Instant Forecast Reaction: "Sweet Fancy Moses"

If you follow the MMB revenue updates you knew something big was coming.  Just how big probably took everyone by surprise:

• $7.049 billion left on the table last session, plus
• $4.556 billion increase in current biennium net revenues over end of session estimates, plus
• $6.327 billion forecasted structural balance (revenues less expenditures) in FY 24-25
• Less topping off a budget reserve (now approaching $3 billion) and stadium reserve transfers
• Equals a $17.616 billion projected balance available for the next biennial budget, of which roughly $12 billion is already “in the bank.”

Technically speaking, the $17.6 billion is not a surplus because appropriations for FY 24-25 have not been enacted.  Commissioner Schowalter’s description of it as “the largest projected balance in the history of Minnesota" gives some sense of scale but still fails to generate appropriate perspective on the magnitude.  This, we think, does a good job of that: the $17.6 billion projected balance is over $1 billion greater than all state general fund spending that occurred just ten years ago (FY 2012).

Adding to the head-wrapping challenge is the fact that this forecast actually factors in an anticipated recession.  The state’s macroeconomic forecasters predict it will be mild in nature and last only 3 quarters.  But the resulting modest decline in forecasted FY 24-25 tax revenues from end of session projections is more than offset by higher forecasted investment income receipts from large state cash balances exposed to higher interest rates.

There is also no indication that the music is going to stop anytime soon and cause future lawmakers to scramble for budget balancing chairs.  The FY 26-27 out biennium is projected to feature a structural balance of $8.4 billion.  Even inflation projections fail to put a meaningful damper on the positivity.  Formally incorporating expenditure inflation into the forecast (more on that below) still leaves a projected balance of over $16 billion available for the next biennial budget and a structural balance in excess of $5 billion for the FY 26-27 out biennium.

As always, the forecast comes with the usual “your mileage may vary” caveats which include future inflation, monetary policy, economic shocks, and corporate profits and capital gains volatility.   The latter is an interesting one to keep an eye on as corporate income tax receipts for FY 24-25 are now forecasted to be 22.8%, or $832 million above the previous estimate despite the anticipated short recession.

Political leader reactions to the forecast and messaging were largely consistent with the past but seemed to lack the political stridency of past such press conferences.  That may be a function of new leadership personalities, the realities of a DFL “trifecta," or both.   However, elements from last year's conference committee compromises clearly reached their expiration date on November 8.   For example, full exclusion of Social Security Income  -- the high profile foundation of last year’s omnibus tax bill agreement --  now looks a little more iffy as DFL leadership expressed some reservations while Governor Walz pledged no tax cuts for  wealthy Minnesotans, which is what a full exclusion most certainly entails.

A Few Thoughts and Observations

Individual Income Tax Collections: They’re Real and They’re Spectacular

Earlier this year, as individual income tax collections continued to thump forecast expectations, MMB’s revenue update would always include a note of caution about their interpretation.  This stemmed from timing issues arising out of the state’s Pass Through Entity (PTE) tax.   In short, earlier PTE payments would be credited against business owners’ individual income tax liability resulting in larger refunds later when they filed their individual returns.   At one point, MMB estimated that about $1 billion of the fiscal-year-to-date variance reflected the timing of pass-through entity (PTE) tax payments and refunds. However, individual income collections continued to show little sign of slowing down from any large refund effects, and individual income tax receipts are now forecast to be $1.785 billion more than the February forecast, adjusted for law changes.  The book is not yet closed on the impact of timing issues, but it’s clear more of the revenues are real rather than timing related to PTE tax payments.

The Source of Education “Savings” Spells Challenges Ahead for Education Delivery

A contributing factor to the large balance available for next year’s budget is essentially lower than expected spending on E-12 education.   E-12 spending in the current biennium is down $280 million from prior estimates.  This is driven primarily by lower pupil counts which are the primary factor in most E-12 education aids and formulas.   Pupil counts are expected to be flat for FY 2022 and FY 2023, and then projected to decline through at least 2027.  

When a system built on pupil counts collides with the highly fixed cost structures of educational delivery, funding challenges materialize.   A loss, for example, of 50 pupils spread equally over 13 grade levels translates into slightly less than four fewer children per grade –unlikely to trigger restructuring.  Yet those lost pupils translate into a $336,000 financial hit for a district.   Last session the House proposed a one time increase of $25 million in state declining enrollment aid which is a band aid on a structural problem. 

This is just one example of why “full funding of schools” can’t just be a numbers discussion.  Minnesota’s complex education finance system, aid appropriations, and formula designs need a careful review based on an empirically rigorous understanding of how environmental factors outside of districts' control actually influence education cost structures.

The HHS Beat Goes On

Another contributing factor to the large budget balance was substantially lower than expected health and human service spending. FY 22-23 HHS forecasted spending was down $1.1 billion from end of session estimates primarily thanks to a three-quarter extension of the federal government’s larger match on Medical Assistance spending.   But structurally, the general fund pressure and competition created by HHS spending growth rates continues unabated.  HHS expenditures are expected to increase by $2.6 billion in the next biennium under current law consuming over 5 times the expected growth in total tax revenue in FY 24-25 compared to the current biennium.

The Great Inflation Debate: Episode 21 

From all indications one of the first item of legislative business in the 2023 session may be formally adding inflation to expenditure estimates in the economic forecast.  MMB inflation estimates are, in fact, included in the forecast ($1.552 billion in FY 2024-25 and $3.309 billion in FY 26-27).  We would expect lawmakers to have the sensibility to take the reality of inflation and this important estimate into consideration in their budgeting decisions. Advocates argue that is not enough, it must be officially built into expenditure forecast estimates.  One of the enduring myths surrounding this topic is that the removal of forecasted inflation in 2002 was a sudden, radical departure from long-held Minnesota budgeting practice.  In fact, M.S. 16A.103, Subd. 1a which specified formal recognition of general inflation in forecasted expenditures only existed from 1991 to 2002.   Minnesota budgeting has been “dishonest, “irresponsible,” "intellectually bankrupt,” and all the other invectives thrown at opposition to this idea through most of state history.  Somehow Minnesota state government survived and thrived.

In the coming weeks, and as the 2023 session discussion commences, look for more from us on what underlies this superficially uncomplicated debate and another presentation of our arguments on why formal inclusion creates a structural bias in what should be a neutral budgeting process.