State’s fiscal woes have no easy answer
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ISER economist reviews the nature of the problem and discusses the options for closing the gap between expenditures and revenues
ALAN BAILEY Petroleum News
As oil prices tumble and with them the potential solvency of the state of Alaska’s finances, a heated debate is emerging over both the extent of the problem and the means of putting the state’s fiscal position back onto an even keel.
On Dec. 7, during Law Seminars International’s Energy in Alaska conference, Gunnar Knapp, director of the Institute of Social and Economic Research at the University of Alaska Anchorage, provided a factual and objective overview of the state’s fiscal situation and the various possible options to deal with the state’s financial problems.
“Our state faces an extremely serious fiscal challenge,” Knapp said. “We are spending this fiscal year well over twice the revenues that we’re bringing in, and we are paying for this deficit in our spending by drawing down our savings.”
Unsustainable deficits In the past three years the state has drawn down its savings reserves from more than $16 billion to $7.6 billion: Continuing deficits at current levels could drain those reserves completely in two to three years, Knapp said. With budgeted spending for the current financial year amounting to $5.2 billion, in the absence of some additional source of state revenue nearly $3 billion of this expenditure would need to come from savings. But the revenue level in this calculation assumes an oil price of $66 per barrel - the current price of $42 will make the deficit even larger.
“You can’t continue with deficits of this magnitude for very long,” Knapp said. “We will have to … close the funding gap between our spending and our revenues.”
Closing the gap will require some combination of spending cuts, new state revenue sources and the use of earnings from the Alaska Permanent Fund, Knapp said, adding that there are no easy or popular choices to be made. And, while the use of the state’s savings can enable a deferral of the hard choices for perhaps a couple of years, the longer the decisions are delayed the worse the problem becomes, given the resulting erosion of state savings and the increasing risk to the state’s credit rating and investor confidence.
People need to question whether the state’s current savings are to be used to “keep the party going for a few more years,” or whether they should provide benefit for future generations of Alaskans, Knapp commented.
The fundamental challenge The fundamental challenge for the state of Alaska is that 90 percent of its income currently comes from oil revenues, while the state’s oil production is falling and the state’s population is rising.
“You can’t go on indefinitely paying for almost all of state government for a larger and larger population from ever declining oil production,” Knapp said.
Moreover, state oil revenues are extremely sensitive to the oil price. And with the current bust in that price, much of the state’s income has evaporated. However, with the sensitivity to oil prices being lower below an $80 oil price than above that price level, it would take a price rise to above $80 to create a major increase in income to the state treasury, Knapp said. And there is no oil tax regime that could restore state oil revenues to the levels of a few years ago, he said.
To put things into perspective, even at the assumed $66 oil price, the projected state deficit is huge, amounting to around $4,100 per Alaska resident, Knapp said. In fact, just giving up the entire permanent fund dividend this year would solve less than half of the problem, he said. At the same time, simply hoping that oil prices will go back up again is neither a realistic nor a responsible approach to meeting the fiscal challenge, he said. Even a price rise to around $70 to $90, a price level at which much oil production becomes profitable, would leave revenues well short of expenditure. Moreover, declining North Slope oil production will likely continue to put downward pressure on oil revenues.
What are the options? So what is the state’s current annual expenditure of $5.2 billion being used for? And what scope is there to trim back the state budget?
Given the barebones capital budget, already cut in response to the fiscal crisis; and given the impossibility of cutting state employee retirement commitments or of cutting debt servicing payments, future cuts will need to come from oil industry tax credits, currently budgeted at roughly $500 million, or from the operating costs of state departments, Knapp said.
Education funding and expenses for health and social services are by far the two biggest line items in state departmental spending, he said. And much of this spending is driven by spending formulas. Education funding predominantly includes K through 12 schooling, while health and social services include Medicaid and services for addressing some of the ills in our society.
“These things are not easy to cut,” Knapp said, commenting that there will be considerable scrutiny of the oil tax credits, especially given the legal mandates surrounding state support for services such as education.
Other significant budget items include the University of Alaska, the Department of Corrections and the Department of Transportation.
Cuts not enough Moreover, with the deficit being more than half of current spending levels, spending cuts by themselves are extremely unlikely to solve the problem, Knapp said.
On the other hand there are several ways of addressing the state’s fiscal problem through increasing state revenues. Options include the introduction of a state income tax; the introduction of a statewide sales tax, increasing fishing or mining taxes; or tweaking oil production taxes. But none of these options either individually or together would provide sufficient income to close the fiscal gap, Knapp pointed out.
So, given the improbability of closing the gap through cuts in expenditures or raising new revenues, there is much interest in the potential to use earnings from the Alaska Permanent Fund to bolster state income, Knapp said. This year the Permanent Fund earnings have been greater than the state’s oil revenues, he commented.
“How could your largest source of revenues be off the table in any discussion about your fiscal options?” he asked.
Moreover, while oil revenues can be expected to decline over the years, as oil production drops, earnings from the Permanent Fund can be expected to grow.
Permanent Fund earnings There are several possible mechanisms by which Permanent Fund earnings could be channeled into the state’s general fund, for state use.
In the simplest approach, the state Legislature could simply vote to appropriate some of the earnings.
As an alternative, it could be possible to scrap the payment of Permanent Fund dividends from the fund’s earnings reserve account, as at present, and instead pay out annually a combination of state revenues and Permanent Fund dividends as some set percentage of the total market value of the fund. This approach commonly used by large endowment funds and referred to as percent of market value, or POMV, approach, would require a constitutional amendment but would result in a relatively stable payout. However, the POMV approach was proposed in the late 1990s and at that time was resoundingly rejected by the Alaska electorate, Knapp said.
A bill, SB 114, recently introduced for consideration in the state Legislature, suggests a different approach in which dividends for Alaska residents would be paid as a percentage of oil royalties, rather than from Permanent Fund earnings. The remainder of the royalties would go into the Permanent Fund. All of the earnings from the Permanent Fund would then be available for use as a source of state revenues.
The Walker administration has proposed a more radical overhaul of the Permanent Fund arrangements, converting the fund into what is referred to as a sovereign wealth fund. As in SB 114, residents’ dividends would be paid as a percentage of oil and gas royalties, rather than coming from the Permanent Fund. The remainder of the royalties, together with oil and gas taxes, would go into the Permanent Fund, with a fixed payout from the Permanent Fund then being transferred each year into the state’s general fund for state government spending.
Under the administration’s proposal, however, the dividend payout would be set at a lower level than in SB 114.
Alaska has options So, despite the angst over the state’s fiscal situation, continuing oil revenues and the continuing stream of earnings from the Permanent Fund do give Alaska options that other states do not enjoy, Knapp said. But Alaska will need to move its fiscal arrangement more towards what other states do, spending less on government, taxing more and paying smaller dividends to residents, Knapp said.
Alaskans can simplify the fiscal debate by agreeing on their economic assumptions for the future; agreeing on dividend, savings and spending objectives; and agreeing on what fiscal system would best achieve those objectives, Knapp said.
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