The fiscal year (FY) 2018-19 state general fund budget surplus—projected to be $1.65 billion last February—could easily turn into a $104 million deficit after taking into account the tax cuts and other measures enacted earlier this year, as noted in the first part of this series. Because the revenue loss from many of these tax cuts will mushroom in the future, the state deficit will likely grow even larger in the FY 2020-21 biennium and beyond.

As required by state law, official state economic forecasts fully include the impact of inflation on the revenue side of the general fund ledger, but largely ignore it on the expenditure side. As noted in a February 2017 North Star article, this approach results in a projected budgetary balance that is inappropriately optimistic. Per the repeated recommendations of the non-partisan Minnesota Council of Economic Advisors, the following projections of the general fund balance for the upcoming FY 2020-21 biennium fully incorporate the projected effects of inflation on both revenues and expenditures, thus producing a more realistic estimate. The methods used here to calculate inflation-adjusted general fund spending are approximate;* more refined estimates from Minnesota Management & Budget (MMB) will be available in the November 2017 economic forecast.

The structural balance equals the gap between the total revenue coming into the general fund over the course of a biennium (i.e., current resources) and total spending made from the general fund. Because the structural balance does not include one-time revenues carried forward from the previous biennium, it is seen as a valid measure of the long-term fiscal health of the general fund. If general fund current resources exceed spending, there is a structural surplus; if spending exceeds current resources, there is a structural deficit.

Within the current biennium (FY 2018-19), general fund spending is expected to exceed current resources by $585 million. (This projection incorporates the $50 million shortfall in revenue collections during the first two months of FY 2018 relative to February 2017 forecast projections.) In other words, there is a projected $585 million structural deficit in FY 2018-19. Fully including the anticipated impact of inflation on general fund revenues and expenditures, the FY 2020-21 structural deficit is projected to be $1.22 billion—more than double the FY 2018-19 structural deficit.

These projections are based on current law spending levels and thus do not take into account the absence of funding for the Minnesota legislature, which was line-item vetoed by Governor Dayton. Assuming that Minnesota is going to continue to have a functioning House and Senate, this funding will have to be restored at some point. Including funding for the legislature will increase the size of the structural deficit by a projected $129 million in FY 2018-19 and $134 million in FY 2020-21. If we include the need to fund the legislature in general fund spending, the projected structural deficit would be $714 million in FY 2018-19 and $1.35 billion in FY 2020-21.

The large tax cuts enacted earlier this year help to explain the increase in the structural deficit from FY 2018-19 to FY 2020-21. Approximately 88 percent of the $1.22 billion FY 2020-21 structural deficit (and 80 percent of the $1.35 billion structural deficit including funding for the legislature) can be attributed to the $1.08 billion decline in FY 2020-21 tax revenues resulting from 2017 legislation. The deficit problem will likely grow worse in future years, as the foregone revenue resulting from the 2017 tax cuts escalates. For example, as noted in the preceding article, the cost to the general fund of the state business property tax freeze is projected to more than double from $80 million In the FY 2020-21 biennium to $179 million in the FY 2022-23 biennium and to $405 million by FY 2026-27.

The state’s fiscal situation is further compromised by the reduction in the state’s budget reserve. Rather than increase the size of the $1.93 billion budget reserve to the $2.05 billion level recommended by MMB in the September 2016 reserve report, the legislature reduced it by $327 million in order to subsidize health care for qualifying individuals (i.e., health insurance premium relief). Last month, MMB recommended that the budget reserve be increased to $2.19 billion—36 percent more than the current reserve level. A reduced reserve diminishes the state’s capacity to absorb unanticipated financial shocks.

The state general fund is not only facing a negative balance in the current FY 2018-19 biennium, but an even larger structural deficit in the upcoming FY 2020-21 biennium, based on projections that fully account for the anticipated impact of inflation on both revenues and expenditures. The state’s fiscal situation is further compromised by a diminished budget reserve. This outcome is due in large part to the expanding nature of the 2017 tax cuts.

*The  estimate of inflation-driven spending that is excluded from the official forecast is calculated using a method similar to that used by MMB in the 2017 February forecast.