16 June 2022
In the three months since a state economic and revenue forecast revealed the largest surplus in Minnesota state history, tax collections have continued to come in higher than predicted.
While it isn’t available for spending until it shows up in the next official state forecast in November, monthly tax collections are up $1.3 billion since that record $9.25 billion surplus in February. While national economic news is filled with climbing inflation and a sinking stock market, tax collections continue to exceed expectations.
So why is state economist Laura Kalambokidis so worried?
Kalambokidis, Minnesota government’s top economist for the last decade, said she worries both about looming economic threats and her — and other economists’ — ability to predict what will happen.
Inflation itself is impacting tax collections from higher than projected incomes due to wage increases and higher sales tax revenue due to increased prices, she said. But how the Federal Reserve reacts with increases in interest rates — moves intended to slow the economy — will have their own impact on the economy and tax collections.
The Federal Reserve board voted Wednesday to increase by three-quarters of a percent the rate banks charge each other. That rate influences the rates on other loans such as mortgages, car loans and credit cards and can cool the super-hot economy.
“The Fed is in this very tricky situation of trying to achieve a soft landing, meaning to slow economic growth in order to bring inflation down without triggering a recession,” Kalambokidis said. “And there are so many extraordinary and global risks right now that that’s a hard trick for them to pull off. So the question of can the U.S. achieve a soft landing and what are the risks of a true recession? The risks of a recession have increased since we released our forecast in February.”
At the same time, the state, national and world economies have changed so dramatically that what economists thought they knew isn’t so certain. That mean the types of computer modeling they have relied on for years must be changed — re-modeling the models.
Kalamobokidis isn’t alone. Economists everywhere are struggling with how to predict something that was always difficult to predict.
“We’re remodeling, you know, we’re not just using the same approaches as before,” she said. “We’re trying to figure out as we go. What/how/how do we need to do this differently in order to incorporate all of this risk? So the risk and uncertainty is very different from anything I’ve seen in the years that I’ve been doing this.”
Kalambokidis has been state economist since 2013. “I look back on all those years prior to 2019 or prior to 2020 and how I thought about the challenges of forecasting the economy and revenues in those years. Those challenges were real, but nothing compared to what we faced the last two.”
It’s not that the state is in a bad place economically or when it comes to revenue. The state’s rainy day fund is maxed out at $2.6 billion. The state retains $7.2 billion of the surplus and is projecting additional surpluses in the next biennium. Lawmakers are considering tax cuts and additional spending if the House and Senate can resolve differences in approach and philosophy.
Despite continued increased collections — actual dollars in the state bank rather than predictions — Kalambokidis said she is starting to see softening that suggest the things she worries about might be showing up in the state economy. “We’re starting to see some evidence in the revenue collections that’s consistent with some of the economic risks that we know exist right now,” she said.
One example is in sales tax collections which, unlike income taxes, are more representative of what is happening currently. Those collections were up slightly over forecast in February and March, up by $54 million in April and down by $11 million in May.
At first, inflation that shows up in higher prices increases state tax collections. But if it slows the economy and causes people to buy less, those collections will fall.
“Higher prices, if nothing else changes, can increase revenues,” she said. “But higher prices caused the Fed to try to slow the economy, which then can slow our growth in revenues. It’s not clear exactly where we are in that.”
Minnesota Management and Budget qualifies each monthly revenue report with this warning: “Monthly revenue variances should be interpreted with great caution.” That’s because most state revenue comes from sources that don’t flow on a regular basis, that is, one-12th of a year’s worth each month.
Kalambokidis said that is especially true in the first half of the year, “because a lot of the revenue story is being driven by income tax receipts that are based on the economic activity of the prior year.
“There seems to be a disconnect between the revenue story and what may be going on in the economy,” she said.
Individual income tax and corporate franchise tax collections coming in now are for last year. And some of that higher-than-projected income tax collected comes from capital gains from a hot stock market last year, something unlikely to be repeated this year.
Significant risks and uncertainty
Since the February forecast, the state’s current taxes have produced $2.3 billion more than projected — a 9.4 percent increase over an already robust forecast. But the state is estimating that $1 billion of that reflects a new tax that forecasters are having trouble predicting.
The pass-through entity tax was created to allow some Minnesota businesses to save money on their federal income taxes. Partnerships and so-called S-corporations are businesses owned by individuals. In the past, the income from those businesses passed to the partners who pay individual income taxes on that income. And under the 2017 federal tax changes, all U.S. taxpayers can only deduct $10,000 of state and local taxes from their federal taxes.
By converting that income into a business tax, the full amount is deductible. The change produces no change for the state except that those businesses and their owners file taxes at different times of the year. The businesses may be paying the pass-through entity tax to the state in the first half of the year, but a partner may have filed for an extension on his or her state income tax and might not claim the resulting tax credit until later in the year.
The result is the state is collecting taxes now that it will end up refunding later in the year. Because the tax is new, not just in Minnesota but in the other states that have adopted the scheme to help partnerships, no one is sure how and when money will flow into the state and back out to the partnership’s owners.
What keeps her up at night?
“The risks and uncertainty are much more significant than in the years prior to COVID, prior to the pandemic,” she said. “So in the last two years the unprecedented, unexpected negative shock to the economy from the pandemic, and then the unprecedented and unexpected infusion of fiscal support from the federal government, those things moved the U.S. economy…basing our expectations on history is not making us as comfortable as we used to be because things have changed so much… changed in ways that we haven’t yet figured out.”