The ink was hardly dry on the November 2016 forecast when conservatives started calling for big tax cuts. After all, there is a $1.4 billion surplus projected for the upcoming FY 2018-19 biennium—what better time to go on a tax cutting spree! However, a closer examination of the November forecast indicates that caution is in order before significantly reducing state revenue.

The November forecast for FY 2018-19 is a prediction of how much revenue will flow into the state’s general fund and how much spending will be paid for from it over a two year period that will not begin for over six months and will not end for over two and one-half years. This prediction is contingent upon a number of interacting forces, none of which can be known with certainty and any of which can cause the forecast to deviate from actual outcomes if forecasted inaccurately. The November forecast document enumerates some of the sources of uncertainty:

First, annual real GDP growth of 2.0-2.2 percent as is expected in this forecast is well below the 3.1 percent average annual growth that we saw during the 20 years prior to the Great Recession. Slow growth makes the economy more vulnerable to shocks, reducing its capacity to weather an unexpected event. Second, the current economic recovery and expansion period is now well into its eighth year, and will soon be the third longest since the 1850s. If growth continues into the middle of 2019, this will be the longest U.S. expansion, surpassing that of the 1990s. While simple old age is not thought to end an expansion, some would argue that the closer the cycle gets to record-setting length, the lower the probability of continuing to avoid a downturn. Finally, the IHS [Minnesota’s macroeconomic consultant] November economic outlook depends on several key forecast assumptions. If these assumptions do not materialize, the economic outcome will differ from IHS’s baseline forecast.

In addition, the IHS baseline forecast—which provides the underlying economic assumptions that are the basis of Minnesota’s November forecast—was released prior to the presidential election. The impact of potential new federal fiscal, trade, and immigration policies upon the economy and state finances were not anticipated in the November forecast and could have unforeseen consequences upon the size of the state budget surplus in future biennia—adding an entirely new dimension of uncertainty to the current forecast above and beyond the usual forecast uncertainties.

In short, the forecasted state budget surplus is a projection, not a promise. There is no guarantee that the projected surplus will materialize to the extent currently anticipated. Furthermore, most of the risk of uncertainty in the November forecast is on the downside, according to IHS. Huge tax cuts predicated upon an exceptionally uncertain forecast would risk a return to the era of large recurring budget deficits from which Minnesota only recently escaped.

Even if forecasts of the size of the FY 2018-19 budget surplus turn out to be accurate, tax cut proponents must be mindful of the fact that much of the surplus revenue is one-time and cannot be counted on to recur in future biennia. For example, approximately half of the $1.4 billion surplus projected for FY 2018-19 is a one-time positive balance carried over from the previous biennium, not a permanent increase in the gap between state revenues and expenditures. Thus, only about half of the projected FY 2018-19 surplus is permanent revenue that is available for some combination of permanent tax cuts and/or permanent spending increases.

Finally, the size of any projected state budget surplus should be viewed as tentative so long as the state continues the questionable policy of ignoring the impact of inflation upon the most state expenditures. Since the turn of the century, state law requires Minnesota Management & Budget (MMB) to fully consider the impact of inflation on state revenues, but to ignore the effects of inflation on most categories of state expenditures in its official forecast projections. Minnesota’s highly respected and non-partisan Council of Economic Advisors (CEA) cautions against this dubious fiscal practice in the November forecast:

As it has done every year since 2003, the CEA recommends that budget planning estimates for the next biennium include expected inflation in both the 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 [Congressional Budget Office] 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 2016 Budget and Economic Forecast understated the cost of current services as provided by law in FY 2018-19 by roughly $1.7 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.

Fortunately, MMB provides an estimate of the impact of inflation upon general fund spending in the November forecast. Based on these estimates, inflation in general fund spending is greater than the size of the projected budget surplus, as illustrated in the following chart.

MMB’s estimate of the impact of inflation on state spending presented in the above chart may overstate inflationary pressures, insofar as they apply inflation to all general fund expenditures, including some spending categories to which inflation was already incorporated in the official estimates. [Addendum, 12/7/16: After publication, MMB staff informed North Star that beginning with this forecast, its estimate of inflation-driven spending in future biennia no longer applies inflation to all general fund expenditures, but only to those expenditures which are not adjusted for inflation or which are not already based on market prices; thus, while MMB’s inflation estimate is approximate, it does not necessarily overstate inflation, as suggested in the preceding sentence.] However, there can be no doubt that inflationary pressures unaccounted for in the official forecast would dramatically reduce—and possibly wipe out entirely—the official forecasted surplus.

As noted in the first part of this series, the state general fund is in much better shape today than it was six years ago, when there was a multi-billion dollar deficit, even prior to factoring in the impact of inflation. However, the extremely large official surplus indicated in the November 2016 forecast is based upon estimates that—in the words of the CEA—are “fundamentally misleading,” “inconsistent with sound business practices,” and which “potentially encourage legislators and the public to regard the state’s financial position more optimistically than the facts warrant.” Policymakers should not jeopardize Minnesota’s fiscal future by providing large permanent tax breaks based on a surplus determined under a flawed methodology.

State policymakers need to be cautious before doling out large permanent tax cuts based on surplus estimates that are exceptionally uncertain, consist largely of one-time revenue, and which are overstated due to the failure to adequately account for inflation on the spending side of the state budget.