Minnesota has forecast a budget surplus of $1.87 billion over the next two years based on the latest calculation by the office of the state economist. That is good news and is an increase from the $1.06 billion forecast just last November. But the near 80 percent variation in less than four months is instructive.
Minnesota’s budget projections are made by very capable people using the best techniques available. But they are highly dependent on assumptions about the future course of both the state and national economies. And even relatively small shifts in such overall economic activity can have big effects on state finances. So we should proceed with caution before making any decisions about cutting taxes or increasing spending.
Unfortunately, that is not the case. Instead, like the proverbial fools who repeat their folly, politicians of both parties are replaying old scripts from similar situations. Republicans: cut taxes; Democrats: increase spending. What else is new? What else is as bad a mistake?
Remember that we were told we had “a boatload of money” in the late 1990s? Yes, we did. But it was only because the economy was booming at an unsustainable pace under any circumstance. Throw in the 9/11 attacks, wars in Afghanistan and Iraq, and then the worst financial crisis in 75 years and we were in pretty deep fiscal goop.
If we had been responsible at that time, things would have been much easier for the state over the past decade. Instead, we increased spending and passed a tax cut in the exuberance of the “boatload of money.”
The problem is that politicians and the citizens who elect them still don’t understand the idea of “structural” versus “cyclical” budget deficits or surpluses.
Government revenue and government spending both vary with the business cycle — a pattern of boom and bust, expansion and contraction — that has been evident in economies for centuries. Yes, there are situations like now where we run a surplus. But would we continue to have a surplus if the economy slowed down to its long-run-average pace? What about if we went back into a recession, with shrinking output, or even stagnation, a period of zero or very low growth?
If you have a state budget that still has a surplus, even if the economy is running at its long-term trend, neither in a boom nor a bust, then that is a structural surplus, one resulting from the underlying structure of the economy and not on the business cycle. If the surplus disappears as the economy slows, then it was a cyclical surplus, not a structural one.
Ditto for deficits. If you have a deficit when the economy is in the doldrums but that disappears as activity returns to long-run trend, then that deficit is cyclical. But if you still have a deficit when the economy is at that trend, it is a structural deficit.
Minnesota has structured its tax system to accentuate such cyclical fluctuations. We exempt necessities like food and most family clothing from sales taxes. But we do tax cars, appliances, electronics and luxury goods like jewelry and designer clothing.
The idea is that if you lose your job or get hours cut, you don’t stop buying food or new pajamas for a growing 8-year-old. But you forgo a new car, washing machine or flat-screen TV. But because the sales tax is concentrated on such discretionary purchases, its revenue yo-yos up and down much more than overall household spending.
The sales tax is quite progressive, with higher-income people — who buy jewelry and new cars — paying higher rates and providing the lion’s share of total revenue. But the income of this higher-income group depends to a greater extent than average on stocks and bonds or on mega-bonuses. So revenue from the income tax also yo-yos up and down, with a greater amplitude of cycle than the underlying economy.
There also is variation on the spending side, with, for example, the state share of Medicaid rising along with unemployment, together with unemployment compensation outlays.
To economists, the obvious thing to do is establish some mechanism to smooth deficits and surpluses over the entire business cycle. This would involve putting surpluses into a much-expanded “rainy day fund” during booms and drawing down that fund during slumps.
Note that while no economists, even the most dyed-in-the-wool Keynesians, argue for taxing and spending changes at the state level to actually control the economy, there is a consensus that it is not helpful to cut taxes and increase spending during a boom and to increase taxes and cut spending in a slump. These moves tend to make the business cycle more extreme. Smoothing state finances over the whole term of the business cycle would make a positive, even if modest, contribution to stability in the underlying economy.
Insulating control of a larger rainy day fund from political pressure would be crucial. So establish a Federal Reserve-like board of respected elder statesmen and -women to oversee it, one that would be required to certify that a true structural surplus or deficit exists before any changes in taxes or long-term spending be allowed. For Minnesota, names like Dave Durenberger, David Minge, Arne Carlson, Esther Tomljanovich, Jim Ramstad and Alan Page come to mind. Also Bill George, Eric Magnuson and Robert Bruinincks.
Invest the funds in private sector securities patterned on a broad S&P 500 or Wilshire 3000 index and with some range of well-rated bonds. Divide the funds into tiers or tranches, with the criteria for the top tier allowing more flexibility for tax and spending changes and much less flexibility in lower tiers. But make sure that the specified levels in the overall fund be large enough so that it would never run dry over even the most accentuated downturns.
This isn’t a new idea or original with me, I have advocated it for 16 years now and am not optimistic that it will ever come to be. But until we adopt this, or something that has the same functional effect, we are going to be locked into a cycle of giddy spending and tax-cutting sprees when times are good and economically wasteful and often-less-than-transparent “cuts” when times are bad.
Under bipartisan leadership, Minnesota has led the nation in innovative and fruitful fiscal policy changes in the past. We could do so again now.