About that Budget Deficit

In a chaotic period dominated by COVID response and civil unrest, action on the budget deficit drifted down lawmakers’ to-do list.   A look at the status, environment, and options for budget repair in the next special session

When the interim budget projection in May flipped the state from a $1.5 billion surplus to a $2.5 billion deficit, one might have expected budget repair to be a focal point for lawmakers.  That was most certainly not the case.    In the context of policing reform, civil unrest, emergency powers, bonding, and COVID aid to local governments, the state budget deficit seemed to be a legislative afterthought.

Our next moment of budget recalibration does not come until the November forecast.  The possibility of an equivalent or larger deficit heading into a biennial budget session with a much tighter window for repairs is not a pleasant thought.     As MMB’s economic forecast has suggested, this is a possibility.   Growing consensus appears to be that a v-shaped recovery is unlikely and states’ economic recoveries will likely be protracted slogs lasting a couple of years.   With this in mind, it’s worth taking a closer look at the environment for budget repairs in the next special session. 

What Impact Might the Special Session Have?

If the proposals floating around the end of the first special session foreshadow what the final deals will look like, its doubtful much, if any, headway will be made.   A tax bill by itself could increase the deficit because of federal conformity actions.   The House’s omnibus tax bill from early May would reduce general fund collections by a projected $31 million in the coming fiscal year while the Senate’s bill would have a $258 million negative impact – in both cases largely a function of federal conformity proposals.   According to news reports, legislative leaders have indicated that behind the scenes an agreement has been reached on a tax bill.   Since no conference committee meetings were held and no information has leaked on what type of compromise has been reached, it’s difficult to predict what the general fund impact would be.   Something between the two committees’ goalposts would seem to be a fair assumption.  

The other side of the ledger is more difficult to assess.   Under normal circumstances a $2.5 billion budget deficit might be expected to stop discussions of new supplemental spending dead in its tracks.   But these are far from normal circumstances.  No targets were made public so it is difficult to get an even general any sense of where negotiations would wind up on any supplemental budget spending.   The governor’s own supplemental budget provided the most detail, and that was understandably ratcheted back a couple of times as COVID developments unfolded. 

The waning moments of the special session did offer a preview of what will certainly be a critical budget management tool going forward.  In a bill distributing $841 million of federal CARES aid to local governments, the House included an amendment which added $148.3 million of the Governor’s supplemental budget interests to the bill.    However, the bill would have generated a small amount of savings for the state general fund.  That is because the bill also included several expenditure transfers out of the state general fund and into the state’s fund supported by federal coronavirus relief dollars.  Some Republicans criticized this budget shift as an accounting convenience to enable new spending, but the needle on this action points to opportunism rather than gimmickry.  The state should look to take advantage of all possibilities to relieve pressure on the general fund by transferring expenses and spending obligations that can be justified as COVID-related into federal supported funds.    Immediately backfilling the space created with brand new spending might be objectionable, but from a state budget standpoint, the underlying strategy is a smart thing to do.

Federal dollars, and any reduced general fund pressure it creates, will play a major role in any budget agreement.   Of the $1.87 billion allocated directly to the state, $1.66 billion still remained unallocated when the first special session ended.    The Governor’s subsequent decision to release that $841 million under the formula approved by the House and Senate left $818 million that can be used for COVID-related expenditure reimbursements.  Both the House and Senate have outstanding proposals heading into the next special session leaving $669.3 million and $755.7 million balances in the coronavirus relief fund respectively.    Acceptable uses include medical, public health, payroll, federal compliance, and economic support.   Even though Treasury guidelines place restrictions on what spending reimbursements are permissible, they are broad enough to likely accommodate a variety of state spending deemed COVID-related.   A possible queue for this treatment appears to already exist.  Earlier this year the Senate unanimously passed a bill to change the source of $333 million of COVID related appropriations and transfers out of the state general fund and into federal COVID relief funds.  

State spending targeting the economic fallout of the civil unrest following the death of George Floyd also has budget implications.   Proposals in the House included $125 million to create a special master panel to award claims for damages not covered by insurance and $168 million for grants and loans to businesses and nonprofits in affected areas.    The Senate has proposed a new $327 million “Protest Response Fund” enabling local units of government to provide forgivable loans to businesses and organizations located in the affected areas.   It’s worth noting that although the assistance mechanisms differ, the total spending in both the House and Senate bills are roughly the same and are also in line with the $333 million of COVID-related spending the Senate voted to shift to federal support.   It appears to us policymakers are looking hard at ways to support the reconstruction and redevelopment of impacted areas without significant additional general fund appropriations.

