State Deficit Worse Than It Appears

True to expectations, the condition of Minnesota’s finances has deteriorated from what was projected at the end of the 2017 special session. Based on the November forecast released earlier today, a modest deficit is now projected for the current fiscal year (FY) 2018-19 biennium and a significant deficit is projected for the upcoming FY 2020-21 biennium. To compound matters, the deficit situation is worse than the official forecast indicates.

Deficits Projected

For starters, the $188 million deficit projected for the current biennium is based on a budget that does not contain funding for the legislature, which was line-item vetoed by Governor Dayton earlier this year. After factoring in the eventual need to provide funding for the Minnesota House and Senate, the FY 2018-19 deficit swells to just over $300 million.

More importantly, the $586 million deficit projected for the next biennium is premised on the fiction that there will be no inflation in the vast majority of general fund expenditures. As required by state law, the official forecast incorporates the full impact of inflation on state revenues, but ignores most of the impact of inflation on the spending side of the ledger. In the November 2017 forecast document, the non-partisan Minnesota Council of Economic Advisors (CEA) repeated its admonition regarding the folly of continuing to ignore most of the impact of inflation on state general fund spending:

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 [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 CEA further notes that the negative effect of ignoring the full effects of inflation on state spending will increase when the rate of inflation increases above the historically low levels experienced in recent years.

Fortunately, Minnesota Management & Budget (MMB) includes estimates of the full impact of inflation on state general fund spending. Including inflationary spending pressures omitted from the official forecast would have the effect of increasing projected FY 2020-21 expenditures and the projected FY 2020-21 deficit by $1.311 billion. Factoring in these inflationary costs, Minnesota’s structural budget deficit (i.e., the gap between the revenue generated during the biennium minus spending) is $1.65 billion. The structural deficit is a barometer of the long-term health of general fund finances; the significant imbalance between the revenues going into the general fund and the expenditures made from the fund should be a cause of concern.

A Big Drop in Revenue

In the February 2017 forecast release, a substantial general fund surplus was projected for the FY 2018-19 biennium. A large part of the deterioration in general fund finances during the intervening nine months between the February and November forecasts is the result of an over $1.2 billion reduction in general fund revenue. This large revenue reduction is the result of two forces–one beyond the control of state policymakers and the other a self-inflicted loss.

Growth in real U.S. Gross Domestic Product (GDP) and wage & salary income in 2016 and forecasted growth in 2017 through 2021 have declined relative to the February forecast. This has contributed to a reduction in forecasted revenue of approximately $559 million. This accounts for 46 percent of the total projected FY 2018-19 revenue reduction from the February forecast to the November forecast. This portion of the revenue reduction is due to national economic trends beyond the control of Minnesota policy makers.

Most of the over $1.2 billion projected revenue loss from the February to November forecast is due to choices made by state policymakers in 2017. These policy changes reduced general fund revenue by an estimated $657 million or 54 percent of the total February to November revenue decline. Nearly all of this revenue decline is the result of the 2017 special session tax act. Many of the tax cuts contained in this act were of questionable merit; for example:

  • The legislature opted to freeze the state business property tax, despite the fact that this tax was the slowest growing of the major state taxes. As noted in previous North Star articles, business effective tax rates and business taxes per private sector employee in Minnesota are already below the national average. Most of the tax relief resulting from the state business property tax freeze will be exported to out-of-state businesses or to the federal government.
  • The expansion of the state’s estate tax exclusion from $2 million to $3 million will benefit only a tiny sliver of the wealthiest Minnesotans, who already enjoy the lowest state and local effective tax rates in the state. This increase in the estate tax exclusion is on top of another large increase in the exclusion enacted in 2014.
  • The removal of the annual inflation adjustment to the state’s cigarette tax will have the effect of reducing this tax from year to year in real (i.e., inflation-adjusted) dollars. This reduction of the cigarette tax will reduce the tax’s impact as a deterrent to smoking among price sensitive groups, such as teens.

The impact of many of these tax cuts will mushroom in future years, thereby contributing to growth in the state’s structural budget deficit. In fact, a substantial portion of the growth in the structural deficit from FY 2018-19 to FY 2020-21 is the result of the expanding nature of several of the tax cuts enacted in 2017.

Forecast Uncertainty

As with all forecasts, there is considerable uncertainty in the current November forecast. Ongoing policy turmoil in Washington regarding funding the federal government, raising the debt ceiling, foreign trade, and immigration create an unusually high level of forecast uncertainty. In addition, as the current economic recovery–already the longest in post-war history–continues, the likelihood of a recession increases.

While conservatives are touting the stimulative effect of possible federal tax changes, the long-term impact of these trickle-down tax cuts is far less certain. The expansion of the federal deficit creates downside economic risks that may outweigh the benefit of tax cuts that are overwhelmingly concentrated to corporations and high income households. In general, the CEA feels that in 2019 and beyond most of the risk in the current forecast is on the downside.

The forthcoming February 2018 forecast will serve as the baseline for policy action during the 2018 legislative session. In the absence of a significant improvement relative to the November forecast, policymakers should reconsider the wisdom of some of the tax policy choices made in 2017.