OPM Secretary Melissa McCaw

State income tax revenues surged upward again Tuesday, but this time it was the middle class — not the wealthy — behind most of the gains.

A new report from fiscal analysts projects overall revenues this fiscal year will surpass budgeted expectations by $464 million — an improvement of $204 million from a rosy revised forecast issued in mid-November.

The consensus report from Gov. Ned Lamont’s budget staff and from the legislature’s nonpartisan Office of Fiscal Analysis also anticipates nearly $500 million in additional revenue during the upcoming two-year budget cycle — an average of almost $250 million per year — where multi-billion dollar deficits deficits loom.

But it remains unclear whether Lamont and the General Assembly can spend much of this projected windfall, given stringent new spending cap rules enacted in late 2017.

“The first half of this fiscal year has included strong performance from our major revenue sources — leading to budget surplus projections with an expected and much-needed deposit to the Budget Reserve Fund  — and that strength is reflected in the consensus revenue estimates we are releasing today,” said Office of Policy and Management Secretary Melissa McCaw, Lamont’s budget director. “Nevertheless, we are continuing to watch recent signals in the economy, such as volatility in the markets or taxpayer behavior in response to federal changes, that could impact our subsequent revenue forecasts.”

According to the new revenue report, receipts from the personal income tax — Connecticut’s single-largest source of revenue — have been upgraded by another $75 million since the Nov. 10 forecast.

But unlike most projections over the past 12 months, gains were not registered in the quarterly filings tied to capital gains, dividends and other investment related income.

This time around, the growth was in paycheck withholding, which represents about two-thirds of the overall $9.7 billion income tax revenue stream. And while Connecticut’s wealthiest households pay the bulk of income tax connected with Wall Street, middle-income families are the chief contributors to the paycheck withholding portion.

Former Gov. Dannel P. Malloy and the General Assembly adopted a budget last spring for the current fiscal year and counted on 4.4 percent growth in paycheck withholding — a robust level for a traditional stable source of tax dollars.

But Comptroller Kevin P. Lembo noted in his last monthly budget forecast, issued just after New Year’s Day, that paycheck withholding had been growing during the first five months of the fiscal year, between July and November, by 8.7 percent.

Unemployment in Connecticut fell to 4.1 percent in November, while personal-income growth in the state matched or exceeded national growth for the second consecutive quarter.

The new forecast also upgraded projections for the state’s second-largest source of revenue, the sales tax. Receipts for the current year are projected to come in $79 million higher than anticipated in mid-November.

Analysts also projected modest growth in receipts from the corporation and inheritance taxes. And the state’s share of video slot receipts from the tribal casinos in southeastern Connecticut is not declining as sharply as originally anticipated.

Video slot proceeds, though down from $274 million last fiscal year to $249 million in the latest report, still are running $25 million higher than anticipated in the mid-November forecast.

Building a buffer against the next recession

If the new revenue numbers hold until the fiscal year ends on June 30, Connecticut has a chance to build upon what appears likely to be a record-setting budget reserve.

Income tax receipts, which frequently have fallen short of state officials’ expectations since the last recession ended in early 2010, have been doing the opposite over the past 15 months.

Connecticut held just $212 million in its rainy day fund in January 2018, a cushion of slightly larger than 1 percent of annual operating costs.

Because some of the state’s tax receipts — particularly those tied to investment earnings — vary greatly from year to year, Lembo recommends a reserve of 15 percent.

But over the past 15 months, Connecticut’s rainy day fund has exploded. It now approaches $1.2 billion. In addition, a special “volatility cap” program designed to force the state to save excess income tax receipts tied to investment earnings currently holds $648 million this fiscal year. These funds would be deposited into the reserve this fall.

Much of this growth, though, has been attributed to one-time factors, particularly changes in federal tax policy that led to changes in state income tax payments.

The uptick in paycheck withholding and sales tax receipts, though, typically are viewed as a good sign of sustained economic growth. And they are one of the chief drivers behind the current fiscal year’s budget surplus, which also is on the rise.

Lembo had projected the surplus $242.4 million earlier this month. It now could rise to $446 million based upon the updated revenue projections. If this surplus also is deposited into the rainy day fund, the total could approach $2.3 billion by the fall — a reserve of almost 12 percent.

The largest reserve in state history involved nearly $1.4 billion held in 2008. At the time it represented about 8 percent of annual operating expenses.

Lamont has said he wants to safeguard the reserve as much as possible.

This could put the new governor at odds, though, with his fellow Democrats in the legislature’s majority.

Analysts had been projecting that state finances, unless adjusted would run $1.7 billion in deficit next fiscal year, with the potential gap stretching to $2.3 billion in the 2020-21 fiscal year.

The new forecast estimates Lamont and legislators can expect an additional $260 million in revenue next fiscal year, dropping the potential shortfall under $1.5 billion. Similarly, the latest projections add another $238 million in revenue to the 2020-21 deficit calculations, whittling the shortfall two fiscal years out closer to $2 billion.

“Connecticut should view these numbers with cautious optimism. The numbers affirm that national growth has benefited Connecticut and the policies of our bipartisan budgets are beginning to move Connecticut in a positive direction,” said Senate Minority Leader Len Fasano, R-North Haven on Tuesday. “However, we must remain cautious and not use early signs of growth as an excuse to abandon fiscal restraint.”