Report concludes Minnesota’s budget is prepared for the next moderate recession, but tax collections are among the most volatile

A new report from Moody’s Analytics stress tested state budgets to assess how prepared states are for the inevitable next recession.  Minnesota is one of sixteen states with enough reserves on hand to weather a moderate recession.  However, the report also shows Minnesota tax collections are among the most volatile, which means the state will need to contend with a larger revenue dip when the next recession hits.

On a bipartisan basis, Minnesota lawmakers have built the state’s budget reserves up to $1.6 billion since being depleted during the Great Recession.  The state also maintains a $350 million cash flow account, bringing the total funds available for a rainy day close to $2 billion.

That’s good for Minnesota, but the Moody’s report also highlights where Minnesota’s tax policy makes dealing with the next recession more difficult.

One of the key lessons the Moody’s report identifies is that “recessions impact revenues differently than they used to.”  State revenues are now far more volatile and, therefore, far more sensitive to the business cycle than in the past.  Prior to the 2000s, state tax collections were just a touch more volatile than the underlying economy.  But in the 2000s, state tax collections grew to be three times more volatile than GDP.

This means states are now experiencing steeper declines in revenues during recessions.  Why?

Moody’s identifies two reasons.  First, “states are relying more heavily on increasingly progressive personal income tax structures.”   As the report explains, “personal income taxes are much more volatile than sales taxes because they are linked explicitly to personal income and not personal consumption, which proves much more stable over time.”  Making matters worse, states are “relying more heavily on a smaller number of high-income taxpayers for revenue” who have “extremely volatile incomes.”

The second reason states are experiencing more volatility is a “growing use of economically targeted tax incentives.”  By coupling taxes to specific economic activity, state tax systems distort the relationship between taxes and the economy.  According to Moody’s, “this decouples tax collections from the underlying measures of economic growth and can make life extremely difficult for economists and revenue estimators trying to project future revenue collections.”

Each of these volatility inducing tax policies are on full display in Minnesota.  In 2013, Minnesota raised the top income tax rate from 7.85 to 9.85 percent, which is now the third highest rate in the country.  Minnesota’s tax code also includes a wide assortment special tax carve outs.  The number of carve outs increased substantially with the passage of the 2017 omnibus tax bill.

As a result of these policy choices, Minnesota tax collections are among the most volatile in the country.   As the Moody’s report shows, Minnesota’s tax revenues are subject to the tenth steepest drop in a moderate recession.  A number of states with more volatile revenue sources rely heavily on gas and oil revenue, including Alaska, Louisiana, North Dakota, and Oklahoma.  Minnesota’s volatility is entirely self-induced.

Though Minnesota might have a relatively healthy budget reserve, the state’s volatile revenue system does increase the risk of a more severe shortfall and will impose more stress on the state budget when the next recession comes around.  Minnesota’s high income taxes already creates a less competitive business climate.  Here’s yet another reason to dial down these rates.