That Rainy Day Feeling

“In my dream I was standing on the bank of the Nile, when out of the river there came up seven cows, fat and sleek. After them, seven other cows came up—scrawny and very ugly and lean. The lean, ugly cows ate up the seven fat cows that came up first. But even after they ate them, no one could tell that they had done so; they looked just as ugly as before. Then I woke up.” — Genesis 41: 17-21

About 4,000 years ago – prompted by a prophetic dream rather than legislative testimony – the first recorded government reserve was established. Pharaoh’s dream captures the importance of good planning. Bad years don’t just offset good years; they can completely “consume” them.

Fast-forwarding a few millennia, a recent House Tax Committee hearing explored the modern day version of this issue: the need for a healthy state budget reserve. Despite the theoretical appeal of a well-funded reserve to weather economic downturns, the ever-present “spend it” vs. “give it back” political tug of war makes that policy goal difficult to achieve. The recently enacted “first” omnibus tax bill directs $150 million of the state’s $1.2 billion surplus to the budget reserve, bringing it up to $811 million or 2.1% of the general fund’s non-dedicated revenues for the biennium.¹

How Much is Enough?

The status of the state’s budget reserve gained much greater attention following the 2008 report of the Budget Trends Study Commission. One of the Commission’s primary findings was that the budget reserve ceiling had not grown to an appropriate level to adequately manage the underlying risks Minnesota’s tax system had developed over time. According to the report, the state’s general fund tax base had become approximately 30% more volatile since the 1970’s. The Commission identified potential tax system changes that could reduce volatility and restore stability to more historic levels. However, Commission members concluded that the necessary changes would be quite radical and “would also affect revenue growth rates and the distribution of the tax burden among taxpayers.” This unacceptable trade-off of greater revenue stability at the expense of revenue growth and tax progressivity led to a recommendation that the budget reserve serve as the state’s primary budget stabilization mechanism and that the size of the reserve be increased.

Back in 2008, Management and Budget (MMB) calculated that the state would need a budget reserve equal to 4.1% of biennial general fund resources ($1.4 billion in FY08-09) to offset cyclical revenue volatility and accommodate a budget deficit 95% of the time. Growing general fund activity and greater tax system volatility have further fueled reserve requirements. MMB’s most recent reserve recommendation, from this January, has crept up to 4.9% of biennial general fund resources or $1.925 billion.

Perhaps triggered by the daunting political challenge of ever arriving at a point where $2 billion of the state’s checkbook would be “off-limits,” the House Tax Committee invited representatives from the Pew Charitable Trusts to provide an overview of best practices from around the country on managing tax and budget volatility. The presentation, based on a recent Pew policy report, provided perspective on patterns of economic and revenue fluctuation in various states over the past 20 years, how state tax policies can magnify or moderate revenue volatility, and how states are working to manage this uncertainty.

According to the report, from 1995 to 2012 Minnesota’s economy and state tax collections were actually less volatile than the 50-state average. That may come as a surprise given the moments of budgetary whiplash we have experienced over that time. It very likely reflects both our diverse economy and the fact that policymakers have not been shy about using every tax type at their disposal. However, some states have been more successful in having their tax collections track and trend with economic conditions than Minnesota has.

State approaches to budget reserves also vary. According to Pew, only 12 states tie deposits into their budget reserves to either economic or tax collection volatility. Five of these 12 states tie reserve deposits to overall revenue collection while four tie their deposits to collections from specific revenue sources. The 38 remaining states (including Minnesota) either tie deposit rules to budget surpluses (forecasted or actual) or simply act as the spirit moves them.

Reasons Beyond Recession

In Minnesota, the spirit has moved both the House and Senate tax chairs to author a bill with two policy objectives. First, it sets a target amount for the state’s budget reserve at 5% of general fund expenditures and transfers for the current biennium. Second, it dedicates a portion of two of our most volatile revenue sources – income taxes from capital gains and corporate franchise taxes – to the budget reserve when collections exceed historical thresholds and other technical conditions are met.

It remains to be seen whether this prescriptive attempt to skim highly volatile revenues off the top during really good times and set them aside for later will receive broad legislative support. However, three separate but related features of Minnesota’s tax and fiscal policy climate suggest to us that a very healthy budget reserve is a fiscal necessity.

The endless political bludgeoning of property taxation – One of the eternal mysteries of Minnesota public finance is reconciling policymakers’ expressions of concern about government budget stability with their relentless war against the property tax. Since governments, and not economic conditions, determine collections, property taxes are by far the most stable, predictable, and refreshingly reliable component of Minnesota’s state-local tax system.

