Inflation has jumped this year, with the U.S. Consumer Price Index (CPI) reaching 7.0% over the last 12 months as of December 2021, a 40-year high. The question remains what effect this will have on municipal credit quality. While S&P Global Economics forecasts U.S. inflation to recede to lower levels in 2023 as supply-chain issues are resolved (see "Economic Outlook U.S. Q1 2022: Cruising At A Lower Altitude," published Nov. 29, 2021, on RatingsDirect), the potential credit effect of recent inflation, and of inflation generally on municipal credit quality, is worth considering.

S&P Global Ratings has identified several potential municipal credit effects from this increased inflation--some positive and some negative.

Potential Effects

Not Every State Indexes Income Tax Rates

The approach each state takes to levying income taxes will have a significant impact on whether a revenue windfall will come their way. The states best positioned to see an increase in revenues in the short term don't adjust their tax brackets for inflation or index the standard income tax deduction; this allows effective tax rates to float up as inflation occurs, permanently boosting real after-inflation tax collections.

In total, The Tax Foundation reports that 22 states and D.C. have at least one major unindexed provision, and 15 states fail to index their income tax wage brackets (see table 1). Unless their legislatures reset their tax brackets and/or deduction amounts, we expect these states will be net revenue gainers in real terms as a result of inflation.

Five states (Arizona, Arkansas, Louisiana, North Carolina, and Oklahoma) are cutting individual income taxes effective Jan. 1, 2022, according to the Tax Foundation. It is possible we may see more states cut taxes, in part to avoid tax bracket creep.

Table 1

An illustration of bracket creep is evident in states that avoided updating their income tax brackets for an extended period. For example, until 2021, Montana had seven income tax brackets ranging from $3,100 up to a top tax bracket of only $18,700. This was previously a progressive income tax, but by 2020, almost everyone essentially paid the top rate.

Inflation's Effect On Capital Gains Tax Collections

Inflation also creates nominal capital gains when stocks or other assets are sold at higher prices, even if there is no real gain at all after inflation. Inflation can thereby boost state capital gains tax revenue, even when asset prices increase no more than the inflation rate. No state indexes capital gains within their state income tax; as a result, this is a revenue source that "lifts all boats," even for states that index wage income tax rates to inflation. While stock market returns will not necessarily correlate every year with inflation, to the extent corporate earnings increase over time, stock market gains may follow.

We have seen certain states that break out capital gains tax from their total personal income tax collections recently report record levels of capital gains tax as a percentage of revenue. For example, California's recent executive budget proposal for 2023 estimates that fiscal 2022 capital gains tax will represent about 12% of its fiscal 2022 total general fund tax revenue, near the level of the prior year, compared with only 3% at a low point in 2009. Higher-than-budgeted capital gains tax has contributed to general fund revenues that the state now projects to come in about 13% above originally budgeted levels in fiscal 2022. California's legislative analyst's office recently estimated fiscal 2022 revenue will come in more than $10 billion over budget, in part due to above-budgeted capital gains, as well as strong sales taxes and corporate earnings.

Those states that benefit most from capital gains tax have progressive income taxes and unequal income distribution, with large numbers of high-income taxpayers, who tend to receive a disproportionate share of income from capital gains. S&P Global Ratings previously analyzed state dependence on capital gains tax (see "Market Volatility Has Varying Impact On U.S. States’ Capital Gains Tax Exposure," published March 10, 2020) and determined that some states, led by California, were much more dependent on capital gains tax than others. In good times, such as now, these states will produce strong revenue gains, but will also be more at risk of a decline in revenue in the event of a stock market pullback that dries up capital gains tax returns.

Caps On Annual Revenue Increases

California's Proposition 13, enacted in 1978, is perhaps the most well-known limitation on local property tax increases. This state constitutional amendment limits property tax rates to no more than 1% of AV, except in limited circumstances, while at the same time limiting the annual increase in AV of a property to no more than 2% per year, unless there is a sale of the property, or prior reductions in AV.

