1 An Introduction to Alaska Fiscal Facts and Choices (slight annotated version for the Alaska Press Club) Gunnar Knapp Director and Professor of Economics Institute of Social and Economic Research University of Alaska Anchorage January 12, 2016 ISER publications and presentations are solely the work of individual authors and should be attributed to them, not to ISER, the University of Alaska Anchorage, or the research sponsors.

Alaska’s 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. 2

We can’t continue to run huge deficits like this year’s. We don’t have enough savings. 3

In the next few years, we will have to close the funding gap between our spending and our revenues. We will have to make big changes in what we spend or how we pay for it—or both. 4

From 2005 to 2014, oil revenues averaged 90% of Alaska’s “unrestricted general fund revenues” (which pay for state government). Alaska has been extremely dependent on oil revenues to fund state government. 5

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

Oil prices have fallen drastically over the past year and a half —and are continuing to fall. 7 The price was $32/barrel on January 8

Projected Historical $7.8 billion drop in oil revenues from 2012 to 2016 (88% 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. 8 From 2005 to 2012 oil prices and revenues rose dramatically

In just four years, most of the money we had been using to pay for state government evaporated. It’s gone. That’s why we have a big problem.

Won’t oil prices go back up and save us? It happened 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 10 Hoping that oil prices rise is not a realistic or responsible solution to our fiscal challenge.

Even if oil prices rise, our future oil revenues will decline as oil production falls. Alaska Department of Revenue projections of future North Slope oil production

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. Projected Historical 12

We used the surpluses prior to 2012 to build up our savings reserve. Since 2013 we have been rapidly drawing down our reserves. Continued deficits of this year’s level could drain our reserves in 2 years. 13 ProjectedHistorical

This year’s (FY16) projected deficit is huge. FY16 unrestricted general fund spending $5.2 billion $3.6 billion (69% of spending) $1.6 billion Projected deficit Projected revenues $7,100 per Alaskan $4,900 per Alaskan $2,200 per Alaskan “Per Alaskan” figures are based on 2014 Alaska population estimate of 735,601.

How we are spending $5.2 billion in FY16 1,247 (96%) is K-12 formula 641 (55%) is Medicaid formula

Trends in General Fund spending, FY07-FY16 16

The Permanent Fund is worth more than $50 billion. Most of the value is in the principal, which we can’t spend. We can only spend the “realized earnings” in the earnings reserve, which are currently about $7 billion. 17

The Permanent Fund earns billions of dollars in most years, which go into the earnings reserve. 18

Every year, we take money out of the earnings reserve to pay for dividends and inflation proofing. 19

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. 20

Like oil revenues, Permanent Fund earnings are highly variable—but they have been growing as the Fund grows. For the past two years they have been more than our oil revenues. ProjectedHistorical

HOW WILL WE FILL THE FUNDING GAP? Our only significant and practical options are some combination of: Spending cuts New revenues Using Permanent Fund earnings There are no easy choices. The funding gap is so large that we will probably need to use all of these options. 22

Fiscal Gap solutions: some useful terms coined by Scott Goldsmith... Zombie Solutions: We’ve talked about them forever, they don’t happen, and they wouldn’t solve the fiscal gap problem. 23

Fiscal Gap solutions: some useful terms coined by Scott Goldsmith Nickel and Dime Solutions: They would help, but they amount of money they would raise is small compared to the scale of the problem. Talking about them is a distraction from discussing real solutions. 24

Fiscal Gap solutions: some useful terms coined by Scott Goldsmith... Nickel and Dime Solutions: They would help, but they amount of money they would raise is small compared to the scale of the problem. Talking about them is a distraction from discussing real solutions. 25

Fiscal Gap solutions: some useful terms coined by Scott Goldsmith... Tug of War solutions: Four real solutions over which we face an “inevitable and prolonged tug of war”: budget cuts, income taxes, sales tax, dividend cuts 26

The challenge with spending cuts is figuring out what to cut that isn’t mandated, essential or “penny-wise but pound-foolish.” 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 taxes than residents of any other state. Alaska 29

Using Permanent Fund earnings would require some combination of: - Reducing Permanent Fund dividends - Reducing inflation proofing -Adding less to the Earnings Reserve -Drawing down the Earnings Reserve

How would different options for closing the fiscal gap affect Alaska’s economy and Alaskans? OptionEffect on the economyWho would be most affected Cutting spending Fewer government jobs & income Fewer contractor jobs & income Multiplier effects of lower spending by government & contractor employees Government employees Contractor employees Trade and service industry businesses & employees Beneficiaries of government services that are cut

How would different options for closing the fiscal gap affect Alaska’s economy and Alaskans? OptionEffect on the economyWho would be most affected Income taxes Sales taxes Less personal income Multiplier effects of lower spending by households Richer families (income taxes) All families (sales taxes) Trade and service industry businesses & employees Resource industry taxes Less business income Fewer resource industry jobs Multiplier effects of lower spending by resource industry businesses & households Resource industry businesses Resource industry families Trade and service industry businesses & employees

How would different options for closing the fiscal gap affect Alaska’s economy and Alaskans? OptionEffect on the economyWho would be most affected Cutting dividends Less personal income Multiplier effects of lower spending by households All families (The relative effects would be greatest for poor families & large families) Trade and service industry businesses & employees

