Indiana’s legislative session addressed some of the most vexing public problems the state faces: hospital monopolies, housing, collapse in college attendance and a slew of social issues. But one aspect of the session is worth considering above all else — the state budget — because of its broad effect on almost everything else.
It has been 40 years since Indiana last passed a budget under periods of high inflation. Only a handful of legislators were out of their 20s during the last bout of serious inflation and many in leadership were still in elementary school. Thus, few legislators had any real personal experience with inflation. Moreover, the long hiatus of inflation meant few economists wrote clearly about the practical issues surrounding budgets and inflation. My writing failed to emphasize the budgetary effects, focusing more on causes and projections.
One result of all this is an ongoing problem with “money illusion” that accompanies inflation. Money illusion is simply the natural difficulty we have in assessing inflation when viewing an increase in wages or prices. We all suffer from it to some degree, hence money illusion clouded much of the budget debate in this session.
Inflation itself is best thought of not as rising prices, but as declining value of a currency. The effects are broadly equal across market wages and prices. For example, over the past three years, inflation and private sector wages have risen together. Some workers are better off, some worse off, but on average changes to prices and wages are roughly equal. Similarly, federal pensions and Social Security are linked to changes in inflation. So, despite the whining and gnashing of teeth, most citizens have seen earnings and price growth at about the same pace.
However, state and local public sector pay hasn’t kept up with inflation. The clearest example is the 2019 Governor’s Blue Ribbon Teacher Pay target of $60,000 average for teachers. Strangely, we still hear that as a policy goal, but that promise is now worth only $51,900. Moreover, with state budgets growing far more slowly than inflation, Indiana teachers’ pay will shrink below its 2018 inflation adjusted levels by the end of this biennium.
Indeed, except for Medicaid and Family and Social Services, all of Indiana’s budget areas are in long-term decline. Adjusting for inflation, per student funding in K-12 is back to 2010 levels. Even if inflation stops today, the coming budget won’t get spending back to 2010 levels. This is true in higher education, roads, public safety, and other public infrastructure. During periods of even low inflation, the legislature chose to increase budgets at a pace slower than inflation.
One consequence of the slow growing budget is the often repeated myth of a structural surplus of state taxes. In fact, Indiana’s tax system is inelastic, so that growth in state and local revenue is lower than growth of the tax base. From 1997 to 2019, the share of GDP we captured in state taxes declined from 4.7% to 4.2%. In terms of the big taxes – sales, income and property – collections are all smaller than the growth of the tax base.
The federal response to COVID pushed huge revenues into state coffers, here and elsewhere. But, the biggest increase in tax revenues was due to inflation. Thus, nearly all the budget surplus is a mirage of money illusion. The windfall taxes the state refunded last year, was a mirage. The surplus we grew over the last year is money illusion – a mirage.
There are benefits to slow growing budgets. They force government to make choices about service quality and quantity. This sets the climate for taxation and public services – both quality and quantity. Hoosier policymakers have purposely chosen to be a low tax state. As a consequence, we also deliver low levels of public services. Many households and businesses prefer low taxes to higher quality and quantity of public services.
Stark differences between states make it easier for businesses and households to assess the mix of taxes and services, then vote with their feet. Over time, states can assess whether their policy has an effect on population and economic growth. It may be worth noting that Indiana’s population and economy have grown more slowly than the nation as a whole in each and every year of the 21st Century. Conceivably, those facts should help inform us about the preferences of businesses and families, and think deeply about the long term effect of money illusion.
Michael Hicks is the George and Frances Ball Distinguished Professor of Economics and the director of the Center for Business and Economic Research at Ball State University.
