Forecast Whiplash

The release of the November economic forecast flipping the current budget from a $2.4 billion deficit to a $641 million surplus while a pandemic rages on was a surprise to many - including us.  The news was undoubtedly greeted by lawmakers with some sighs of relief and the sounds of some prepared talking points being run through the shredder. 

MMB’s forecast shows considerable improvement on both sides of the ledger.  It adds back $1.9 billion in revenue led by higher sales tax collections.  (U.S consumer spending on durable goods has actually increased since the onset of the pandemic.) That’s about half of the biennial revenue projected to be lost last May.  General fund spending is expected to be a little over $1 billion less than forecasted earlier this year, almost all of it in health and human services and K-12 education.   Declines in the former arise as a result of the federal government’s continuation of the 6.2 percentage point increase in the federal match for the state’s Medical Assistance program and lower than expected utilization of services.  K-12 savings arise out of lower than expected student counts – in part a function of COVID-influenced home schooling, private school enrollment, and delayed kindergarten enrollment decisions.   Interestingly, the macroeconomic assumptions underlying the numbers assume no additional federal support being made available and a post-pandemic economy not reemerging until in the middle of next year.

MMB also forecasts substantial improvement for the out-biennium.   The FY 22-23 shortfall of projected revenues to current law expenditures has been cut by over 70% to a more manageable $1.27 billion.   Biennium-on-biennium revenue growth is forecasted to be 5.1%, but that is more than offset by 7.3% biennium-on-biennium projected spending growth.  The shortfall does not include MMB’s expenditure inflation estimate.

All this sets up a much more fiscally-friendly discussion about near-term state supported pandemic related spending measures.  However despite reports of positive, bipartisan discussions there appears to be some not insignificant disagreements on what that relief looks like and who gets it.  The numbers may have changed dramatically; the politics perhaps not so much. 

A Few Observations

It’s not an accident MMB uses the term “shortfall” rather than “deficit” — Close observers of the budget documents will note that MMB projects a negative budgetary balance for FY 22-23 of only $633 million, or about half of the $1.273 billion deficit being reported in the press.   The difference can be explained by the assumption that the $641 million surplus from this biennium will be spent rather than available for next year.

MMB's primary interest for planning purposes is to communicate structural balance: the difference between projected revenues and current law expenses in a future budgeting period before an actual budget has been created.  Therefore the -$1,273 billion figure is highlighted but is carefully labeled “shortfall” not “deficit." Of course these nomenclature distinctions are pretty much lost on everyone (including us as we have casually used "deficit" and "surplus" in planning estimate contexts in the past and have been taken to task by MMB for doing so.)   It would behoove MMB in the future to spend the extra three minutes to address these interpretation matters to clarify any potential confusion and nip any suspicions of government game playing and misrepresentation in the bud.

A Budget Challenge in Most Recessions Becomes an Asset — A few weeks ago a Wall Street Journal headline read, “U.S. States Face Biggest Cash Crisis Since the Great Depression”   In describing the economic fallout of the pandemic, Maryland’s governor said, "Responding to this crisis has created a multiyear budget crisis unlike anything the state has ever faced before, more than three times worse than the Great Recession."  Numerous states have already enacted across the board spending cuts.

So what’s Minnesota’s secret sauce?   One big advantage is that the structure of our economy is less reliant on sectors that are being hit hard (e.g. leisure and hospitality) and overrepresented in areas that have felt much smaller impact like medical equipment, food, finance, and headquarters related employment.   But the design of our tax system has also played a role – particularly our greater reliance on highly progressive income taxation. 

It’s well established that income tax revenue is increasingly volatile when more of it comes from wealthy taxpayers whose tax returns are disproportionately affected by economic booms and busts.   But the COVID recession is a very different type of “bust.”   Minnesota’s higher income earners are unlikely to have experienced any notable setbacks while at the same time capital markets and gains remain strong.  Whereas in most recessions the revenue volatility from our heavier reliance on high-earner income taxation presents a budget challenge, the nature of the personal income tax structure has worked to the state’s benefit in the current environment.

Budget Reserves Buy Time as Well as Stuff, and Time Can Be Just as Valuable — Earlier this year there were calls for more frequent economic updates in order to be able to take action sooner to balance the budget.   Legislators’ concerns about waiting too long to take corrective action are valid, but the massively revised forecast illustrates the potential disadvantages of making big, impactful, disruptful budget decisions in a time of extreme unpredictability and volatility.   In responding to a question on whether more frequent forecasts are needed, Commissioner Schowalter strongly disagreed noting it is far better to manage volatility “with reserves and surveillance.”   Legislators were able to take their “wait and see” approach thanks to the reserve.

The Federal Aid Question — In responding to questions about the federal government’s role in budget improvement, MMB emphasized federal dollars do not show up in the forecast numbers and the forecast assumes no further federal action.   Yet it’s impossible to overstate the role the federal government has played since COVID’s arrival in keeping the economy afloat and mitigating state budget damage.  Nor should our changing budget forecast fortunes give the impression that additional support from the federal government is not a big deal.  We have burned through all $2.19 billion of federal CARES funds for COVID expenses during the pandemic’s build up and are now entering what appears to be the peak of the pandemic over the next several weeks.   Do we have a lot of COVID pre-purchased health care "inventory"?   How are we paying for health care overtime, et. al. this time around?   Questions like these abound, and while the reserve offers the state budget protection to cover new COVID expenses it would have been nice if MMB could have provided more understanding on what the lack of federal action going forward means for the state.

Return of the Annual Inflation Debate – Following MMB’s presentation, DFL leadership quantified the out-biennium challenge as a $2.6 billion rather than $1.3 billion problem, doubling the MMB shortfall projection by adding MMB’s estimate of expenditure inflation.   It sets the stage for yet another annual session debate between those who insist formally including inflation into expenditure estimates is the only responsible thing to do and those (like us) who argue the way we treat inflation now is adequate and to do otherwise would introduce bias into what should be a neutral budgeting process.