Big Tax Cuts Jeopardize Fiscal Solvency

Going into 2017, Minnesota was looking at a large budget surplus for the upcoming biennium. By the time the dust had settled at the end of the 2017 special session, the surplus had been reduced by nearly ninety percent. After including the impact of lower than expected revenue collections and other factors, the surplus projected for FY 2018-19 could become a deficit. In light of these developments, circumspect Minnesotans may be having misgivings about the big tax cuts enacted last May.

The chart below shows the projected fiscal year (FY) 2018-19 general fund balance at three different points in time. Based on the state economic forecast released last February, the budgetary balance was projected to $1.651 billion.‡ As a result of actions taken during the 2017 regular and special legislative sessions, the surplus had shrunk by $1.472 billion to $179 million.

The end-of-session projection illustrated in the second bar does not take into account two major factors likely to impact the state’s general fund balance. First, the projected $179 million end-of-session surplus does not include $129 million in funding for the legislature that was removed from the state budget via the Governor’s line item veto; assuming that Minnesota is going to continue to have a functioning legislature, this funding will have to be restored at some point. Second, based on recent revenue updates from Minnesota Management & Budget (MMB), preliminary FY 2017 revenues were $104 million less than what was projected in February; furthermore, revenue collections during the first two months of FY 2018 were $50 million below projections.

Assuming no improvement or further deterioration relative to February forecast projections and factoring in the eventual need to include funding for the state legislature, the $1.651 billion general fund surplus anticipated early in the year could become a $104 million deficit. The budgetary balance situation will become clearer when updated revenue collection information from MMB is released later this month.

A portion of the reduction in the state’s budgetary balance is the result of spending increases enacted earlier this year. During each year of the current FY 2018-19 biennium, however, real (i.e., inflation-adjusted) per capita state general fund spending is projected to increase at an average rate of just 0.2 percent,* so state spending is doing little more than keeping pace with inflation and population growth. Furthermore, projected real per capita state general fund spending in FY 2018-19 will still be three percent less than it was in FY 2002-03—the biennium during which full funding of K-12 general education was shifted into the state general fund. Adjusted for the state general education takeover and K-12 funding shifts, projected real per capita state general fund spending in FY 2018-19 will be nearly seven percent less than in FY 2002-03.†

A major contributor to the massive deterioration of the state general fund surplus is the large tax cuts enacted during the 2017 special legislative session. While relatively modest to begin with, the most rapidly increasing of these tax breaks and—over time—likely the largest is the freeze of the state business property tax. The biennial loss of revenue from the state business property tax freeze is projected to grow to over $400 million by FY 2026-27. Over the course of next decade, state revenues are projected to decline by approximately $1 billion as a result of the freeze.

Even before the complete freeze, the state business property tax was the only major state tax that was capped at the rate of inflation. In fact, in real per capita dollars, the state business property tax levy declined from one year to the next. Largely as a result of the state business property tax, the share of total Minnesota property taxes paid by businesses has declined significantly since enactment of the tax fifteen years ago, despite the fact that business estimated market value (EMV) has increased as a percent of statewide EMV.

Even prior to the freeze of the state business property tax, Minnesota’s total business effective tax rate, business taxes as a share of total state and local taxes, and business taxes per private sector employee were all below the national average, according to information from the most recent “State and Local Business Taxes” report from Ernst & Young and the Council on State Taxation. In fact, a North Star analysis of data from this report further shows that business property taxes per capita and per private sector employee and as a percent of private sector economic activity are also below the national average.

Another benefit granted to Minnesota businesses in the 2017 tax act was an expansion of the research and development (R&D) credit through an increase in the second tier credit rate, which will reduce general fund revenues by approximately $19 million per biennium. The increase in the R&D credit was enacted despite a 2017 report from the Office of the Legislative Auditor that suggests the credit might not be providing benefits commensurate with the cost to the state in foregone revenue.

The wealthiest Minnesotans will benefit from yet another major expansion of the general estate tax exclusion. This exclusion, which was increased to $2 million in 2014, was further expanded to $3 million in the 2017 tax act. This measure—which will exclusively benefit extremely high-income households that already enjoy the lowest state and local effective tax rate—will reduce state revenue by a projected $35 million in FY 2018-19, $75 million in FY 2020-21, and even more in subsequent biennia.

The 2017 tax act also froze the state’s cigarette tax, effectively guaranteeing that the tax per pack will decline in inflation-adjusted dollars. Over the course of the next decade, the tax is projected to fall from $3.04 to $2.37 in constant 2017 dollars—a 22 percent drop. As the real dollar amount of the cigarette tax declines, so too will the tax’s effect as a deterrent to smoking among price-sensitive groups, including teens and young adults. As a result of the cigarette tax freeze, state general fund revenue is projected to decline by $12 million in FY 2018-19 and $37 million in FY 2020-21; the revenue loss from this tax break will likely continue to escalate rapidly in subsequent biennia.

The “structural balance” is a measure of general fund financial health equal to the gap between the revenue that comes in to the state general fund over the course of a biennium (i.e., “current resources”) and the expenditures made from the general fund. Thanks in large part to the tax cuts enacted during the 2017 special legislative session, the large FY 2018-19 structural surplus that existed prior to the 2017 legislative session has become a structural deficit of approximately one-half billion dollars, even prior to factoring in the need to provide funding for the legislature or the recent decline in general fund revenue collections.

Because the revenue lost through the 2017 tax cuts will increase in future biennia, the financial condition of the state could further deteriorate in future biennia. This topic will be explored in the final part of this series.

 

Addendum, 10/12/2017: The reason that the FY 2018-19 balance as projected in the February 2017 forecast was this large to begin with was due to the fact that under current law, the official forecast projection fully includes the impact of inflation on state revenues, but largely ignores its impact on state expenditures. If—per the recommendation of the non-partisan Minnesota Council of Economic Advisors—inflation was fully factored into both state revenues and expenditures, the projected surplus would have been approximately $1.1 billion less than the official balance, based on MMB estimates.

*Real per capita general fund spending is projected to increase by 0.9 percent from FY 2017 to FY 2018 and decline by 0.5 percent from FY 2018 to FY 2019. The average annual increase over both years of the FY 2018-19 biennium is 0.2 percent. Total general fund spending inflation adjustments here are based on the implicit price deflator for state and local government purchases, which is the appropriate index to use when examining the impact of inflation upon general fund expenditures.

Full state funding for general education did not occur until the second year of the FY 2002-03 biennium (i.e., FY 2003). In order to provide for a more apples to apples comparison of changes in general fund spending over time, it is useful to add to FY 2002-03 general fund spending the amount of additional spending that would have occurred in FY 2002-03 if full state funding of general education had been in place for both years of the biennium instead of just one. In addition, to facilitate comparison of spending levels, an adjustment should be made for the K-12 funding shift that occurred in FY 2002-03, which artificially deflated the FY 2002-03 spending levels. After making both of these adjustments, real per capita general fund spending in FY 2018-19 is projected to be 6.7 percent less than it was in FY 2002-03.