This was followed by passage of Massachusetts' Proposition 21/2, which limits tax rates to 2.5% of fair value and limits the increase in property tax collections to no more than 2.5% per year, plus any tax from new construction. In each case, reduced local revenue was made up to some extent by increased state aid, particularly for schools. As a result, local taxing jurisdictions experienced reduced revenue and states experienced increased costs, particularly for schools, as an indirect effect.

To the extent inflation exceeds these limitations, inflation-adjusted revenues for local jurisdictions will decrease, while spending pressure for states will increase. In particular, the subsequent passage of California's Proposition 98 guarantees a certain level of school spending that the state will have to backfill as local school district tax revenue declines, with the consequence that local property tax shortfalls become a state risk, at least in terms of school spending.

According to the Lincoln Institute of Land Policy, almost all states, with the exceptions of Hawaii, New Hampshire, Tennessee, and Vermont, have some sort of limit on assessments, tax rates, or levies.

Local Governments: Higher Costs Outweigh Potential Revenue Increases

Unlike states, local governments often depend less on income taxes than on other economically sensitive revenues, such as sales taxes. However, when prices go up due to inflation, sales tax collections rise accordingly, even if consumers are spending less until they adjust to any sticker shock. But even with a 7.0% inflation rate and supply-chain disruptions, we don't expect most issuers will see a change in sales tax revenues over the short term that will meaningfully affect credit quality.

Inflation has not had a direct credit effect on local governments to date, but persistent elevated levels pose challenges. As many local governments start to deploy American Rescue Plan Act funding for projects, higher costs for both personnel and materials translate into less money available to deploy elsewhere. Over time, higher inflation rates could also result in greater reluctance to support capital or operating levies, increasing the possibility of an effect on local government operations.

State And Local Government Multiyear Labor Contracts

One challenge for state and local governments in this inflationary environment is rising personnel costs, particularly considering the current labor shortage (see "Labor Force Exit Has The U.S. Economy In A Bind," published Nov. 22, 2021). It is not uncommon for state and local governments to sign multiyear union contracts, and in periods of steady inflation, these do not impose an undue risk. However, in periods of unpredictable or variable inflation, the risk arises that growth in government revenue might not match negotiated increases in union wage contracts, particularly in periods of high inflation. In such cases, labor contracts may require continued wage growth in excess of inflation for a period, even when inflation recedes to lower levels. Negotiating shorter contracts during periods when inflation may be uncertain, or having provisions for salary reopeners, may provide for greater financial flexibility. Where issuers were limited in negotiations during the current COVID-19-induced labor shortage, this could create pressure for years to come and, in some cases, widen future revenue and expenditure mismatches.

Debt: Inflation-Induced Budget Growth Results In Lower Fixed Debt Cost Percentages

In the short run, inflation may help issuers service their debt, because increased revenues from inflation will shrink debt service as a percentage of budget. Essentially, the fixed debt liability principal will be reduced in inflation-adjusted terms, while debt service carrying charges will be reduced in real terms, especially if existing debt carries a fixed interest rate.

However, in the long run, interest rates will likely rise, possibly to rates above the inflation rate, and debt service carrying charges may increase again. During the inflationary period of the 1980s, many municipal issuers turned to issuing short-term debt to avoid high interest costs, which made them vulnerable to future rate rises when the government made fighting inflation a priority.

Inflation Could Exacerbate Income Inequality

According to S&P Global U.S. chief economist Beth Ann Bovino, a much tighter-than-expected monetary policy could also exacerbate income inequality in 2022. The Fed indicated in 2020 that it would broaden its job market scope beyond targeting just the national unemployment rate, which tracks closely with the white unemployment rate, to include job market conditions for other demographics. The unemployment rate for Black and Hispanic Americans is well above the national rate and the rate for white Americans, suggesting the Fed's mission is not complete. But if high inflation persists, the Fed could be forced to respond--and tighten monetary policy--before other demographics, such as Black and Hispanic Americans, fully experience the benefits of a healthy economic recovery on job prospects. To the extent lower income groups are disproportionately affected by inflation, it could raise state social service spending. State spending on Medicaid alone accounted for 27% of total expenditures in fiscal 2021, according to the National Association of State Budget Officers.

