The Sudoku Puzzle in Minnesota’s FY 22-23 Budget

For the fourth consecutive biennial budget session, Minnesota lawmakers will miss the constitutional deadline and require a special session to complete their budget work.   There is an abundance of reasons for this, but a big contributing factor is the need to figure out how $8 billion of forthcoming American Rescue Plan Act (ARPA) funds fits into a budget framework.  Of particular relevance is the $2.83 billion State Fiscal Relief fund.   It is guaranteed to play a huge role in any budget agreement.  But apart from the ongoing political fight over how the distribution of funds is controlled, the money also comes with a lot of federal strings and conditions everyone is trying to understand.  The resulting situation is like a Sudoku puzzle where players are given clues to find a numerical solution that satisfies three outcomes simultaneously.  Lawmakers have billions to create a budget solution that delivers COVID recovery, two years of general fund operations, and federal tax conformity simultaneously using Treasury information that currently seems to be giving state officials and lawmakers more clues than guidance.

For the third time in a week, MMB Commission Schowalter was summoned to the tax conference committee to offer what understanding the agency has on the conditions and stipulations surrounding the use of these funds.   Primary focus has centered on the guidance for the “revenue replacement” rule for fiscal recovery funds.  In an aid package that again emphasizes direct spending to address the health and economic fallout from the pandemic, the revenue replacement provision is qualitatively unique.  It provides financial support to compensate for lost government revenues from the pandemic and therefore can be used for maintaining general government services.  The interest in this more flexible use of funds has increased since the amount of “lost Minnesota revenue” due to the pandemic in the eyes of Treasury is much larger than what MMB was expecting — “multiples larger” in the words of the Commissioner.  As we recently noted, our back of the envelope calculation is something on the order of $1.9 billion which from all indications appears to be a pretty accurate estimate.

Revenue Replacement 101

Since it’s becoming increasingly evident this provision will be a key to unlocking any future budget agreement, it’s worth a look at the important features of this provision and its accompanying guidance: (Note: this is an overview. There is much more detail in the guidance, including the “steps” employed to determine and calculate any potential recoupment.)

• A state’s estimate of “lost revenue” is based on a pre-pandemic state revenue baseline and multiplying it by an annual growth rate provided by Treasury (4.1%, which is the average annual growth across all state and local government own source revenues in three full fiscal years prior to the COVID emergency).  The resulting total is called “counterfactual revenue” and is best thought of as the revenue the state should have expected to collect if the pandemic did not exist.  This counterfactual revenue is then compared to what the state actually collected/collects to determine “lost revenue.”  The main reason why MMB’s forthcoming revised estimate of lost revenue is increasing so much is that it encompasses a lot more revenue elements than what MMB was anticipating and goes beyond revenues that support the state General Fund.  Another possible contributing factor is that the growth rate adjustment Treasury allows states to employ to calculate lost revenue can be higher based on actual state experience.  We are not sure what revenues are included, but it is possible Minnesota’s growth rate was larger which would make any gap between counterfactual revenue and actual collections larger.

• Revenue replacement funding (or for that matter state fiscal relief funds in general) cannot be used to “directly or indirectly offset a reduction in net tax revenue.”   This includes not just rate cuts, but new and enhanced tax credits, exemptions, exclusions, subtractions, regulations, administrative interpretations — in short most anything that the state enacts to cause revenues to decline during the period for which these funds are available for use.  Doing so exposes the state to a possible clawback or recoupment of federal funds

• HOWEVER, the states can still enact tax cuts and provide tax relief if it offsets these reductions.  This can be accomplished in one of three ways. The first two are relatively straightforward, raise revenue elsewhere or cut spending.   The spending cut option, however, is complicated by the fact that current guidance appears to permit spending cuts only in areas where state government doesn’t spend fiscal recovery funds as determined at the department, agency, or authority level.  As we previously noted, it’s difficult to identify an agency or department in state government where ARPA support would not be part of their spending plans.  It appears we might expect some further guidance here.  Moreover, the ability to offset tax revenue reductions with spending cuts is also conditioned on the difference between total spending in a given year and what the state spent in FY19, adjusted for inflation.  That ensures new “fiscal space” has actually been created by cuts to accommodate any reductions in revenue.

