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How well is Minnesota government prepared to weather the next recession?

A recent assessment gives the state relatively good marks when it comes to Minnesota’s fiscal health, at least compared to other states. But that doesn’t mean the state is immune to serious economic threats.

MinnPost photo by Peter Callaghan
The Minnesota state economist in the office of Management and Budget, Laura Kalambokidis, said that the state’s latest Revenue and Economic Update does not foresee a recession in the nation or state over the next few years.
Minnesota state budget leaders fancy themselves well-prepared for whatever the economy might send their way whenever the longest recovery in U.S. history inevitably ends.

A recent assessment by the Pew Charitable Trusts gives the state relatively good marks when it comes to Minnesota’s fiscal health compared to other states. It has better than average reserves. It has restored many of the cuts made to weather the Great Recession. And has lower than average debt and pension obligations, researchers found

But the same analysis shows Minnesota is not immune from economic threats. It’s still feeling some effects of budgeting decisions left over from the Great Recession, and the process it uses for running stress tests — throwing  different economic scenarios at its tax system to see how much should be in state rainy day accounts — doesn’t take into account impacts on spending that a recession could cause.

“The next recession, by all likelihood, won’t be as severe as the Great Recession. Just by law of averages the next recession will be more mild,” said Steve Bailey, a manager with Pew’s state fiscal health project. “But that doesn’t necessarily mean the benchmarks the states used to figure out how prepared they were carry over to this recession.” 

‘Minnesota will not be immune’

The current U.S. economic expansion is already the longest in its history, and Laura Kalambokidis, the Minnesota state economist in the office of Management and Budget, said that the state’s latest Revenue and Economic Update does not foresee a recession in the nation or state over the next few years, though “that doesn’t mean that there is no possibility of a recession,” she said.

“Macroeconomic forecasters tend not to actually forecast a recession in their baseline until they are absolutely sure what’s going to cause that recession.” 

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Yet a state consultant, IHS Markit, has increased the probability estimate of its more-pessimistic economic forecast scenario, she said, which is a way of signaling increased risk of a recession. Added Kalambokidis: “If the U.S. goes into recession, Minnesota will not be immune.” 

State Economist Laura Kalambokidis
MinnPost photo by Greta Kaul
State Economist Laura Kalambokidis
Calling the current period a “late-cycle economy,” Kalambokidis said the diversity of the industrial and job base in Minnesota provides some insulation from the worst effects of a downturn compared to states that are over-reliant on a few volatile industries, such as oil and gas. Even so, the state is likely to see increased unemployment, a slowing in wage growth and a slow down or decline in revenue growth during any recession.

It is all of that risk that Kalambokidis and her staff consider when considering the state’s reserves. The latest budget reserve report by Management and Budget recommended a budget reserve of 4.9 percent of projected general fund revenues for the current two-year budget period, which translates to $2.3 billion. The reserves at the end of the last biennium, which ended June 30, is $2.075 billion.

‘One of the leaders’

Pew’s Bailey said the old rule of thumb for reserves was they should equal at least five percent of annual tax revenues. Minnesota’s are nearly double that because they are based on two-years of collections, not one. But the Pew researchers also recommend that states look at all of the factors that might be unique to them, rather than simply rely on the 5 percent standard, when it comes to reserves. “The rule of thumb now is that every state has to have its own rule of thumb,” Bailey said. 

Bailey complimented Minnesota on doing revenue stress tests. “In terms of analyzing volatility, Minnesota is one of the leaders,” Bailey said, saying it is “slightly more well prepared” because it has looked into how much is needed in reserves based on different potential scenarios for the next recession. But he also suggested the state broaden those tests, as Utah has done, to look at pressures a recession might place on spending. A spending stress test might conclude, for example, that the state has a higher percentage of fixed costs and might want even higher reserves. 

MMB has reduced the recommended size of the reserve since its last risk assessment, to 4.9 from 5 percent, attributing the improvement to “declining volatility in the bases of the corporate and general sales taxes.”

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In addition to the reserve fund, the state maintains what it calls a cash flow account of $350 million. That fund is there to respond to monthly ups and downs of tax collections and state spending.

Three trends affecting states’ response

Overall, state rainy day accounts have never been fatter, Pew reported, based on data from the National Association of State Budget Officers. Reserves are good because the analysts consider dipping into them the least painful way to respond to economic downturns. Others tactics include tax hikes and spending cuts, each of which come with political and personal repercussions.

