Minnesota’s budget surplus grew to $19 billion, but new law requires accounting for inflation

Had Gov. Tim Walz’s budget office presented the latest economic and revenue forecast one week ago, it would have reported a $19 billion revenue surplus.

But when Minnesota Management and Budget Commissioner Jim Schowalter walked to the podium Monday, he revealed a surplus of $17.5 billion.

What changed in one week to reduce the reported surplus? Did state tax collections plummet from previously robust levels? Did some new spending priority gobble up a billion and half dollars? Did a long-expected but never-quite materializing recession slam the state and its finances?

None of that happened. Tax collections, in fact, are up — again — in the three months since the last forecast. And while some spending bills have passed and been signed by Walz, they total only about $113 million.

Instead, the difference is that Walz signed House File 35, a bill that passed mostly with DFL votes that changes how inflation is recorded in budget forecasts. In November, the forecast included an estimate that inflation could make running the government more expensive by $1.5 billion. In February, that same $1.5 billion estimate was brought above the line and added to projected spending for the next two years.

Long term budget outlook from the November 2022 Economic Forecast

Long term budget outlook from the February 2023 Economic Forecast

That accounting move means that rather than showing a $19 billion surplus with a potential inflationary impact of $1.5 billion, the forecast showed a $17.5 billion surplus that assumes the state will spend an extra $1.5 billion on existing programs because of inflation. The only reason the surplus appears unchanged since late last year even after that inflation accounting change is that the state, once again, missed on its forecast of how much current taxes will bring in by … about $1.5 billion.

Inflation was removed from the spending forecast 20 years ago but MMB has included its estimates as an addendum to the forecast.  

Walz and DFL legislative leaders greeted the Monday forecast as status quo — no change — from November. Republicans saw it as an even larger surplus.

Neither party changed its rhetoric. A buoyant Walz said the surplus creates historic opportunities to invest in programs that help families and to provide one-time checks to middle and low-income residents.

“I think there is strong agreement among Minnesotans: Get us some of this money back, reduce the costs for us, invest in the things that build this state, get your work done on time and then go home,” Walz said.

Senate Minority Leader Mark Johnson said much of the surplus should be returned to taxpayers.

“The numbers right now look pretty even from what the November forecast was but we should be cognizant of the inflationary effect that is built into that,” the East Grand Forks Republican said. “If you add in that $1.4 billion, we’d have a $19 billion surplus. That’s how it would have been reported last week had the governor not signed the bill.”

But the money comes from taxpayers, he said, and the Senate GOP is preparing a batch of tax cut proposals that will include a full elimination of state income tax on Social Security.

“That’s our main focus. Not government growth. Not special interests. But Minnesota families,” Johnson said.

The forecast bottom line is this: The state projects it will collect $60.8 billion from current taxes in the two years starting this July. Existing spending programs, plus inflation, would consume $55.5 billion of that. The difference, plus a leftover surplus from the previous biennium, results in about $17.5 billion. And with these numbers now official, legislative budget and taxing committees will soon get spending targets and draft budget bills to come in within those targets.

Those targets are due by the end of March. Adjournment is the third Monday of May.

But just as officials explained in November, more than two-thirds of the surplus is considered one-time money. That is, it is accumulated from taxes collected over the past two years that were likely driven by massive federal spending in the state via three pandemic relief laws. MMB estimated a year ago that $73 billion flowed to the state in extra unemployment benefits, rebate checks, cash for state and local governments and help for businesses.

Prior to the pandemic and the economic impacts of federal spending, a $1.87 billion surplus was the largest the state enjoyed in 15 years. After a forecasted deficit two months into the pandemic, surpluses began to grow: $635 million in November of 2020; $1.7 billion in February of 2021; $7.75 billion in November of 2021; $9.25 billion in February of 2022 and $17.6 billion in November of 2022.

The latest forecast projects that the state will remain in a positive budget condition for the two-year budget period that begins in July 2025. But that surplus will only be $5 billion, leaving Walz and legislative budget writers with the task of spending in ways that don’t commit the state to ongoing obligations. Walz’s continued support for rebate checks is driven by that desire — to return money to taxpayers without reducing tax rates that would impact future budgets.

“Minnesota’s strong financial health will allow us to deliver meaningful change for working families across the state,” Senate Finance Committee Chair John Marty said Monday, adding that the one-time spending “requires a strategic approach as we build a responsible budget for today and the future.”

Some in the DFL coalition are renewing calls for tax increases on corporations and high-wage earners. Marty has a bill that would add a fifth income tax tier for wealthy individuals. And Walz referred to a chart in the MMB presentation that showed that corporate profits increased quickly during the pandemic, growth that is now projected to slow. Those increased corporate profits have already been taxed and are one factor in the size of the surplus.

“That’s the piece about fairness, about trying to capture some of that and reinvest back in,” Walz said. He has only proposed an increase in the capital gains tax, not the individual income tax or corporate profits tax.

Recession, what recession?

The one discouraging word during the Monday presentation was that the state is still expecting a brief recession. But state economist Laura Kalambokidis described it using an unfamiliar term — an “investment-driven recession” — that would be brief and shallow and end by the third quarter of this year.

What’s an investment-driven recession?

“The cause of the recession isn’t consumer spending,” she said. “It is investment, and in particular residential construction and inventories.”

What consumers spend is two-thirds of the nation’s gross domestic product, Kalombokidis said. And usually when a recession is expected it is because economists think consumers are going to pull back on spending, she said. 

“That’s not what is expected to happen here. Consumer spending is expected to remain solid. But what is expected is reduced business investment and reduced investment in residential construction. The parts of the economy that are interest-rate sensitive.”

When the Federal Reserve increases interest rates to try to bring down inflation, it affects those sectors, and their reductions in activity will lead to a short recession, Kalambokidis said. 

According to the updated forecast released Monday, “the recession is shorter, starts later, and has a smaller decline in real GDP and a lower peak unemployment rate than in the prior forecast.”

Minnesota is among the states with the lowest unemployment rate and the highest labor participation rate, that is, the percentage of workers who could work who are holding jobs.

“There is a high demand for workers across the state with only about four unemployed job seekers for every 10 job openings,” she said. “This means there is little slack in Minnesota’s labor market compared to other parts of the country.”