Minnesota's financial outlook has dramatically improved one year into the COVID-19 pandemic, with state economists projecting a surplus of $1.6 billion for the next two-year budget.

The sharp economic upswing comes just three months after budget officials predicted Minnesota would face a $1.3 billion deficit in the next budget cycle. Economists said federal relief efforts helped change the economic picture, along with a boost in consumer spending when people got stimulus checks, relaxation of some COVID restrictions and progress on vaccines. The state is also spending less than anticipated, particularly on child care assistance and education.

"While the sun is starting to shine, we are hardly in the clear and we continue to have uncertain times," Minnesota's top budget official Jim Scho­walter said. "We know a lot of this is based upon anticipated federal pandemic response. That money is not in the bank."

Friday's news sets the stage for months of budget negotiations at the State Capitol and adds fuel to a political fight over taxes. Legislators have been clashing over how to address the disproportionate impact the pandemic has wrought on lower-income Minnesotans, a trend highlighted in the forecast Friday.

Gov. Tim Walz proposed a $52.4 billion budget plan in January, which included increased taxes on the top earners and corporations and additional spending on education and assistance for some lower-income families.

The governor will revise his budget based on the new numbers, and then the DFL majority in the House and GOP leadership in the Senate will offer their budget proposals in late March.

But Walz did not back off any of his tax hikes Friday.

"My commitment to a fair, progressive taxation system is still there, but I'm more than willing to find some compromise to make this work," he said.

Republicans countered that higher taxes are not the right answer, particularly as the state tries to recover from the pandemic.

"Raising taxes will slow our economic comeback, and make it harder to bring back jobs and paychecks to where they were before the pandemic," House Minority Leader Kurt Daudt, R-Crown, said in a statement. "We know the Governor's tax hikes will not become law this year, and we can save ourselves weeks of headaches if the Governor and Democrats acknowledge that now."

But Democratic legislative leaders suggested Friday that the state might still need to raise taxes on corporations and wealthy residents. Democrats noted the projection does not account for an estimated $1 billion in inflation.

"Today's forecast is good news, but it's important to recognize that our budget doesn't currently meet the needs of all Minnesotans," House Speaker Melissa Hortman, DFL-Brooklyn Park, said in a statement. "We must pull together and make the investments all Minnesotans need to recover from the pandemic and thrive once it's over."

The pandemic's disparate impact on working-class Minnesotans and small businesses would not be solved by the state taxing "in a regressive fashion" and spending more, Rep. Pat Garofalo, R-Farmington, said during a news conference Friday. Instead, he suggested the state lift COVID-19 restrictions on businesses and stop taxing unemployment benefits and the forgivable loans to Minnesota businesses through the Paycheck Protection Program (PPP).

Senate Majority Leader Paul Gazelka, R-East Gull Lake, said he wants to act on the PPP tax change next week, adding, "We're going to make sure these small businesses that struggled through this whole pandemic, that we have their backs and we take care of them." Walz said he wants to work on a solution for businesses faced with those taxes, although he didn't say whether he supports having the money be fully tax-free.

While the forecast provides an updated starting point for budget planning and tax debates, a key variable in the budget picture remains unknown: When will Congress pass the next coronavirus relief package and how large will it be? A variation of President Joe Biden's $1.9 trillion proposal could provide a boost for the state budget. The state forecast assumes a $1.5 trillion pandemic relief proposal will be enacted by mid-March.

Schowalter cautioned that one-time infusions of federal aid were key factors in the state's expected economic turnaround.

Uncertainty about federal action and the unpredictable nature of the pandemic have challenged economists as they try to gauge the state's financial picture in the years ahead.

A year ago, the state was expected to have a $1.5 billion surplus in the current two-year budget, for fiscal years 2020 and 2021.

That quickly fell as the pandemic set in, with experts instead projecting a $2.4 billion deficit last May.

But with the pandemic hitting lower-income Minnesotans harder, state tax dollars did not fall as steeply as expected. State spending also declined. In the new forecast, there was an expected surplus of $940 million for the budget.

Friday's report detailed the pandemic's toll on the state economy. Minnesota's leisure and hospitality sector alone lost 123,400 jobs between February and December of last year — a 44% decline. Income from wages in Minnesota fell by 0.6% in 2020 but is expected to grow by 6% this year. That drop was not as severe as the 4.8% decline in wages during the last recession. The forecast noted that high unemployment yet a small drop in total wages reflects the pandemic's uneven impact on low-wage workers.

Predictions from the state's economic consultant, IHS Markit, are based on assumptions that the COVID-19 infection and death rates peaked in mid-January and will continue to recede and that there will be widespread vaccination by this fall.

State Economist Laura Kalambokidis stressed that there is still uncertainty about federal funding, what consumers and businesses will do and how soon the virus will be under control.

"We're going to have to continue to monitor it closely," Kalambokidis said. "The path of the pandemic is not done."

Jessie Van Berkel • 651-925-5044

Briana Bierschbach • 651-925-5042