• The third way to offset tax reductions without triggering recoupment is by achieving higher organic revenue growth.  This would appear to be a rather subjective measure but Treasury provides a method for determining whether the revenue growth from economic recovery is sufficient to “pay for” revenue reductions.  It is based on a pre-pandemic state revenue baseline (FY 2019) which is then adjusted for inflation every year thereafter.   At the end of fiscal year 2022 (and 2023) the state reports on all revenue reducing changes it made and revenues it actually collected.  If actual revenues collected are still greater (with the reductions) than the 2019 revenue baseline adjusted for inflation, then the state would not be considered to have violated the offset provision.

• In addition, recognizing that that minor changes in a wide variety of policies may result in minor changes in revenue, Treasury guidelines also established a “de minimis” level of revenue reduction without risking recoupment.  That level is 1% of the state FY 19 revenue baseline again adjusted for inflation.  Again, we are not clear on how revenue is being defined, but this would appear to give the state a couple hundred million dollars or so of wiggle room without triggering a compliance problem with the offset provision.

• There is one final curveball with replacement revenue.  Revenue replacement need is reevaluated three times - at the end of calendar years 2021-2023.  If at any one of those "checkpoints" state actual revenue collections exceed counterfactual revenue, we will essentially have been deemed to be recovered.  As a result, the use of funds for general government purposes due to revenue replacement would stop and any remaining funds would then have to be spent in support of the other two more direct COVID relief uses (respond to public health emergency/negative economic impacts, and provide premium pay to essential COVID workers).

Unfortunately, all this guidance comes with an “interim” label which raises a different question.   That label wouldn't be so unsettling if the questions Treasury is asking respondents in final rule making didn’t seem to have such potential for changing the guidance.  For example, just in the section on Revenue Loss, Treasury is asking if there are sources of revenue that should or should not be included, and acknowledges that Treasury “is considering whether to take into account other factors, including actions by the state as well as the expiration of the public health emergency, in determining whether to presume losses are ‘due to’ the COVID-19 public health emergency.”  It’s difficult to conceive of the federal government sending out billions and then pulling the guidance rug out from under states after they have acted.   But in this light one can at least appreciate the skittishness MMB and others are demonstrating about being pinned down too soon on actionable language and interpretations. It also explains why many have expressed concern about the federal government intruding so deeply into states’ fiscal policy affairs and forcing states to budget under significant uncertainty.

The Next 30 Days

This complexity has major implications for tax decisions this year and the availability of revenue replacement funds in the future.  But it does not change the most relevant fact for FY 22-23 budgeting purposes as contained in the first bullet: Minnesota will soon have a lot of potential replacement revenue funds at its disposal.  In fact, it is likely the entire first payment of state fiscal relief funds coming shortly — something in the neighborhood of $1.4 billion — would qualify as revenue replacement dollars.   We don’t know this for sure, but there is nothing we have come across to indicate all that money theoretically couldn’t be used to maintain existing government services rather than address specific spending needs associated with pandemic health response and economic recovery.

That, of course, will not happen, but it demonstrates the complicated balancing act lawmakers face in tackling the three issues this budget must address.   And the complexity really doesn’t stop there.  An additional $3 billion of ARPA funds are being directed to specific state administered programs — many in the health and human services area.   A parallel discussion is undoubtedly playing out right now within state agencies overseeing these programs, and the finance committees that oversee them, in figuring out how existing state funding streams work and overlap with ARPA funds and how to optimize program financing without getting into trouble with federal guidance.  The complexity even extends beyond the general fund into programs funded by state special revenue funds.  State services supported by dedicated revenues are also fair game for support from revenue replacement dollars.  How all this important information and understanding does (or does not) get communicated to and incorporated by that small handful of people setting the global targets behind closed doors should make everyone’s palms sweat.

According to computer scientists there are 6,670,903,752,021,072,936,960 different solvable Sudoku puzzle grids.    Lawmakers might feel right now they have about that many options to consider how to use use federal dollars and reach a budget agreement.   They have about a month to get that number down to one.