Federal support, so critical to the state’s pandemic response and budget management, may not be finished.  Several weeks ago, the Democratic-controlled House passed a new stimulus bill, the $3 trillion HEROES Act, that included $915 billion in additional -- and more flexible -- state and local aid.   The Republican-controlled Senate has not taken up the bill and President Trump has described it as "dead on arrival."  However, several Republican senators have spoken in favor of some form of general state and local government aid.  Four have joined two democrats in sponsoring the State Municipal Assistance for Response and Transition (SMART) Act which would provide a more “modest” $500 billion to states and local governments.    Importantly, this package would allow compensation for revenue losses as well as COVID related expenses.

Based on current language, Minnesota would receive about $2.7 billion based on population share plus likely hundreds of millions more based on the two other distribution formula elements: 1) the state’s relative share of COVID-infected population in the U.S. (as of June 1 addressing the possible moral hazard problem); and 2) the state’s relative share of lost tax and other own source revenue.   One-third of the $2.7 billion aid portion would have to go to Minnesota local governments.   Current language would not allow any of this aid to be used to rescue state pension funds which addresses one of the most commonly expressed objections to this proposal.  If movement happens on this bill in the 116th Congress it would almost certainly be toward the end of the year.  But it’s safe to say enactment of this legislation or something like it would make Minnesota elected officials at all levels breathe much easier heading into 2021.

The Familiar Tools

Before considering tax increases and spending cuts, lawmakers will also try to get the most it can out of the other tools in the state’s budget balancing toolkit.

Reserves -- Lawmakers past and present deserve a major tip of the hat for the wisdom and prudence shown in developing and managing the state budget reserve.    The $2.7 billion (when including the cash flow reserve) is enough to cover the projected deficit, but how and how quickly it should be used is a critical question given the uncertainty surrounding the pandemic and the economic repercussions.   It would be beneficial, as developments warrant, to have some additional flexibility to cut spending without fully draining the reserve.   In that respect, the inability to unallot before the reserve has been fully drained is a disadvantage.   Some have suggested giving the Governor greater unallotment powers -- for example up to 50 cents for every dollar drawn out of the reserve – to provide the budget flexibility current circumstances demand.  Given the heavy political backlash against the use of his existing executive powers, we don’t expect a vote on that anytime soon.

Transfers -- Transfers of other state special fund balances into the general fund or transfers of general fund obligations into state special funds have long been part of the state budget balancing playbook.  However, those options may be more limited this year as COVID has inflicted collateral damage on state special funds as well.  Looking at the 14 select non-general fund statements which are included in MMB’s May 2020 Interim Budget Update reveals tax revenues are expected to decline by $166.1 million compared to the previous biennium.  Most of this is due to lower forecasted general sales, motor vehicle tax and provider tax collections.  That sum may be conservative since it does not include declines in other revenue sources accruing to these funds such as fees, licenses, and investment income.

Accounting shifts -- School aid shifts are easy targets for criticism, but history shows they have long been used to buy additional time for state budget adjustments.   According to House Research the state aid payment shift saves, on a one-time basis, around $100 million for each percentage point that the current year aid payment is lowered.  Thus, if the normal 90/10 aid payment split were reduced to 80/20, the state would realize a one-time savings on paper of around $1 billion without actually cutting school district revenue.    Of course, on the receiving end, the delay impacts a district’s cash flow and has the effect of potentially imposing borrowing costs.    How well school districts own reserves and budgets in these times would be able to accommodate these shifts needs to be understood. 

The combination of the state’s healthy budget reserve and federal support has dampened some of the urgency lawmakers feel regarding the state budget deficit.   The prospects of another possible round of federal relief, an opening economy, and the availability of internal budget balancing maneuvers also foster a “wait and see” attitude.   Put this all together, along with the desire to avoid tax increases and spending cuts in an election year, and it is unlikely any more attention will be given to the deficit whenever the next special session occurs.  Whether we will come to regret not giving the issue more consideration sooner remains to be seen.  As a Moody’s analyst recently commented, “The virus is in the driver’s seat. We are all just along for the ride.”