Despite an improving economy, a new budget forecast shows that Minnesota will face a $1.1 billion deficit by this summer.

While Minnesota will finish the current fiscal year with a surplus, rising costs and the expiration of one-time budget shifts are expected to wipe out those gains during the two-year budget period that begins July 1.

"We're worse off than we should be and could have been if we had responsible budgeting in the previous two years," Gov. Mark Dayton said Wednesday. "The years of previous fiscal irresponsibility are now landing on our heads."

The state's budget woes could worsen if Washington leaders don't find a way to avoid the so-called fiscal cliff by January. Without a new agreement, a severe menu of tax hikes and budget reductions will start in January state forecasters estimate could immediately spike Minnesota's deficit to $2.8 billion. Minnesota companies, they said, could shed thousands of workers, corporate profits would sink and consumer spending would fall, possibly plunging the state and nation into another recession.

State Economist Tom Stinson described that scenario as "ultimate gloom." Nevertheless, he said, "there's no reason for us to have a recession in 2013 or 2014. If we do, it will be self-inflicted. But that doesn't mean we won't have one."

The new budget number now becomes the foundation of the budget and tax proposal the DFL governor will present next month, when Democrats officially take power in the House and Senate and begin charting their course for the state -- one likely to include proposals for more tax revenue.

Republican Sen. David Hann, the incoming minority leader, said Democrats are looking at the forecast and making the wrong diagnosis. "We don't think we need new tax increases," said Hann, R-Eden Prairie. "Maybe it's even time to talk about tax cuts as a way to stimulate the economy."

The improving economy, reduced costs and a mix of one-time budget shifts will allow the state to end the 2012-13 biennium $1.3 billion over projection. By law that money must go to pay down the $2.4 billion borrowed from public schools. With the new deficit projection, there is no immediate plan to pay back the remaining $1.1 billion unless legislators specifically earmark the money in the upcoming budget.

The twice-annual economic forecast takes into account an array of indicators, including local economy, national economy, even the financial instability spiraling throughout Europe. But with the politically created fiscal cliff looming, forecasters warned that already fuzzy budget projections are even more uncertain than is normally the case.

Poised for growth

Forecasters predict that the national economy is primed for significant growth, with low interest rates and flush corporate balance sheets. Economists say the housing and auto sectors are "poised for a breakout."

Minnesota's economy already is doing better than many parts of the nation. The state's unemployment rate is hovering around 5.8 percent, about 2 full percentage points better than the national average.

Forecasters say they finally see some encouraging signs in Minnesota's ailing construction sector, which endured the worst of the last recession and suffered the most stubbornly high unemployment rates.

"We are expecting the housing sector to begin to turn around and begin to grow over the next couple years," Stinson said.

He also noted that a new budget in Washington could unleash a torrent of pent-up spending and give a notable boost to the economy in Minnesota and the nation.

"One can imagine increased business spending and increased business hiring once they knew what the rules could be," he said.

Budget officials note that the number of new workers entering the workforce has slowed more than expected and that many continue to hold jobs below their skill level, which drives down wages and masks larger problems in the workforce.

"The economy is a little weaker than we thought it would be last February. Not a lot weaker, but a little weaker," Stinson said.

The forecast shows that budget reserves will swell to nearly $1 billion, but that state leaders will continue to face a stubborn imbalance between expenses and revenue collected.

"The structural imbalance is the underlying story," said Minnesota Management and Budget Commissioner Jim Schowalter.

Forecasters expect state spending in the next two years to be $100 million less than earlier estimates, with the deepest reductions in health and human services. The savings come in lower than anticipated health care costs for low-income families with children and fewer people than expected enrolling in state-subsidized care.

The Affordable Care Act, President Obama's hotly debated health care overhaul, will cost the state an additional $163 million over 2014 and 2015. The state's share of the federal health care act actually requires less money from the general budget, but more from a separate account called the health care access fund. That fund is paid for in part by a tax paid by physicians, hospitals and insurance providers.

Stadium lag

Forecasters predict a 51 percent shortfall in new electronic pulltab revenue to pay the state's share of the new Minnesota Vikings stadium. That revenue is expected to tick up as more establishments switch over to electronic pulltabs.

Bob Hume, a Dayton spokesman, said the lower revenue collection was the result of the pace at which a brand-new technology was being put in place, not any underlying problem with electronic gaming as a source of revenue. Hume said that there is no reason to assume revenues won't meet expectations once electronic gaming is fully implemented and that a contingency reserve fund would cover any shortfalls in the meantime.

The forecast already is sharpening the budget debate at the Capitol as both sides dig in over taxes and spending.

Dayton and some of his top administrators have spent months touring the state working on the most significant tax overhaul proposal in 25 years. The governor said he prefers new revenue to deeper cuts in the health and human services and higher education budgets, which have been hit hard by previous reductions.

"I'm not proposing to raise taxes on all Minnesotans. I'm proposing to raise taxes on the wealthiest 2 percent," said Dayton.

Republicans say the strong financial finish of the past two years vindicates their refusal to raise taxes. They say it caused hard choices, but kept more money in taxpayers' hands.

"What we heard today in the briefing was good news," incoming House Minority Leader Kurt Daudt said. "If the Democrats are looking at this document as some sort of evidence or reason for increasing taxes, they're not going to find that here."

DFL legislative leaders say a budget shortfall during a relatively strong economic time is prime evidence the tax system is amiss.

"Our state budget has been on a roller coaster of deficits for the past decade," said incoming House Speaker Paul Thissen, DFL-Minneapolis. "Our success," he said, must be judged on building a budget that "is fair and is stable and that promotes the long-term innovation and prosperity and opportunity for all Minnesotans."

Baird Helgeson • 651-925-5044