Pensions: Expectations From Inflation-Boosted COLAs

Actuarial measurements are complex, so the effect of inflation on pension liabilities will vary. Issuers that grant COLAs to retirees based on CPI may be exposed to risk if actual inflation differs materially from the actuarial assumption. However, the discount rate--the main generator for pension liability measurement in the valuations--is based on the assumed long-term rate of return, and this depends on a pension fund's inflation assumption. Table 2 provides the median inflation assumption and total assumed return, including the inflation assumption, for public pension plans in the U.S.

Table 2

Short-term increases in the inflation rate can affect state budgets' pension costs, but the size and exposure are expected to be contained and are not an immediate credit risk. The assumed return and discount rates incorporate inflation, and so any increase in the assumption would lead to better funded pensions, though this assumption is based on long-term forecasts and not affected by periodic market swings.

The most significant effect near-term inflation movement has on state pensions typically comes from COLAs and salaries, which could lead to increased pension benefits paid out both this year and in future years, and could have a negative effect on pension plan funding. The National Association of State Retirement Administrators notes that for public pension plans that define an automatic COLA using an inflation index as a fixed cap, such as CPI, inflation is currently below the typical cap. This means any short-term increase to CPI would lead to an increase in benefit payments to current retirees; however, in our view, this is not necessarily enough alone to pressure operating budgets. If high inflation were sustained for a long period, issuers that grant generous COLAs could be at a disadvantage compared with those that limit COLAs or do not offer them. Without COLAs, sustained high inflation above actuarial assumptions (not just temporary fluctuations from long-term assumptions) could potentially reduce the value of future pension payouts and lower pension liabilities in real terms.

The U.S. Bureau of Labor Statistics reports that from 2011 until April 2021, the CPI had been below 3%, with a 1.6% monthly average. However, during that time the median long-term inflation assumption by public funds decreased by only half a percent, to 2.5%, indicating a lagging and slow-moving effect.

OPEB: Will Medical Cost Increases Outstrip State And Local Government Budget Growth?

OPEB obligations largely consist of health care benefits. These are for the most part funded on a pay-as-you-go basis in many states. For a number of years, retiree medical cost inflation has exceeded overall CPI and, presumably, growth in government revenue. As of November 2021, according to the Bureau of Labor Statistics, the medical care component of the U.S. city average of the CPI has increased 31% over the past 10 years, compared with 23% for the overall CPI, although we note that this medical component is for all employees and not just retirees.

To the extent medical care inflation exceeds state revenue growth, budgets may be pressured, but this has already been a long-term trend, and it is not clear whether the difference between medical care inflation and overall CPI will widen if overall inflation increases. In the last 12 months, medical care inflation increased 2.1% while overall CPI increased 7.0%, so medical care inflation growth actually trailed overall inflation, a positive situation where revenues may have increased faster than OPEB costs. To the extent inflationary pressures are the result of supply-chain delivery problems of goods from overseas, as opposed to the delivery of domestic medical services, OPEB costs are not likely to pose a heightened near-term risk to state and local government credit quality.

Transportation And Enterprise Systems

Transportation- and enterprise-secured debt issuers may be less exposed to inflation than general obligation issuers. Many transportation- and enterprise-related issuers have greater flexibility to cope with inflationary effects, due to their ability to pass on higher costs through rate hikes. Some toll roads even have provisions for automatic rate increases tied to an inflationary index (see table 3). However, in cases where rate-setting is limited, either politically or by policy, pressures could arise.

Table 3