Despite that good news, the Pew analysis, “Are States Ready for the Next Recession,” points to three trends that could threaten the ability for states to react to the next economic downturn. 

First, many of the costs facing state governments are fixed, that is, they must be funded under federal mandates and contracts. Medicaid is the largest of those obligations, and it has risen from 12.2 percent of total state spending across the U.S. in 2000 to 17.1 percent in 2016, Pew reports. It’s also a spending area that increases during economic downturns.

Other examples of fixed spending include the Children’s Health Insurance Program; pension payments; and debt service, such as from bond sales for construction projects. “In general, states have more fixed costs in their budgets, costs that no matter what the economy is they have to fund,” Bailey said. 

Another potential trouble spot is in the lingering effect of how states responded to the last recession: with cuts to programs and by reducing the number of employees. While some states have gradually rebuilt those programs and hired back workers, others have not. In fact, total employment in state governments remains down 4.7 percent from 2008, Pew noted, and nearly half of the states are spending less now than before the recession, adjusted for inflation. (Minnesota is not one of them. Only eight states are spending more now than they did pre-recession, and Minnesota’s growth is well above the average of the 50 states.)

While it might seem that being leaner and spending less would give a state government greater ability to survive economic slowdowns, it also means that budget cutters don’t have much room once a recession hits before carving into services many residents consider essential, Pew concludes. The report cites cuts to education as especially concerning, since teachers and parents both have recently called for increases in classroom spending and salaries, leading to disruptive strikes in a number of states.

Finally, many states — Minnesota among them — are heavily dependent on personal income taxes, which tend to see more fluctuations than other major sources of revenue, such as sales taxes. Minnesota collects 53 percent of its $48.2 billion two-year general fund revenue from individual income taxes and 24.7 percent from sales taxes.

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Pew also cites the volatility of tax revenue derived from income on interest, dividends and capital gains that are subject to swings in the stock markets. “Because state revenue growth relies on more volatile sources, policymakers need to plan for steeper declines by accruing more reserves,” its analysis concludes. 

Bailey added that “there are a number of spending-cut tools the state’s needed during the Great Recession that they may not be able to rely on to the same degree.”

Though not among the three biggest risk factors, the report also warns that states could also face a decline in revenue from Washington, D.C. as federal government tries to respond to a slowdown. Federal funds make up 30 percent of the Minnesota’s overall spending.

A good position — or ill equipped? 

Mark Haveman, the executive director of the Minnesota Center for Fiscal Excellence, a nonprofit that studies and promotes “sound fiscal policy,” said the state is in a good position to get through any recession. He said that the reserve account is nearly “topped off” as is the cash-flow account. And by law, one third of any surpluses reported in the upcoming November revenue forecast must flow into the reserves.

“No less importantly, our budget reserve target factors in the state’s revenue system volatility, which is an important feature beyond just the size of the reserve given our reliance on highly progressive income taxation,” he wrote.

In response to the threats identified in the Pew report, Haveman said the state is in a different position than other states. On pensions, he said that unlike states that require automatic payments based on what actuaries determine is needed, Minnesota allows lawmakers to decide when and how much to pay in. That provides flexibility, though he stressed that it doesn’t negate the need to deal with pension funding gaps.

“We will almost certainly face significant budget consequences of this convenient flexibility at some point in the future,” Haveman said. And he said the extension of the medical provider tax, “would prove to be a valuable insurance policy against any recession induced spike in state Medicaid spending.” 

“Ultimately, of course, the nature and severity of the recession determines how unscathed we come out,” Haveman wrote.

Officials from the Minnesota Budget Project, a project of the Minnesota Council of Nonprofits, do have concerns about the reserves, however. Clark Goldenrod, deputy director of the project, expressed worry that the deal that ended the 2019 Minnesota Legislature would result in a drawdown of the state reserves by $491 million in the next biennium if actions aren’t taken to adjust future spending or taxes.

“The United States has had 10 years of economic growth since the last recession,” wrote Goldenrod after the budget deal was passed. “This is uncommonly long, and along with recent projections of slowing economic growth, it’s likely that the next recession isn’t too far away.” 

“The state’s current reserve is not yet to the recommended level to address a common-sized economic downturn and is well short of the types of deficits Minnesota has seen in the past,” Goldenrod wrote. “Reducing the budget reserve by almost one-quarter will leave the state less equipped to respond to a recession, potentially meaning services like job training, food assistance, or health care might not be there with Minnesotans and their families need them most.” 

Clarification: This story was updated to clarify Mark Haveman’s statement on pension funding.