Showtime! 2019 Session Preview

Politics is often equated with theatre, and if more money buys bigger productions, then the recently-released November economic forecast suggests Minnesota’s 2019 legislative session will feature no shortage of dramatic scenes, impassioned soliloquies, and unexpected plot twists.  With opening night only a few weeks away, we take a look at the playbill.

Setting the Scene

Given the favorable economic conditions, no one has seemed all that surprised by the $1.5 billion surplus Minnesota Management and Budget (MMB) is projecting for the upcoming FY 20-21 biennium.  Importantly, that surplus does not include an almost $500 million addition to the state’s budget reserve fund, which would bring it to $2.07 billion for the end of the current FY 18-19 biennium, which ends on June 30.  This leaves the reserve about $150 million short of the $2.22 billion MMB currently recommends as a target, based mainly on the volatility of the state’s revenues and the amount of non-dedicated general fund revenues the state receives.  However, the $1.5 billion surplus does include the $720 million legislators have left on the bottom line for the current biennium, with which they could finance additional spending or tax cuts for the period prior to June 30.

On the revenue side, growth is expected to be respectable, with $2.9 billion (6.4%) in new revenues for the coming biennium.  However, as Table 1 shows that growth is concentrated in tax revenues – non-tax revenues are projected to decline by about 9%.  The forecast predicts the lion’s share of tax growth in two areas: individual income taxes ($2.1 billion) and sales taxes ($879 million).  Corporate tax revenues are projected to decline by about $50 million, with taxes from all other sources projected to grow by about $130 million.  The reasons driving the tax growth are positive signs for Minnesota’s economy over the short term – wage and salary income are projected to grow by 5.1% next year and by 4.7% in 2020, with 4% to 4.5% growth projected for the sales tax base.

Two TCJA-related issues are worth mentioning with regards to the individual income tax projections.  Although Administration officials were adamant during the 2018 session that state law prohibits individual filers from electing different deduction statuses on their federal and state returns, last summer Revenue quietly issued notice to the contrary.  Had the state stuck to its guns, many Minnesotans would have had to give some of the tax savings they will realize through the higher federal standard deduction away to the state.  The forecast indicates that the state’s decision to reinterpret the provisions around deduction elections will save taxpayers $88 million in the next biennium.  When combined with the $34 million in lower revenues resulting from taxpayers’ decisions to change their federal tax accounting methods, as provided for under the TCJA, it’s clear that even without any tax bill last year, TCJA policy is still affecting state revenue collections.

The Supreme Court’s Wayfair decision has also made its way into the economic forecast.  There had been some debate during the last year over just how much new revenue taxing on-line sales might generate, given that many major retailers with on-line presence were already collecting and remitting taxes.  As the forecast indicates, that caution was likely warranted.  The state’s economists are predicting that about 25%, or $225 million, of the forecasted increase in sales tax revenues next biennium will come from taxing on-line sales.

Moving to the other side of the ledger, under current law FY 20-21 spending is forecast to grow by $1.9 billion (4.2%) over FY 18-19 levels.  Note that many of the spending areas shown in Table 1 decline between the current and upcoming biennia – we believe this is largely the result of one-time appropriations for FY 18-19 that, under the forecasting rules, are assumed to blink off.  However, in many respects the major spending storyline remains unchanged from previous years: health and human services spending is expected to grow by $1.5 billion.  As a result, an area of the budget now constituting about 30% of general fund spending is projected to consume over 50% of new general fund revenues.  This is in spite of forecasters actually lowering their estimate for general fund spending on Medical Assistance (Medicaid) in FY 20-21 by $383 million, primarily because of lower managed care rates.  This disproportionately rapacious consumption of new general fund revenues reflects a rate of spending growth that is actually smaller than the 13% growth rate seen on average between biennia since FY 1988-89.  Another large ambition-denting factor is the $756 million in new spending that E-12 education claims also under current law.  Ambitions will also be limited since the “structural surplus” – current revenues less current spending and transfers – is $873 million, with the other $671 million being one-time money.  Many lawmakers will be leery of using one-time resources to finance ongoing tax cuts or spending increases.

