politics Torontoist Explains: Inflation and the City Budget

Everybody mentions it but no one explains it. Here's how inflation affects the city budget.

This article is part of Torontoist’s special 2016 municipal budget coverage. If you’d like to see more coverage like this then join Raccoon Nation now.



“The Toronto Police Service typically answers such calls for restraint with a spending hike well in excess of inflation.” “…[A]s a conservative, Tory [is] showing oldee-timee reluctance to square the circle—to do the things that in the past have been understood as politically unpopular: raise property taxes higher than the rate of inflation…” “Since then, the Ontario government has increased rates for families on OW and individuals on ODSP by 17.2 per cent, and rates for individuals on OW by 24.4 per cent. After accounting for inflation and the increased cost of living, however, these gains are marginal.” “‘In an effort to maintain/improve the value proposition in the face of inflation and currency headwinds, this should be aided by further penetration of $2.50 and $3.00 items and a further shift away from items priced at $1.00…'”

As we head into the 2016 budget process, you’re going to hear a lot about the rate of inflation. What, exactly, is inflation? How do we know the rate of inflation? What does it have to do with property taxes? Will this have an impact on your everyday life? If you’re an alien, a time traveller from a utopian post-scarcity future, or just someone curious about local politics, this explainer’s for you.

What Is Inflation?

A dollar sure doesn’t go as far as it used to. We see it happen all the time: Tim Hortons raises the price of coffee, Dollarama introduces $3 items, a month’s rent goes up $10. Before you know it, you’re paying $2 for what you used to get for $1! Gosh darn kids, get offa my lawn!

You could look at it as the cost of living going up, or as the amount of stuff you can buy with a dollar going down. This is what we mean when we say inflation.

Economists spend a lot of time thinking and writing about inflation, which tells you everything you need to know about their profession. It’s a very complicated and sensitive subject, and there’s a lot of disagreement on the details.

But one popular explanation for the cause of inflation is the quantity view of money. This states that inflation is caused by the growth of the money supply in relation to the demand for that currency. Basically, if demand is constant and you print more money, the price of goods will increase along with it.

Regardless of the details, economists agree that under normal economic conditions, a dollar today is worth more than a dollar tomorrow, and that’s good enough for our purposes.

Inflation can also be a self-sustaining cycle:

Over time, you need more money to buy the same amount of stuff.

You negotiate a cost of living raise so you can buy the same amount of stuff.

Your employer needs more money to buy the same amount of stuff (your time and effort).

Your employer raises prices so they can buy the same amount of stuff.

The people who buy your employer’s stuff now need more money to buy the same amount of stuff.

Lather, rinse, repeat.

Economists, of course, have quantified “the same amount of stuff.” It’s called the Consumer Price Index, or CPI. Inflation is measured by how much the CPI rises or falls over time (it typically rises). The rate of inflation is usually about two per cent.

That’s not an accident; the Bank of Canada adjusts interest rates (the cost of borrowing) to keep the rate of inflation where it is. Setting the interest rate a little lower than the rate of inflation encourages people to go borrow money, because the amount they owe will not increase much over time. That means they have more to spend, which can help stimulate a sluggish economy. However, if the inflation rate rises too quickly, prices and wages become unstable and money loses value so fast that it is no longer useful. (For extreme examples, see Weimar Germany or Zimbabwe.)

The reverse situation—deflation, or the cost of living actually falling over time—is also undesirable. A drop in prices, wages, and (or?) profits produces economic slowdown, rather than growth. Lowering the interest rate, even to zero per cent, will not stimulate the economy like it normally would, because a negative rate of inflation will always be lower. Like the event horizon of a black hole, beyond this point conventional monetary policy breaks down. So it’s in the Bank of Canada’s interest (heh) to maintain a low but steady rate of inflation.

Were the last two paragraphs confusing? Well, they confused me, too. That’s all right, because when it comes to the budget, all you need to remember is that every year, the cost of everything goes up by about one to three per cent (this year it’s on the low end—estimated to be 1.3 per cent).

Inflation and the Budget

Let’s look at John Tory’s letter to the Budget Committee outlining his priorities for the 2016 budget. The first two:

Continue holding property tax increases to the rate of inflation or below.

Find at least 2 per cent in savings across all City agencies and divisions.

Property Taxes

Property taxes are the City’s single largest source of revenue, bringing in billions of dollars a year. (Last year, roughly a third of the City’s revenue came from property taxes.) How do they work?

For our purposes, all you need to know is that when council votes to increase property tax by such-and-such per cent, they really mean property tax revenue. If they vote for a two per cent increase, it means they want next year’s amount of property tax revenue to be two per cent higher than the previous year’s.

But wait, didn’t we just say that the cost of everything is going to go up two per cent? We’d better factor that in. Work the math out for yourself: two per cent minus two per cent equals…

Yes, that’s right. On paper, it looks like the City is collecting and spending more tax money year after year. But if property tax revenue rises at the same rate as inflation, it cancels out. The numbers are higher, but the City is still getting the same amount of stuff. Like the Red Queen in Alice Through the Looking-Glass, we have to keep running in order to stay in the same place.

Does it get more complicated? Why, yes! Typically, politicians and media refer to the property tax revenue increase, but what they’re really referring to is the residential property tax increase. Residential property taxes are just one part of total property tax revenues—there’s commercial and industrial property taxes, too. These increase at one-third of the rate of residential property taxes, which is part of a longstanding policy to make non-residential property taxes more competitive in the city (relative to residential taxes, non-residential has been historically overtaxed, and so now we’re making up the difference).

This means that if you limit residential property tax revenue increases to the rate of inflation, the blended property tax revenue increase—what the City actually collects—will be less than inflation.

Let’s review:

Increasing property tax revenue “at inflation” means that, in real terms, revenue is staying the same.

Increasing property tax revenue “below inflation” means that, in real terms, revenue is decreasing.

In order to actually increase property tax revenue in real terms, it must go up faster than inflation.

We are interested in the blended property tax revenue increase, not just the residential property tax.

Savings

Now, let’s look at Tory’s second priority: a two per cent budget cut for all City divisions.

Take City Planning [PDF] for example. In 2015, their gross expenditures were about $43 million. Let’s say they take a two per cent cut, and inflation is again two per cent.

Next year’s expenditures will be two per cent higher: $43.9 million.

Next year’s budget will be two per cent lower: $42.1 million.

Because of inflation, a two per cent cut is more like four per cent, and there is now a $1.8-million budget gap to fill.

It will be challenging for the City to implement the ambitious Poverty Reduction Strategy—or even Sunday-morning subway service—while decreasing revenue. But when you’re through the looking glass, all kinds of math and logic looks fun!