One wouldn’t know this by the constant push to drive down property tax bills and local governments’ reliance on property taxes with various forms of state support – backed by far more volatile revenues. As discussed elsewhere in this issue, some see last year’s property tax measures as necessary but insufficient. The Dayton administration has expressed interest in cutting property taxes even deeper, while other legislative leaders have rhetorically wondered how people would explain that more property tax relief isn’t a good idea.

We can come up with several explanations – one of which is that the state has proven to be an unreliable partner for local governments. Forty years of impassioned testimony by local officials and their lobbyists have hammered home their frustration with “balancing state budgets on the backs of local government” when lawmakers have cut or frozen aids and failed to fully fund the old market value homestead credit in tough economic times. The state’s failure to live up to its “obligations” creates budget exposure and unpredictability for local governments. Despite past experience, lawmakers appear to be adamant about attempting again to reduce local governments’ reliance on the trusty property tax. The House’s second omnibus tax bill ratchets expectations up even further by committing the state to adjust future LGA appropriations for inflation. One thing is certain: because state service responsibilities will take priority over these aids when times get tough – putting them first on the budget chopping block – the state will need a very healthy budget reserve to deliver on its aid promises more reliably than in the past.

The bipartisan aversion toward temporary taxes – One of the more interesting case studies in the Pew report is the North Carolina experience. Unlike most states, North Carolina’s tax revenue has grown and contracted more or less at the same time and pace as its economy for the last two decades. Good times did not bring in windfall tax receipts, but bad times did not see the disproportionate plunge in collections that make budget-balancing challenges worse.

One big reason for this performance is the adoption of surcharges in difficult economic times. During the Great Recession, North Carolina adopted two temporary taxes. The first was a modest two-year individual income tax surcharge of 2% to 3% on married-joint filers with taxable income over $100,000 (with lower income thresholds for other filers). The other was a corporate income tax surcharge of 3% on the amount of tax due, before applying any payments or credits.

If policymakers deem additional revenues absolutely necessary to ride out difficult economic periods, temporary surcharges are a smart approach and one which this organization has endorsed for decades. During the Great Recession, legislators introduced broad based surcharge bills but the idea failed to gain traction. Opposition to surcharges comes from both sides of the political aisle – for some they utterly fail to satisfy long-term spending ambitions, while others express deep skepticism that “there is no such thing as a ‘temporary’ tax.”

But the price of this aversion to temporary taxation can be seen in our recent windsock tax policy that blew with changing economic conditions. Large, highly controversial, and administratively problematic structural changes to Minnesota’s tax system were enacted to meet budget balancing requirements only to be repealed less than a year later when economic circumstances improved. Blink on/blink off tax changes of this scope and scale make for entertaining politics but undercut the valuable tax policy principle of predictability, which takes a real toll on business and Minnesota’s economy. Absent a change in attitude about surcharges and other forms of temporary taxation in tough times, bigger reserves are the default stabilization mechanism.

The continuing emphasis on tax progressivity to the exclusion of most everything else – Minnesota’s current tax policy filter has a pretty simple mesh. If it’s progressive, it passes through; if not, it gets trapped and dumped. Besides being a very successful political tool, this filter also makes big state budget reserves increasingly necessary.

Broad-based taxation of individual income has proven to be one of the more predictable and growing revenue sources for government. But our chosen targets – the capital gains, business pass-through, and bonus-infused income prevalent among the very top income earners – is much more volatile. And according to economists at Northwestern University, rising income cyclicality is a companion to rising income inequality.² Since 1982, incomes of the top 1% rose on average 5% more per year during booms than the other 99%, but fell 3.7% more per year during recessions. In short, the incomes of the top 1% are 2.4 times more cyclical than those of average earners and even more volatile – rising more in booms and falling more in recessions – than the very lowest earners.

Minnesotans’ general attitude toward government spending and investment (more) and paying for it (not me) does not help matters. There appears to be little public support for broader-based consumption taxes even with a lower rate, and; as we have pointed out, property taxation is already persona non grata. These constraints point to a need to manage our progressivity ambitions with a bigger reserve.

Here Come the Fat Cows

MMB now forecasts total FY 2014-15 tax revenues will exceed FY 2012-13 levels by $5 billion, or 15.3%. More than half of that change is due to the individual income tax. And according to Global Insight, the state’s macroeconomic consultant, accelerating economic growth is expected to continue over the course of 2014, resulting in faster job creation and a reduction in the unemployment rate to near 6% by the end of the year.

With the additional $150 million for the budget reserve now signed into law, we are now 42% of the way to MMB’s recommended $1.9 billion rainy day fund. All indications suggest that with a modicum of spending discipline, we could meet that reserve amount over the next few years. Whether or not it materializes will be a story for the rest of this biennium and also for the next recession – whenever that occurs.