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By David Bailey

MINNEAPOLIS (Reuters) - Minnesota's Democratic governor and Republican legislative leaders failed to reach a budget agreement on Wednesday but said they would continue to negotiate, one day before a possible state government shutdown.

If they cannot agree on a budget by midnight on Thursday, or agree to some kind of extension, all but the most critical Minnesota services will shut down for the first time since 2005, including state parks for the July 4 weekend.

Governor Mark Dayton and top Republicans from the state House and Senate met several times on Wednesday and House Majority Leader Matt Dean sounded an optimistic tone after talks between the leaders ended for the night.

"We are very very close on many many areas and we still believe a shutdown is unnecessary and avoidable," Dean told reporters. "We believe that at this point it would be very difficult to explain a shutdown."

Dayton's staff and the legislative leaders continued to meet separately late Wednesday and suggested that meetings were likely on Thursday.

"We are continuing to work on a solution," Dayton's spokeswoman Katharine Tinucci said. "We are continuing to work on it tonight and tomorrow."

Dayton and legislators have only agreed on an agriculture bill approved during the legislative session that ended in May. Republican Deputy Senate Majority Leader Geoff Michel told reporters there was good progress made on the health budget.

"We have over the course of the last several days made substantial progress on nearly every bill, nearly every budget bill that remains outstanding," Michel said.

Dayton and the Republican-led legislature have been far apart in their public positions over a two-year budget plan to close a $5 billion deficit. Both sides have said they would prefer a deal to a shutdown.

Dayton's first budget proposal included an income tax increase on the wealthiest state residents and an expansion in overall spending. Republican leaders first sought some tax cutbacks in aiming to halt spending.

On Wednesday, Ramsey County Chief Judge Kathleen Gearin ruled that only the most critical services could be provided during the shutdown. Gearin appointed retired Minnesota Supreme Court Chief Justice Kathleen Blatz as a "special master" to manage any issues raised during a shutdown.

Barely 13,000 of Minnesota's 36,000 state employees would continue working into the new fiscal year on July 1 to provide essential services from prison staffing to state police patrols, nursing and veterans homes among other programs.

State spending on road and bridge programs would have to halt with the shutdown, with funding permitted only on projects to prevent an imminent bridge collapse or in response to a road emergency, Gearin ruled.

The Minnesota Zoological Garden would be closed to the public but allow staffing to feed and care for the animals.

Other state and federally administered programs would operate including food stamps, Medicaid and temporary assistance to needy families.

The executive and legislative branches of government also were core functions, Gearin found. In a separate proceeding a different judge ordered that the courts remain open as well.

In addition to state park access, the sale of fishing and boat licenses and other permits would be suspended and state trails and public water accesses will not be maintained, the state Department of Natural Resources said.

(Reporting by David Bailey. Editing by Greg McCune)

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