An Introduction toAlaska Fiscal Facts and Choices

Gunnar KnappDirector and Professor of Economics

Institute of Social and Economic ResearchUniversity of Alaska Anchorage

Alaska Government Finance Officers AssociationAnchorage, Alaska

November 16, 2015

Alaska faces an extremely serious fiscal challenge.We are spending more than twice as much as our revenues.We are paying for the deficit by drawing down our savings.

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We can’t keep on paying for more than half ofstate government from our savings!

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In the next few years,we will have to close the funding gap

between our spending and our revenues.

We will have to make very big changesin what we spend or how we pay for it—or both.

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We face two big choices:

How will we fill the funding gap?When will we fill the funding gap?

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HOW WILL WE FILL THE FUNDING GAP?

Our only significant and practical options are some combination of:

Spending cutsNew revenues

Using Permanent Fund earnings

There are no easy choices.

We will probably need to use all three options.

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WHEN WILL WE FILL THE FUNDING GAP?

We have enough savings to put off the hard choicesfor one or two years.

But the longer we delay:

The more we risk draining our savings and being forced to make drastic immediate changes

The greater the risk to our credit ratingThe greater the risk to investor confidence

The lower our future investment earnings from savingsThe less savings we leave for future generations

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What most states’ revenues and spending flows look like

GeneralFund

Governmentspending

SavingsFund

Non-OilRevenue

s

Major Alaska state revenues and spending flows, FY16

GeneralFund

Oilroyalties

Governmentspending

Permanent Fundrealized earnings

ConstitutionalBudgetReserve

Fund

Permanent

Fundprincipal

PermanentFund

earningsreserve

Non-OilRevenue

s

Oiltaxes

Dividendspendin

g

From 2005 to 2014, oil revenues

averaged 90% ofAlaska’s

“unrestricted general fund revenues”

(which pay for state

government).

Alaska has been extremely dependent onoil revenues to fund state government.

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Our fundamental fiscal challenge:Alaska oil production is falling and our population is rising.

Falling oil production can’t keep paying for most ofstate government for a growing population.

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Our state revenues are extremely sensitive to oil prices—particularly at prices above $80/barrel.

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At prices above $80/barrel, a $10/barrel change in oil prices changes revenues by more than $800 million

At prices below $80/barrel, changes in prices don’t affect

our oil revenues as much.

Last year oil prices fell drastically and unexpectedly.

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ProjectedHistorical

$7.2 billion drop in oil revenues from 2012

to 2015(81% drop)

Mostly because of the fall in oil prices, our oil revenues have fallen drastically.Falling oil production and higher costs and credits have also played a role.

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From 2005 to 2012 oil prices and revenues

rose dramatically

In just three years,most of the money we had been

using to pay for state governmentevaporated.

It’s gone.

That’s why we have a big problem.

From 2005 to 2012, even though spending was rising, we ran big General Fund surpluses. Since 2013 we

have been running big General Fund deficits.

ProjectedHistorical 17

Before 2013 we saved surpluses in the Constitutional Budget Reserve Fund and other funds. Since 2013 we have paid for deficits from those funds.

GeneralFund

Oilroyalties

Governmentspending

Permanent Fundrealized earnings

ConstitutionalBudgetReserve

Fund

Permanent

Fundprincipal

PermanentFund

earningsreserve

Non-OilRevenue

s

Oiltaxes

Dividendspendin

g

Our reserves are projected to be about $7.6 billion at the end of FY16.

We have been rapidly drawing down our reserves.Continued deficits of this year’s level could drain our reserves in 2-3 years.

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This year’s (FY16) projected deficit is huge.

FY16 unrestricted general fund spending

$5.2 billion

$3.0 billion(58% of

spending)

$2.2 billion

Projected deficit

Projected revenues

$7,100per Alaskan

$4,100per Alaskan

$3,000per Alaskan

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But the actual deficit could be even bigger,because oil prices are a lot lower than DOR projected last spring.

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The October 27 price was $45/barrel

Last spring DOR projected an

average FY16 price of $66/barrel

Won’t oil prices go back up and save us?

• It happened before—in the early 2000s—when we faced a similar fiscal challenge.

• It could happen again. But it probably won’t.• There is a glut of oil on world markets• Most oil market analysts think prices won’t rebound above

$70-$90/barrel, because– So much oil production is profitable at those prices– Growth in world oil demand is slowing

• Even if oil prices rise, our revenues will fall as oil production falls.

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Hoping that oil prices rise is not a realisticor responsible solution to our fiscal challenge.

At $70-$90/barrel, how much total revenue would we get?

$3.4 billion @ $90/barrel

$2.3 billion @ $70/barrel

We are spending $5.1 billion this year.

$2.2 billion projectedfor this year @ $66/barrel(the actual average price

through 10/27 is $51/barrel)

How we are spending $5.2 billion in FY16

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Trends in General Fund spending, FY07-FY16

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The most unusual, complicated and least understood part of state financesis the Permanent Fund and the Dividend Program.