No forecast presentation is complete without some reference to the effect estimated inflation would have on the forecast if state law allowed for it to be included.  The state’s Council of Economic Advisors continues to be critical that this practice, which would add $1.2 billion in forecasted spending for FY 20-21 and $2.9 billion for the FY 22-23 planning estimate, is not allowed.  On the one hand, this inflation estimate responsibly does not double count inflation that is already included in the forecast.  Contrary to public perception, forecasted changes for the state’s share of special education funding and its share for managed and long term care spending both already include inflation adjustments.  And the inflation estimate does a respectable job of omitting some significant amounts of general fund spending that logically do not merit automatic inflationary adjustments, like debt service and property tax refunds.

However, a strong argument can be made that other types of general fund spending should also be excluded from inflationary adjustments, like capital projects, other types of property aids and credits programs, and pension appropriations — all of which were, in fact, excluded when the state first started adding planning estimate inflation in 1991.  More fundamentally, it is frankly naive to think that the forecast does not serve as a de facto budgeting tool as well.  As a House Fiscal Analysis Department publication stated in 2002:

“Planning estimate inflation has been a tool to provide more flexibility for a Governor and Legislature in assembling a new budget. The inflation creates a cushion of several hundred million dollars that is already counted as spending in the budget forecast”^[1]

“Several hundred million” back then is $1.2 billion today, which is a very luxurious cushion.  Including inflation enables considerable spending on new or expanded programs without ever having to recognize it as “new government spending.”

Putting aside the complexities of if and how spending inflation should be included, the fuss over this topic pales in comparison to the biggest and most influential “spending reality” the economic forecast ignores.  Governments in Minnesota have not made the full actuarially required contributions into the state’s pension plans, as a whole, for well over a decade, and since FY 2002 these contribution shortfalls have contributed over $6.5 billion to these pension plans’ unfunded liabilities.  Last year, the plans were shorted another $390 million, and even with the highly-lauded pension changes signed into law earlier this year we fully expect the valuation reports for FY 2018 to project yet another year of inadequate funding for FY 2019.  Given that the pension benefits these missing dollars are supposed to finance are required to be paid regardless of what happens with the funding, this “off the books” expense is infinitely more deserving of the media’s and the Council of Economic Advisors’ constant scolding and fiscal hand wringing than spending inflation.

While pleased about the condition of Minnesota’s finances, MMB Commissioner Myron Frans and other MMB staff were quick to warn that the path ahead may have some speedbumps and potholes.  As state economist Laura Kalambokidis pointed out, forecasters are now expecting slower growth for 2021 through 2023 than they had in February, with the state’s real Gross Domestic Product growth projected to fall from 1.9% in each of those years to 1.6%, 1.5%, and 1.4%; respectively.  MMB’s macroeconomic consultant, IHS Markit, expects the national economy to begin slowing in 2019 as the TCJA-related stimulus fades and a stronger dollar brings net exports down.  Moreover, IHS believes Minnesota’s labor force participation rate will fall after 2020 as the state’s demographics continue to change.  Perhaps the most positive medium-term economic news is that IHS only sees a 25% chance for a recession in 2020.

Protagonists and Antagonists

Last month’s elections will also have a major impact on the 2019 legislative session.  The result in the gubernatorial election was, in the end, not really surprising.  Polls throughout the summer and fall correctly forecasted a win for the DFL candidate, Congressman Tim Walz, over Hennepin County Commissioner Jeff Johnson.  Turnout for the election was high, as Walz’s nearly 1.4 million votes were the most ever cast for a gubernatorial candidate in Minnesota history – with Johnson’s nearly 1.1 million the second-most ever cast.  (Both candidates surpassed the former record, Arne Carlson’s total of 1.094 million in 1994.)

The DFL not only retained control of the governor’s mansion; the party also took control of the Minnesota House in convincing fashion.  The party picked up 18 seats, moving the chamber from a 77-57 GOP advantage to a 75-55-4 DFL majority – with four Republicans leaving the fold to establish a “New Republican” caucus.  Notably, 16 of the DFL’s 18 pickups came in the seven-county metro; the other two include a former member winning his seat back in the Bemidji area and the St. Cloud-based race where the GOP incumbent stepped away from the campaign late in the season.  Most of the metro-area seats the DFL picked up were in third ring suburbs/exurban areas, many of which have not been prime DFL territory as of late – think Shakopee, Savage, and Maple Grove.

The GOP controls virtually all the Greater Minnesota legislative seats, with the exception of the Iron Range and some regional centers like Rochester, Mankato, and St. Cloud or college towns like Northfield or St. Peter.  Given that the House DFL has basically built its majority on the Twin Cities suburbs, it will be interesting to see whether and how that plays into their legislative strategy and proposals during the next two sessions.  The deepening of the geographic divide between the parties makes Gov.-elect Walz’s “One Minnesota” message seemingly a challenge to deliver on.

