An Interview with Laura Kalambokidis, Professor of Applied Economics and Minnesota State Economist

Tell us a bit about the role of the Minnesota State Economist.  How have graduate students been involved in your work with Minnesota Management and Budget?  

The main responsibility of the State Economist to produce the twice-yearly economic and revenue forecasts for the state of Minnesota. These forecasts determine the size of the state’s biennial budget. So, in a year like this one, when the governor and legislature are constructing a budget for the next biennium, our forecast sets the starting point for that process. When we forecast a deficit for the current biennium, the governor and legislature must adjust the existing budget to bring it back into balance.

I manage a team of three economists within Minnesota Management and Budget (MMB). In addition to the forecasts, we also publish monthly reports showing how actual revenues are coming in relative to our forecasts, and we produce reports showing how accurate our forecasts have been over time. I present the forecasts to the governor, legislature, the state’s bond rating agencies, and the public. It’s definitely a “show your work” kind of job.

Per Minnesota statute, we are required to produce a forecast each November and February. My team starts each forecast month with the most recent outlook for the U.S. economy from a consulting firm. We use the U.S. outlook and Minnesota-specific data for such variables as wages and employment as inputs to a time series econometric model that generates a forecast of Minnesota’s economy. Our ultimate goal is to forecast tax revenues, so our focus with the Minnesota model is to produce estimates of those variables that have the largest impact on tax revenues, such as wages and business income. We then use the forecast variables from the Minnesota economic model as inputs to a microsimulation model of the state income tax system that estimates income tax revenues for the next four to six fiscal years. We repeat some version of this process for the other major tax types, including corporate and sales taxes. That represents a lot of applied research that gets done in a short amount time, twice a year.

As in many areas of government, my office has no shortage of critical policy questions and relevant data. But, we’re a small team, and we lack the time and personnel to pursue every interesting question that could be answered with our data. We have been fortunate to be able to hire University of Minnesota graduate students to work as research assistants in our office during the summer. They have done a variety of applied research projects. In some cases, we have handed the student one of our models and asked them to review, test, and critique it and offer suggestions for improvements. For example, students have reviewed the Minnesota economic model, the capital gains forecasting model, and the estate and trust income tax model. Since my MMB team rarely has time to present our work for review in conferences, it is a great help to get feedback from Applied Economics graduate students. And the graduate students get experience doing applied research that becomes immediately relevant.

Covid-19 made itself known as a pandemic shortly after the Spring revenue forecast.  How did you and your staff respond?

The timing of the COVID-19 economic shock was tough for Minnesota’s forecasting team. We published our February forecast on February 27, based on a U.S. outlook that had been published earlier that month. We knew the potential for a pandemic posed a serious risk to our forecast, and we said so at the time. But macroeconomists were not yet projecting a recession, so there was no recession in our forecast either.

By mid-March, the pandemic and the steps taken to slow its spread had hit Minnesota’s job market hard. During the week of March 21, an unprecedented 116,000 Minnesotans applied for unemployment insurance benefits. In contrast, during the same week last year, only 3,000 initial unemployment claims were filed. Meanwhile, the state’s macroeconomic consultant began drastically lowering their expectations for U.S. growth. While their February outlook—the one that informed our February forecast—projected 2.1 percent real GDP growth in 2020, by early April they were forecasting a 5.4 percent decline.

Official economic data lag our observations about economic activity in our daily lives, which made it difficult in early spring to measure how the COVID-19 crisis was impacting the state. But, the spike in unemployment claims and the deteriorating U.S. outlook meant that Minnesota’s economic growth was in jeopardy, and our February forecast was no longer the best basis for the budget process. In May, we released an Interim Budget Projection—not a full forecast, but an update of major revenues and expenditures for the current biennium. To my knowledge, MMB has never before produced such a projection outside of the usual forecast cycle.

The May projection flipped what had been a $1.5 billion forecast surplus for the current biennium to a $2.4 billion deficit. This was unwelcome news to the many policymakers and interest groups who were developing proposals to spend some of that $1.5 billion. There were enormous uncertainties associated with the projection, but it gave those policymakers and the public their first look at the size of the budget problem that needed to be solved. Since then, we have also released projections for the next biennium. For fiscal years 2022 and 2023, we project expenditures will exceed revenues by $4.7 million, creating yet another budget problem that needs addressing.

How is Minnesota positioned, relative to other states, to deal with the economic crisis caused by Covid-19?

Minnesota’s economy has been rocked by the COVID-19 pandemic. Our economy is closely tied to the U.S. economy, so as long as the U.S. economic outlook remains volatile, Minnesota’s will, too. But we do have some points in our favor. While no industry is untouched by the pandemic and the resulting economic downturn, the impacts have not been uniform across industries.  Minnesota has relatively low reliance on tourism and entertainment—compared to, for example, Nevada or Florida—which insulates the state from the worst of the shocks to those industries. We also have a large share of our population working in professional service jobs that can be conducted remotely. And the persistent assets of Minnesota’s economy—an educated workforce, a high labor force participation rate, a large share of corporate headquarters per capita, and a diverse industry base—remain intact.

From a financial management standpoint, the state has some key advantages. We entered the crisis with AAA bond ratings, a forecast budget surplus, and a $2.4 billion budget reserve. The budget reserve is one of many tools the governor and legislature have at their disposal as they address the projected budget gaps for this biennium and the next.

Minnesota’s budget reserve is the result of a nationally recognized policy that requires 33 percent of any November forecast surplus to be automatically deposited in the reserve until a target is reached. The target is set by my MMB team based on our analysis of the volatility of the state’s revenue system. The principle is this: if the revenue system becomes more volatile, either because the underlying economy has changed or because tax policy has shifted reliance away from more stable revenue sources—such as sales taxes—toward more volatile sources—such as income taxes—our budget reserve needs to grow to ensure against the increased risk to revenue. In the years since the policy was enacted in 2014, Minnesota’s revenue growth was strong enough that allocations to the budget reserve were required in several November forecasts. With the November 2019 forecast, the state’s budget reserve reached the target. And just in the nick of time.

Thank you, Laura.