Inflation was perhaps the major problem facing state and local government finances as the 1980s began. Double-digit inflation rates throughout much of the late 1970s had driven up the unit cost of providing government services, and because tax bases had not kept pace, an increase in nominal tax rates and cutbacks in public service levels were alleged to have resulted. This paper gives some structure to the discussion of inflation impact on government budgets by formulating a general economic model that separates automatic from discretionary responses, and identifies the relative price, income, and budget effects of inflation. We also estimate the impact of these three components on the real expenditures of U.S. state and local governments during the past two decades.