IPD and the CPI.

In short, the contention that inflation as measured by the S&L IPD is driven upward relative to the CPI largely by the decision of state and local policymakers to provide generous compensation packages to public employees does not hold water. The S&L IPD continues to be the preferred index to use when adjusting total state and local government expenditures for the effects of inflation. The non-partisan Minnesota Council of Economic of Advisors, the premier source of fiscal expertise in the state, concurs, as noted in the November 2006 State Economic Forecast:

The Council continues to believe that projecting future expenditures without making any allowance for inflation except where required under current law understates the severity of the financial problems the state will face in future biennia.  Council members also noted that use of the CPI understates the effect of inflation on the cost of providing state government services.  The Council suggested that the price deflator for state and local government services [i.e., the S&L IPD] was the appropriate price index to use. [emphasis added]

In adjusting total state and local government revenues and expenditures for the effects of inflation, the North Star Policy Institute will follow the recommendation of the State Council of Economic of Advisors and the practice of respected non-partisan research bodies, such as the Minnesota House Research Department and the Office of Senate Counsel and Research, in using the Implicit Price Deflator for State & Local Government Purchases.