GeneralFund

Oilroyalties

Governmentspending

Permanent Fundrealized earnings

ConstitutionalBudgetReserve

Fund

Permanent

Fundprincipal

PermanentFund

earningsreserve

Non-OilRevenue

s

Oiltaxes

Dividendspendin

g

Constitutionally mandated contributions from

oil royalties toPermanent Fund principal

about 30.5% of oil royaltiesabout $0.9 B in FY16

Inflationproofing

about $0.9 Bin FY16

PermanentFund

Principal$47.3 B

May notbe spent

Permanent Fund realized earningsabout $2.7 B in FY16

PermanentFund

earningsReserve$7.6 B

May be spent

Dividend spendingabout $1.4 B in FY16

Formula: about half of realized earnings over the past 5 years

The Permanent Fund is worth more than $50 billion. We can only spend the “realized earnings” in the earnings reserve, which are

currently about $7 billion.

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The Permanent Fund has been earning billions of dollars in most recent years. We have been putting that money in the earnings reserve—and then drawing

money back out to pay for dividends and inflation proofing.

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We have been using Permanent Fund earnings to pay for dividends and inflation proofing.

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In most recent years the Permanent Fund has earned more than we have used for dividends and inflation proofing—so we have been retaining some earnings

and the earnings reserve has been growing.

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Like oil revenues, Permanent Fund earnings are highly variable—but they have been growing as the Fund grows.

This year they are more than our oil revenues.

ProjectedHistorical

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HOW WILL WE FILL THE FUNDING GAP?

Our only significant and practical options are some combination of:

Spending cutsNew revenues

Using Permanent Fund earnings

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It would be very difficult to closeour funding gap by only cutting spending.

Very little capital

spending is left to cut

It would be very difficult to

cut debt & retirement spending

Cutting oil tax credits could affect future production

and revenues

Most cuts would have to come from state agencies—including education & health

There are many potential options for new state revenues—but none would be enough to close the funding gap.

Alaskans pay much lower broad-based state taxesthan residents of any other state.

Alaska 36

It would be very difficult to close the funding gapwith only spending cuts or new revenues.

That’s why there is a lot of interest inusing Permanent Fund earnings.

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Permanent Fund earnings—including but not limited to dividend payments—represent a significant potential source of revenue to address the funding gap.

Earnings are projected to grow over time as the principal grows.

Five potential approaches to significant use of Permanent Fund earnings to fund state government

Approach History/background

Use part of the funds currently going to dividends to pay for government

The legislature could do this by a simple majority voteSpend funds from the earnings reserve

without reducing dividends

Percent of Market Value (POMV) Plan developed during earlier fiscal crisis (late 1990s); rejected overwhelmingly in 1999 advisory vote

Senate Bill 114 Introduced during the 2015 legislative session

Walker administration’s “sovereign wealth fund” concept proposal

Concept proposal released by Walker administration this week; not yet fully developed

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Percent of Market Value (POMV) approach

GeneralFund

Oilroyalties

Governmentspending

Permanent Fund

earnings

ConstitutionalBudgetReserve

Fund

Permanent FundNo more distinction between

principal and earnings

Non-OilRevenue

s

Oiltaxes

Dividendspendin

g

Annual payouts formula would be based on market value of the fund

rather than earnings

SB 114 approach: “Swap” funding for dividends and government

GeneralFund

Oilroyalties

Governmentspending

Permanent Fundrealized earnings

ConstitutionalBudgetReserve

Fund

Permanent

Fundprincipal

PermanentFund

earningsreserve

Non-OilRevenue

s

Oiltaxes

Dividendspendin

g

Dividends would be paid from 75% of oil royalties

A payout would go from Permanent Fund earnings to the General Fund based on 5% of average market value

over the past 5 years.

Sovereign wealth fund approach: Almost all oil revenues would go to the Permanent Fund, which would make a fixed payout to the General Fund.

GeneralFund

Oilroyalties

Governmentspending

Permanent Fundrealized earnings

ConstitutionalBudgetReserve

Fund

PermanentFund

Non-OilRevenue

s

Oiltaxes

Dividendspendin

g

Dividends would be paid from 50% of oil royalties

A fixed annual payout would go from the Permanent Fund

earnings reserve to the General Fund

(estimated @ $3.2 B)

None of the approaches increase state incomeor total funding available over time.

To varying degrees, they are mechanisms for:

• Providing Permanent Fund funding for state government• Reducing the volatility of funding for state government• Increasing total Permanent Fund payouts• Changing the effective role of the current dividend statute in

increasing dividends over time

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Our fiscal options aren’t so bad compared with most other states.

• Most other states:– Don’t have any oil revenues– Don’t have any Permanent Fund earnings

• That’s why most other states:– Spend much less for government– Have income taxes and/or sales taxes– Don’t pay dividends

• Our basic fiscal options are to become more like other states:– Spend less for government– Tax ourselves more– Pay smaller dividends

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