• Economic growth is expected to continue at a slow rate over the next few years.
• State revenues follow that trend; though General Fund growth will be lost to diversions due to the 2015 road funding package.
• The risk of a recession looms; a decline would be particularly troublesome for the General Fund.

The forecast from January’s Consensus Revenue Estimating Conference (CREC) last Friday was not as gloomy as the the weather outside. Economists from the University of Michigan, the State Budget Office, and the fiscal agencies shared their projections for Michigan, and all indicators suggest the current recovery will continue and the state will experience economic growth for at least the next few years.

That’s the good news. But even with strong economic growth, slow state revenue growth is expected to continue. Combined General Fund and School Aid Fund revenues are expected to decline from Fiscal Year (FY)2018 to FY2019, and are projected to grow at less than 2 percent in FY2020 and FY2021. All parties acknowledged that, while the data shows continued growth, the possibility of the next recession is looming in the background.

Uncertainty in economic projections

The CREC forecasts this slow growth to continue for the next few years. If growth continues through July, this will be the longest period of economic expansion in U.S. history. But there was a constant note in the discussion; recessions are notoriously hard to predict. Markets can be fickle, and many external factors, like trade policy, a partial government shutdown, or international economic problems, can contribute to an unexpected reversal. We are most likely closing in on the next recession.

As a result, these projections are likely on the optimistic side. Even if the national expansion continues, the growth rate is projected to slow down somewhat over the next few years, a sign we are nearing the end of the cycle. Any changes could have significant ramifications for the state budget. While the School Aid Fund is projected to see growth above 2 percent, the story is different for the General Fund.

Potential troubles in the general fund

By all accounts, revenues flowing into the state’s General Fund experienced strong growth in FY2018. Net revenues increased by 7.4 percent over the previous year, bringing the fund total just below $11 billion. But the next several years do not look nearly as bright. FY2019 General Fund revenues are expected to drop by almost $250 million and slowly recover over the next couple years. The fund is not projected to reach and exceed the $11 billion mark until FY2022.

Now, much of the decline is due to previously agreed-upon revenue diversions; particularly, redirecting a portion of the Income Tax to highway spending and an increase in the Homestead Property Tax Credit as part of the 2015 road funding package. The revenue diversions account for a large portion of would-be General Fund growth (baseline revenues are projected to grow by about $600 million between FY2018 and FY2021).

This leaves the General Fund in a particularly precarious position if the next recession does hit sooner than later. General Fund revenues are primarily driven by the Income Tax. Around 70 percent of General Fund revenues come from the Personal Income Tax, while others, like the Sales Tax, are primarily dedicated to specific purposes. That means the majority of the state’s discretionary funding comes from one revenue source, and one that has shown to be particularly volatile during the last two recessions.

For example: during the Great Recession, Income Tax revenue dropped 24 percent from 2008 to 2010. In the same time period, Sales Tax revenues only dropped 10 percent. Prior to that, during the state’s decline in the early 2000s, Michigan’s Income tax revenue dropped 20 percent from 2000 to 2003. In the same period, the state Sales Tax actually grew by 1 percent.

In addition, the General Fund’s reliance on the Income Tax has increased over time. It used to only represent around 50 percent of General Fund revenues. The reduced revenue from other tax sources is a result of several factors, including reduced business tax revenues and a diversion of a portion of the Use Tax revenues from Personal Property Tax reform. Hence, the importance of the Income Tax has actually increased for the General Fund since the last two declines.

It is important to note that not all recessions have led to such a drastic fall in Income Tax revenues; during the downturn in the early 1990s, revenues declined by only a single percentage point. So there is evidence that a recession would not necessarily mean significant revenue decline. However, road diversions are planned to scale up until FY2021 (with $325 million in FY2020 and  $600 million in FY2021), even a zero-growth scenario for the Income Tax likely means that net General Fund revenues would fall over the next couple years.

Projections from the CREC are in line with what we’ve explained in the past; even under good conditions, General Fund revenues will be tight in the coming years. And with inflationary pressures, declining revenue, continued diversions, and increased spending needs caused by a downturn, a recession could lead to significant challenges in the state’s discretionary budget. This could also add pressure to the School Aid Fund, as it could act as a safety valve to prevent broader General Fund cuts.