ST. PAUL — Minnesota’s finance officials announced Thursday that a projected budget deficit has shrunk to $627 million, which is down more than 40 percent from the last estimate.

State lawmakers have less than three months to figure out how to fix it.

The updated economic forecast released by the Department of Minnesota Management and Budget sets the tone for a legislative debate over a two-year budget that starts July 1 and runs through June 2015.

The last forecast, released in December, showed a $1.1 billion deficit, and that’s what Gov. Mark Dayton relied upon to build his budget. He will release a supplemental budget in March to account for the changed projection.

The better news could prompt Dayton to scale back his proposed tax increases.

Legislators have hesitated from plunging too deeply into the budget process until receiving the new economic report.

A new projection for the budget year that closes this June shows a surplus of $295 million. Almost all of it is required to be used to pay IOUs to Minnesota schools, reducing a backlog in deferred payments to $801 million.

Minnesota has lurched from deficit to deficit over the past decade, with only a few years above water. And lawmakers have resorted to temporary fixes to get by. They have delayed school aid payments, borrowed against a tobacco lawsuit settlement and plugged in one-time federal stimulus dollars for programs that require ongoing spending.

Dayton tried a new tack this year with a proposal to raise billions of dollars in new taxes that he argues would add stability to the budget. But it has stirred a firestorm of criticism, largely from business leaders who say it would make the state less competitive. A stream of backers and opponents to the Dayton plan paraded before the House Tax Committee on Wednesday night to weigh in on the debate.

The proposal would impose a new income tax rate for couples on taxable income above $250,000, hike taxes on cigarettes and rental cars, charge higher taxes to Minnesota corporations with overseas earnings and demand tax bills to “snowbirds” who spend most of their year living in another state. But the most controversial aspect is his bid to broaden the state sales tax to services such as haircuts and legal bills, and to clothing purchases that exceed $100.

Dayton has also suggested lowering the sales tax rate from 6.875 percent to 5.5 percent, cutting the basic corporate tax rate, freezing business property taxes, cutting unemployment taxes paid by companies and giving all homeowners a $500 property tax rebate.

The net effect is more than $2 billion in new taxes — half going to erase the deficit and half for new spending on education, economic development programs and other priorities.

Earlier this month, the governor invited lawmakers to tinker with his plan.

“As I see it, we have three basic budget options. Plan A is the one I have proposed, or something close to it. Plan B is to stick with our current tax structure, or something close to it. Plan C is something better,” Dayton told a joint session of the Legislature. “No one would be happier than me to see a good Plan C. I’m still looking and I’m sure listening.”

Whatever the moniker, work on the alternative plan begins in earnest with the budget forecast.