Inflation and taxes: Impact varies depending on state tax codes, economies

Inflation has been running at a 40-year high this spring. Some argue inflation is like a tax on consumers or investors. Others argue it’s not.

But you know what absolutely is like a tax? Taxes.

With prices rising on a wide range of consumer goods and services, it stands to reason that revenues flowing to state and local governments would be affected.

Yet the precise impact depends on the state, the specifics of its tax system, and the nature of its economy, according to Scott Peterson, who is Avalara’s vice president of Government Relations.

“It’s very state-specific,” he said. “Each state’s sales taxes are relatively different from each other, and every state’s economy is different from every other state’s.”

The causes of inflation influence tax revenues

Economists suggest our current record inflation is primarily driven by these factors:

  • High demand for goods and services (which companies can’t meet because of the lingering effects of the COVID pandemic) creating scarcities that have driven up prices for manufactured goods, housing, and a range of other items
  • Pandemic-related labor shortages that have led to higher wage and benefit costs for employers
  • Shortages of food and fuel due to the war in Ukraine and the sanctions Western nations have placed upon Russia, which have led to higher global prices for those commodities

Some of the greatest inflationary increases have come in the food and fuel sectors. Price increases there have very different effects on state revenue collections, Peterson said.

When it comes to food, 37 of the 45 U.S. states (plus Washington D.C.) that have sales taxes do not extend those taxes to food. Therefore, soaring food prices — for the most part — don’t have a direct effect on state revenue collections, he said.

There can be an indirect effect, however.

“If I’m spending more for (nontaxable) food, there may be some reduction in my ability to spend money on taxable goods,” Peterson said. “If I’m not able to earn more, or dig into savings, then I’ll have to cut non-grocery spending to have more money for food, and in that case, the state loses tax collections.”

However, when gas prices climb like this, it typically reduces state and local excise tax revenues, he added. That’s because the $5-a-gallon price at the pump creates a real disincentive for people to drive, so many drivers avoid as many trips as they can. Since almost all states levy per-gallon taxes on gasoline, when fewer gallons are sold, those states collect fewer dollars for road and bridge maintenance.

State tax structures respond differently to inflation

The fact that different states have different tax structures makes it hard to make broad generalizations about the impact inflation has on their revenue collection.

States that rely heavily on income taxes may well be seeing increased revenue due to inflation-driven wage growth, Peterson said.

Then again, in states like California (which has a $68-billion budget surplus), revenue growth was driven by last year’s gains in the stock market, which created surges in state revenue thanks to California’s capital gains taxes.

A state’s revenue from corporate taxes can also be hard to predict in times of high inflation, Peterson said.

Most states levy taxes on corporate profits. Inflation may mean companies have higher costs, but if they’re able to pass those costs on to consumers, profits stay about the same, and so do state tax revenues.

However, if a state is home to several major companies that aren’t able to pass on inflationary costs, those states will see declining revenues as profits for those companies fall.

States that have major oil industry installations to tax are likely doing quite well, given high profits for the oil industry, he said.

Not all farm states are the same

Local economic conditions also vary greatly from state to state, Peterson noted, even among states that have economies based on similar industries.

Agriculture is an example. Rising petroleum prices are bad for farmers. They use gasoline and diesel to power their farm equipment; in addition, agricultural chemicals (pesticides and herbicides) are often derived from petroleum, as is a major portion of commercial fertilizers. Therefore, when oil prices rise, it increases costs for farmers.

But right now, the war in Ukraine has disrupted exports from two of the world’s top wheat producers. Together, Russia and Ukraine account for about a quarter of world wheat exports. With that grain out of the market, wheat prices have risen to near historic highs, which is good news for grain growers across the Midwest and West.

However, the combination of high grain prices and high fuel prices is doubly bad for livestock producers, Peterson said, because there are a limited number of major meat processors in the country that are able to use their market power to set prices, leaving individual farmers caught between costs that are rising dramatically and prices that maybe aren’t.

“If that squeeze gets them, they’re out of business,” he said.

State spending lags behind inflation

Inflation does have an impact on how much states have to pay for goods and services, Peterson said, but spending increases tend to lag behind actual inflation events.

That’s because of the nature of state and local government budgeting, he explained. Legislatures and local governments set budgets annually (sometimes biennially) and agencies have to live with those budgets until the next spending cycle.

So if a state highway department finds costs climbing for salt to de-ice roads, the department will have to make cuts elsewhere to make up for the difference, he said.

One place where inflation is likely is highway construction costs, Peterson said. When there’s more money available for highway construction — as there is after Congress passed President Biden’s infrastructure bill — that generates more competition for workers among the companies that build highways, which drives up overall costs.

“It’s a rising employee cost for states, but it’s someone else’s employees,” he said.

Wages for government personnel are typically the biggest expense and — unless the employees have union contracts that say otherwise — raises are often the result of historical trends, he explained. If a state usually approves 2% annual raises for employees, it’s likely to keep approving raises at that rate, no matter what inflation is doing, Peterson said.

Sometimes governments will increase compensation in less costly ways to offset employee losses to inflation. Peterson said in his career as a state revenue officer, he got additional vacation days in some years, or saw one-time bonuses or increased contributions to retirement funds.

To sum up, it’s very hard to generalize inflation’s effect on state tax revenues and spending, Peterson said, given the unique circumstances of each state’s economy and tax structure.

To learn more about differences between the states, you can read Avalara’s state-by-state guides to sales tax rates and economic nexus laws.

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