2018 February Forecast: Small Change from November

The 2018 February Budget and Economic Forecast released by Minnesota Management & Budget (MMB) today projects a $329 million surplus in the current fiscal year (FY) 2018-19 biennium, a slight reversal from the small deficit anticipated in the November 2017 forecast. However, after adjusting for the effects of inflation—which are largely omitted from the official forecast—a substantial deficit is anticipated in the upcoming FY 2020-21 biennium.

The approximately $518 million improvement in the state’s fiscal fortunes relative to November arises from a combination of factors. State expenditures are down by $167 million, primarily due to widely applauded federal reauthorization of the Children’s Health Insurance Program (CHIP). The remainder is due almost exclusively to a $353 million increase in state revenue collections.

For those anticipating a large revenue increase from the recently enacted federal “Tax Cuts and Jobs Act” (TCJA) of 2017, the February forecast results are mildly disappointing. While any positive bump in general fund resources is good news, the revenue increase amounts to 0.8 percent of FY 2018-19 total general fund revenue—not a particularly large forecast-to-forecast swing by historical standards. To give some perspective, MMB calculates a mean absolute error of 3.5 percent in revenue forecasts made 20 months ahead of the end of a biennium. The 0.8 percent improvement is less than one-quarter of this margin. While the February 2018 forecast occurs 16 months—not 20 months—ahead of the end of the biennium, ordinary forecast fluctuations by the end of the biennium could easily eviscerate the FY 2018-19 revenue improvement.

The absence of a long-term escalation in U.S. GDP and consumer spending growth throws another wet blanket on the hopes for stimulus from the TCJA. After an initial bump in anticipated GDP growth in 2018 and 2019 relative to the November 2017 forecast, there is no improvement in 2020 and an anticipated drop in 2021, per IHS Markit, the state’s economic consulting firm. The firm also projects real consumer spending growth to increase in 2018 and 2019 relative to the November forecast, but fall in 2020 and 2021. The February forecast seems to predict no long-term economic boom of the kind TCJA proponents anticipated.

The structural balance is a measure of the long-term health of general fund finances. Officially, the structural surplus in FY 2020-21—determined by subtracting total expenditures from the total revenues raised during the biennium—is $313 million. However, as required by state law, MMB must ignore most of the inevitable impact of inflation on state expenditures, and so produces an unrealistically rosy balance. Fortunately, MMB makes an unofficial forecast of general fund spending that factors in the effects of inflation on all parts of the state budget. That more realistic projection indicates a structural budget deficit of just over $900 million in FY 2020-21.

The non-partisan Minnesota Council of Economic Advisors (CEA) has long been critical of the official practice of ignoring the full effect of inflation on general fund expenditures. A statement from the CEA included in the February forecast is unambiguous:

As it has done every year since 2003, the CEA recommends that budget planning estimates for the next biennium include expected inflation in both spending and revenue projections. The CEA noted that Minnesota’s current practice of excluding projected changes in the prices of goods and services from a majority of the spending estimate is fundamentally misleading. It is inconsistent with both sound business practices and CBO methods and potentially encourages legislators and the public to regard the state’s financial position more optimistically than the facts warrant. The omission of inflation in the spending estimates in the February 2018 Budget and Economic Forecast understates the cost of current services as provided by law in FY 2020-2021 by roughly $1.2 billion, and thus made the amount of projected revenues above the cost of providing services to appear to be larger than it actually is. This distortion will increase if and when inflation accelerates from current historically low levels.

And inflation is expected to increase in response to the increased stimulus provided by the TCJA, which occurs at a time when the economy as already near full employment. As the rate of inflation increases, the impact of willfully ignoring inflation on general fund finances compounds.

Apart from the dubious practice of ignoring inflation, other downside risks loom on the horizon. As the current recovery ages, the possibility of a new recession increases. Uncertain federal policies on global trade could harm Minnesota exports. Economic fallout from the TCJA, including the effects of escalating deficits, loom. For these and other reasons, MMB projects a 20% chance that the February forecast is overly optimistic.

Conservative leaders continue to talk about large tax cuts. In the current situation, more tax cuts would be unwise. Given the small size and uncertain nature of the projected FY 2018-19 surplus, an FY 2020-21 surplus that disappears when we account for inflation, and a plethora of economic uncertainty, a healthy dose of fiscal pragmatism would better serve the state.