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Responsible Budget Forecasting Should Acknowledge Reality

September 20, 2010 By Jeff Van Wychen
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By Jeff Van Wychen
Minnesota 2020 Fellow
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Back in 2002, House Majority Leader Tim Pawlenty and Senate Majority Leader Roger Moe were gearing up for runs for the governor's office. However, a looming budget deficit anticipated for the upcoming biennium was a liability for both leaders. Neither man wanted to run for the state's highest office with the state's long-term budget deep in the red.

The bipartisan solution was politically shrewd but fiscally imprudent.  They decided to ignore inflation's impact on most state expenditures, thereby artificially reducing spending so that in no longer exceeded revenue.  Through this accounting maneuver, the state budget for that upcoming biennium was balanced.  Mission accomplished.

Experts immediately noticed that the "solution" to the looming deficit problem did not pass the smell test.  While the state ignores inflation for most expenditures, it continues to include inflation on the revenue side of the ledger.  For example, the official state budget forecast considers inflation's role in driving up state sales tax revenue, but ignores inflation on the cost of things the state purchases.

By counting the impact of inflation on revenues but not on expenditures, the official state budget forecast understates deficits (or overstates surpluses).  By understating deficit size, the official state spending forecasts for out-biennia serve primarily as a propaganda tool for those who habitually argue that the state does not need to increase revenues.

The most recent forecast update from May 2008 can be used to illustrate the effects of ignoring inflation's impact on state expenditures.  The official state structural deficit (i.e., the gap between current resources and total spending) for the FY 2010-11 biennium is more than one billion dollars-or just over 50 percent-less than the realistic deficit that takes into account inflation for both the revenues and expenditures.  Updated state budget information will be available later this week when the next forecast is released.

Governor Pawlenty has defended the practice of ignoring inflation, arguing that he does not want to place the state budget on "auto-pilot."  In making this argument, the Governor is confusing forecasting and budgeting.

Budgeting is the act of setting future revenue and spending levels.  As such, budgeting is a political process, which involves weighing competing goals and priorities.  No one is arguing that the state should automatically include inflation when budgeting future expenditures.  Decisions whether future government spending should be at, above, or below the rate of inflation should be made by elected representatives in the rough-and-tumble political process.

Forecasting, on the other hand, is (or at least should be) a technical process, driven by objective information and sound methodology.  The goal of forecasting is to accurately determine future revenue and expenditure levels based on current law.  Ideally, forecasting is not driven by subjective preferences, but by objective realities.  Inflation is one such objective reality.  The failure to consider the reality of inflation on state expenditures is not an act of frugality, but of willful ignorance.

Acknowledging inflation's impact on state spending will not place the state's budget on "auto-pilot," as the Governor asserts.  Simply acknowledging reality does not mean that state government must provide inflationary increases in all parts of the state budget.  However, Minnesota can best prepare for the future if we know the inflationary pressures we will be facing.  When it comes to responsible planning, ignorance is not bliss.

For example, suppose a business owner who makes widgets is anticipating his costs for the next year.  Further suppose that the business owner knows it is likely that the cost of his raw materials will inflate by three percent.  In this situation, the business owner would have two alternatives.

The business owner could simply pretend that inflation will not occur.  This will leave the owner in the avoidable predicament of having to take stop-gap measures when the anticipated inflation actually materializes.

The more rational alternative would be for the business owner to make preparations based on the reasonable expectation of inflation.  Based on this information, the business owner could weigh his alternatives-increase prices, seek cheaper substitute materials, or some combination of these and other alternatives.  Regardless of the business owner's ultimate decision, the responsible planning process begins by acknowledging reality, as opposed to ignoring it.

Experts in public finance have long recognized the folly of failing to prepare for the reality of inflation.  In testimony to the Minnesota Senate Finance Committee, John Gunyou, Finance Commissioner under Republican Governor Arne Carlson, and Jay Kiedrowski, Finance Commissioner under DFL Governor Rudy Perpich, noted the inanity of "counting inflation for future revenues, but ignoring it for future costs."

The Minnesota Council of Economic Advisors, a respected group of non-partisan economists who advise the state on economic issues, has favored taking inflation into account in the state's expenditure forecast.  As reported by the Minnesota Department of Finance in a recent forecast document "The Council continues to believe that projecting future expenditures without making any allowance for inflation except where required under current law understates the severity of the financial problems the state will face in future biennia."

To the credit of professionals in the Department of Finance, the inflation-adjusted expenditure forecasts are reported within the back pages of the Department's forecast document.  However, the official deficit forecast-which ignores the impact of inflation on most state spending-is the amount emphasized in the Department's summary and is the amount that the media latches on to and is ultimately the only amount that most members of the public see.

Progressives need to keep in mind that the state deficit amount for the FY 2010-11 biennium reported most prominently will likely be based on the official forecast amount and thus will understate the full magnitude of Minnesota's budget woes.  The real deficit that properly factors in inflation will be approximately one billion dollars-give or take several hundred million-greater than the official deficit.

In recent years, Governor Pawlenty has blocked attempts to restore integrity to state forecasts.  Responsible fiscal planning is best served when forecasts are based upon reality, as opposed to willful ignorance.

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