Dump the 'inflation bias' in state budget forecasts

After several years of serial budget crises, Minnesota now enjoys an enviable budget position. The budget forecast released last week projected a surplus for the end of the current biennium (June 30, 2015) of $1.2 billion — even better than the preliminary forecast released in early December.

The good news extends well beyond the current biennium. The planning estimates show a huge surplus of $2.6 billion at the end of the next biennium (June 30, 2017).

In substantial part, the improvement in Minnesota's fiscal fortunes reflects ongoing growth of the U.S. economy. The national economy remains far below potential, but its steady, if unspectacular, growth has been very good news for the states, including Minnesota.

In addition, Gov. Mark Dayton and the Legislature deserve credit for helping to make this turnaround possible.

One should also acknowledge the contribution of Minnesota's budget forecasting process — which hardly any Minnesotans are aware of. Minnesota Management and Budget's staff has a well-deserved reputation for careful, nonpartisan analysis of expenditures and revenues. This staff is assisted by an advisory group of private-sector economists — grandiloquently called the Minnesota Council of Economic Advisors. (Full disclosure: I have been a member of the council for many years.) The council has a key responsibility: It must approve the assumptions about the U.S. economy that are input into the Minnesota budget forecast. If the U.S. forecast is deemed reasonable or too pessimistic, it will serve as input for the budget forecast. If the council considers it too optimistic, a more cautious forecast will be used instead. This builds an element of caution into the budget forecasts. The council's deliberations are open to the legislative leadership of both parties and their staffs — which enhances the transparency of the budget forecasting process.

Thus, Minnesota can be proud, not only of its predicted budget surplus, but of the careful, nonpartisan analysis that puts the numbers together.

However, all is not well.

The reason is that the official numbers for the planning estimates incorporate expected inflation in the revenue projections but not in the expenditure projections. This results in a large underestimate of expenditures in the next biennium and a corresponding overestimate of the surplus.

The bias is deliberate. In 2002, the Legislature passed a law requiring the official planning estimates to exclude inflation from expenditure projections.

Current inflation is extremely low by historical standards, but nevertheless the impact of the bias is huge. According to the most recent forecast report, proper adjustment for inflation would reduce the projected surplus in the next biennium by over a billion dollars, to $1.5 billion.

Inflation probably will accelerate sometime in the future, and when it does, the inflation bias in the planning estimates will balloon.

Every year since the introduction of the inflation bias into the planning estimates, the council has criticized the practice. The reason is simple. Deliberately inflating surpluses (or understating deficits) is inconsistent with sound business and governmental practices. Publishing a biased number potentially encourages legislators and the public to regard the state's financial position more optimistically than the facts warrant. Sound budgeting is hard enough with high-quality numbers; it is vastly harder with distorted numbers.