The Minnesota Senate remains in GOP hands, with State Representative Jeff Howe defeating Stearns County Commissioner Joe Perske for the seat vacated when Sen. Michelle Fischbach was elevated to lieutenant governor.  However, with the thinnest of margins (a 34-33 advantage), Majority Leader Paul Gazelka will have his hands full this session, since each member of his caucus effectively holds a veto over any proposal for which there is no DFL support.  With a number of metro-area seats now looking more competitive than they might have prior to the election, keeping the caucus united might be a challenge as senators look ahead to 2020.

The dynamics between the two legislative bodies and the governor will also be very different in 2019-2020.  In prior years, Governor Dayton served as a backstop for the DFL, using his veto power liberally to strike down bills the GOP-controlled legislature sent to him.  Gov.-elect Walz is far less likely to need to use the veto, given the DFL’s control of the House.  Conference committees are also likely to take on a much greater significance, since they are likely to feature much more negotiation in a divided legislature than they have during the Dayton years, when the legislature was divided only in 2015-16.

Plot Lines

The stalemates and lack of productivity of recent years has kept several high-profile policy issues endemic to every legislative session on a more or less slow boil.  For other topics the time is now up and decisions must be made.

• Federal conformity.  One of the major failures of the 2018 session was the state’s inability to respond to the federal government’s TCJA-related changes.  Legislators will take another crack at the issue in 2019, but this time informed by whatever trials and tribulations arise out of taxpayers’ tax year 2018 filing experiences.  One crucial (and arguably the most important) policy objective surrounding federal conformity – simplicity – was essentially shut out of the debate last year.  Any potential discussions about making the tax system simpler and therefore easier to comply with (for taxpayers) and administer (for government) were immediately overwhelmed by political preoccupations over who pays and how much.  It will be interesting to see if lawmakers want to repeat this experience.  Fortunately, there is no rush to address this early in the session since our bed for tax year 2018 has already been made.
• Provider tax fate.  The state’s 2% tax on health care providers, hospitals, surgical centers, and wholesale drug distributors (the so-called “provider tax”) is scheduled to blink off after December 31, 2019.  These taxes raise about $650 to $700 million in revenue annually, which now principally go to support Medical Assistance, the state’s Medicaid program.  Legislators will need to determine whether they want the phaseout to continue as planned, or if not whether to continue the provider taxes in their current form or modify them somehow.  We plan to release an Issue Brief exploring the policy issues surrounding this topic sometime during the first few weeks of the upcoming legislative session.
• Transportation finance.  Other committees may choose to look at methods of potentially making Minnesota’s transportation spending more effective, but the tax committees will certainly be drawn into a debate over Minnesota’s gas tax.  According to data from the Federation of Tax Administrators, Minnesota’s 28.5¢ per gallon rate is about 20^th highest in the nation.  However, Gov.-elect Walz was clear on the campaign trail that he would be open to an increase.  Advocates would need at least one GOP senator to break ranks – and the example party activists made of the six GOP representatives who voted to override Gov. Pawlenty’s 2008 veto of that gas tax increase will surely be front and center in the mind of any potential Republican supporter.  Other funding sources – including a reprise of dedicated sales tax revenues– may enter into the discussion.
• Property tax relief.  Like the Terminator, this issue just keeps coming back.  With housing values rising while growth in commercial and industrial values has slowed, tax base is sloshing over to homeowners and we have seen property tax increases of 40% on some Truth-in-Taxation statements.  Unsurprisingly, this has riled homeowners and lawmakers appear ready and eager to jump in (yet again) to save the day.  Will the DFL majority in the House make the state’s property tax refund even more generous (which would tend to benefit the metro area and many of their newly-elected members) or turn to Local Government Aid (which would distribute somewhat more money to Greater Minnesota)?  Our bet is both but that raises the bigger question: just how much local property tax relief can the state really afford when it has its own major spending obligations and responsibilities to address?

With a full and interesting legislative agenda and new personalities, it will be easy for citizens themselves to get wrapped up in the political intrigue and drama surrounding our budget debate.  But that’s not a bad thing.  For as someone once said, “We must all do theatre to find out who we are and to discover what we could become.”

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