How would different options for closing the fiscal gap affect Alaska’s economy and Alaskans? OptionEffect on the economy Who would be most affected Cutting Permanent Fund inflation proofing Adding less to or drawing down the Permanent Fund earnings reserve No immediate effect Slower Permanent Fund growth Lower future Permanent Fund earnings Future Alaskans

WHEN WILL WE FILL THE FUNDING GAP? The more gradually we adjust, the smaller the immediate direct effects on the economy. But the longer we delay: The bigger the future direct effects on the economy. The greater the risk of forced drastic adjustments. The greater the risk to investor confidence The greater the risk to our credit rating The lower our future investment earnings The less savings we leave for future generations 35

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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 37

Our income - What we add to our savings + What we take out of our savings = What we can spend 38 Over any period of time what we can spend is constrained by our income and what we add to or take out of our savings. Four key choices that we face in thinking about how to close the funding gap

Our incomeOil income Permanent Fund earnings Other current revenues New tax revenues - What we add to our savings Royalty deposits to the PF principal Inflation proofing deposits to the PF principal What we add to the PF earnings reserve What we add to the CBRF + What we take out of our savings What we take out of the PF earnings reserve What we take out of the CBRF = What we can spend Government spending Dividend spending Any choice that we make about anything affecting our revenues, spending or what we add to or take out of our savings affects our options for all our other choices.

1. What should we assume about oil prices, oil production, and Permanent Fund rates of return? 40 Oil prices & oil production affect our oil income. Our incomeOil income Permanent Fund earnings Other current revenues New tax revenues - What we add to our savings Royalty deposits to the PF principal Inflation proofing deposits to the PF principal What we add to the PF earnings reserve What we add to the CBRF + What we take out of our savings What we take out of the PF earnings reserve What we take out of the CBRF = What we can spend Government spending Dividend spending Permanent Fund rates of return affect our Permanent Fund earnings.

2. How much do we want to tax ourselves or our industries? Our income Oil income Permanent Fund earnings Other current revenues New tax revenues - What we add to our savings Royalty deposits to the PF principal Inflation proofing deposits to the PF principal What we add to the PF earnings reserve What we add to the CBRF + What we take out of our savings What we take out of the PF earnings reserve What we take out of the CBRF = Our spending Government spending Dividend spending 41 The more we raise from new taxes the more we can spend.

3. How much do we wish to add to or take out of our savings? Our income Oil income Permanent Fund earnings Other current revenues New tax revenues - What we add to our savings Royalty deposits to the PF principal Inflation proofing deposits to the PF principal What we add to the PF earnings reserve What we add to the CBRF + What we take out of our savings What we take out of the PF earnings reserve What we take out of the CBRF = Our spending Government spending Dividend spending 42 How much we add to or take out of our savings affects what how much we can earn and spend in the future. The less we spend now, the more we can spend in the future —and vice versa.

4. How much do we want to spend on government and dividends? Our income Oil income Permanent Fund earnings Other current revenues New tax revenues - What we add to our savings Royalty deposits to the PF principal Inflation proofing deposits to the PF principal What we add to the PF earnings reserve What we add to the CBRF + What we take out of our savings What we take out of the PF earnings reserve What we take out of the CBRF = Our spending Government spending Dividend spending 43 The more we spend for dividends, the less we can spend for government —and vice versa.

Our options and choices for what we can spend are fundamentally constrained by our future oil revenues and permanent fund earnings. They are also uncertain because we don’t know what oil prices and permanent fund rates of return. The following graphs illustrate what the range of what we could spend might be for different combinations of assumptions. 44

What our current oil and other revenues would be at different oil prices

What the Permanent Fund would earn at different rates of return These projections assume that all earnings of the Permanent Fund are spent except those needed to allow the fund to grow at the rate of inflation, so that its real value stays the same.

How much can we spend per year for government and dividends combined? from our current revenue sources (oil revenues, non-oil revenues, and PF investment earnings) without reducing the inflation adjusted value of the Permanent Fund over the next 10 years? It depends on the price of oil and the Permanent Fund rate of return. If we raise new revenues we could spend more. If we want the Permanent Fund to grow we have to raise new revenues or spend less.

How much can we spend per year for government? from our current revenue sources (oil revenues, non-oil revenues, and PF investment earnings) without reducing the inflation adjusted value of the Permanent Fund over the next 10 years? It depends on the price of oil and the Permanent Fund rate of return and on what we spend for dividends. If we keep dividend spending at last year’s total ($1.4B) we could spend: If we raise new revenues we could spend more. If we spent less for dividends we could spend more.

Two potential approaches to using Permanent Fund earnings to fund state government ApproachHistory/background Senate Bill 114Introduced during the 2015 legislative session Walker administration’s “sovereign wealth fund” proposal Proposal released by Walker administration Fall

Major Alaska state revenues and spending flows, FY16 General Fund Oil royalties Government spending Permanent Fund realized earnings Constitutional Budget Reserve Fund Permanent Fund principal Permanent Fund earnings reserve Non-Oil Revenues Oil taxes Dividend spending Arrow sizes are proportional to FY16 revenue & spending flows

SB 114 approach: “Swap” funding for dividends and government General Fund Oil royalties Government spending Permanent Fund realized earnings Constitutional Budget Reserve Fund Permanent Fund principal Permanent Fund earnings reserve Non-Oil Revenues Oil taxes Dividend spending 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. General Fund Oil royalties Government spending Permanent Fund realized earnings Constitutional Budget Reserve Fund Permanent Fund Non-Oil Revenues Oil taxes Dividend spending 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 $3.2 B)