Minnesota's $52 billion state budget for the next two years is the largest in state history and pumps more than $1 billion into education and tax relief — a remarkable turnaround after predictions last year that the pandemic would leave the state with a steep deficit.

The spending plan lawmakers passed last week, nearly 10% bigger than the previous budget, allowed both sides of the deeply polarized state government to declare victory.

But higher-than-anticipated tax returns and the sheer scale of federal aid also forced state leaders to make delicate decisions as they face a potential financial drop-off in the years ahead.

"That was a challenge," said House Speaker Melissa Hortman, DFL-Brooklyn Park. "But we had a shared commitment across party lines to invest that one-time money in a way that it wouldn't cause us severe long-term problems when we get to the cliff."

Senate Republicans emerged from the special session trumpeting $1 billion of tax breaks over four years, while Gov. Tim Walz and House Democrats heralded the largest funding boost to K-12 education in 15 years.

But lawmakers — wary of what a COVID-19 variant outbreak or other calamity could mean for the budget — also plan to tuck away cash in the state's reserves. And they set aside $1.15 billion from the federal American Rescue Plan for future use, though $250 million of that is designated to support pandemic front-line workers.

Minnesota is one of many states that has found itself in far better financial shape than it anticipated when the pandemic descended. As of February, the Pew Charitable Trusts reported that 29 states had collected at least as much tax revenue in the previous year as they had in the 12 months before the pandemic hit.

But last summer, economists were warning that Minnesota could face a $4.7 billion deficit in the next two-year budget.

"A year ago in July when the pandemic was just on the upswing, we were envisioning potentially dire, dire circumstances for school funding and quite frankly for all areas of the state funding," said Christine Tucci Osorio, superintendent of the North St. Paul-Maplewood-Oakdale school district. "There was a time when we were actually worried they might take money back they had already allocated to us from last year."

When the state's financial projection this February instead showed a potential $1.6 billion surplus, North St. Paul district officials took a gamble: They decided not to send out layoff notices as some nearby districts were doing. They instead leaned on their savings and hoped the state would be able to help them out.

The gamble paid off. The state was able to make significant increases in its per-pupil funding formula over the next couple of years.

"It offsets a big part of what we were going to have to do by dipping into our savings," said Tucci Osorio, who added she was disappointed that other education funding measures didn't make the cut. She noted the Legislature only funded voluntary prekindergarten for another two years, and she's not sure what will happen after that.

Danielle Twohy, who runs Metro Dance Center in Shoreview, also breathed a sigh of relief over the state's budget deal.

As the pandemic hit, dance competitions were canceled and some recitals moved to Zoom. Twohy started cold-calling banks for a federal payroll loan to keep her 22 dance teachers on staff, though the pandemic had severely limited their ability to do their jobs.

She secured a PPP loan to keep her studio open through the pandemic but panicked earlier this year when she realized the state would tax those forgivable loans unless the Legislature took action to conform with federal tax breaks.

"As business owners we took it in good faith that we weren't going to have to worry about all of these taxes later and to suddenly be in a position when we are waiting and waiting, it was incredibly stressful," Twohy said. "It's a huge relief that it passed and I'm so thankful that the politicians were able to come together."

Looking ahead

The state's ability to channel more cash than anticipated to schools, business owners and many others was not only a result of federal aid, but higher than expected income, sales and corporate taxes. The latest state revenue review shows that as of May, year-to-date tax receipts for fiscal year 2021 were about $2.2 billion more than projected.

Senate Majority Leader Paul Gazelka, R-East Gull Lake, said he had expected a bump in the money coming to state government from tax returns, as federal dollars made their way into Minnesotans' bank accounts and bolstered their buying power.

"The question is, what's it going to be next year and the year after? Because then we don't have that money," he said. "What did we do to increase spending? How are we going to close the gap? That will be a problem for the future."

Before COVID-19, the state had a low unemployment rate and was pulling routine budget surpluses. The economy is rebounding more quickly as the pandemic recedes than it did after the Great Recession in 2009.

The numbers coming in now dwarf the $900 million in federal stimulus aid that the state received a decade ago to boost the economy, said Tom Hanson, who served as former Republican Gov. Tim Pawlenty's budget chief. Back then, he said, the state was in the red and federal funding barely dug them out of their fiscal hole.

"That was a lot of money, but we were 50 feet below water. And then we got some money from the feds and we were only 20 feet below water, but we were still drowning," Hanson said. "It helped but we still had to do other things to fix the deficit. These guys have money to do everything and set some of it aside."

He added that it was smart for lawmakers to hold onto more than $1 billion of the federal funds for the next budget.

Walz said the state is "living within our means," as lawmakers set a structurally balanced budget that leaves money on the bottom line not only in the next two-year budget but in the following years that often are referred to as the tails.

"It's a responsible budget, the tails situation is being monitored," he said. "I do think there will need to be a relooking at some of these really good programs that we compromised and got one-time funding for, to see how do we ongoingly fund those."

Republicans were adamant during negotiations that there be only temporary plans for spending on programs like voluntary prekindergarten. They want to prevent the state from committing to ongoing mandates they might not be able to afford in the future, said Sen. Julie Rosen, R-Fairmont. She warned that there is "somewhat of a false sense of our budget reality" given the amount of federal money juicing the economy.

Rosen, who chairs the Senate Finance Committee, stressed during negotiations the need to add funds to the state's reserves. State leaders decided they will put any budget surplus this November toward restoring $491 million that had been removed from the reserves.

"If interest rates start rising and unemployment doesn't correct itself and we don't get people back to work, you wonder what is going to happen," Rosen said. "I think we need to be very, very prepared."