Thursday, March 22, 2018

What draw rate should we use with a POMV approach?

One of the issues that has received some, but relatively little attention compared to others during the current fiscal debate is what the so-called draw rate should be if we start using a percent of market value (POMV) approach to establish the flow of cash from the Permanent Fund.

There have been various proposals. SB 26 (the Senate's version of a fiscal plan) uses 5.25% for a couple of years at the start, then reduces it to 5%. The Governor's most recent proposal uses 5% from the start. The House's proposed Constitutional Amendment (HJR 23) was originally 5%, but in the course of redrafting was lowered to 4.75%.

The rate used makes a difference.  The Permanent Fund has a current market value of roughly $60 billion. A draw rate of 5.25%, results in an annual draw of roughly $3.15 billion; a draw rate of 4.75% in an annual draw of roughly $2.85 billion, $300 million less. 

If split 50/50 between the PFD and government (as it should be), the use of the lower draw rate translates into $150 million less to the PFD, or, using last year's number of recipients, roughly $250 less per PFD. 

A lower contribution to the government also means increased pressure for the use of other options, such as taxes or a PFD cut.

The difference between a higher and lower draw rate increases with the size of the Permanent Fund. At a market value of $80 billion, for example, the difference between a 5.25% and a 4.75% draw rate would be $400 million, compared to the $300 million difference at a market value of $60 billion.

Generally speaking the draw rate is intended to equal the so-called "real" rate of return anticipated to be generated going forward from the investments made by the Permanent Fund. The "real" rate is equal to the overall rate of return, including inflation (the so-called "nominal" rate of return) anticipated to be generated by the Fund, less the rate of inflation.

Using the "real" rate of return is simply another (and in our view, better than the current) way of inflation proofing the Fund.

To this point in the discussion, all of the numbers have been based on the anticipated real rate of return -- that is the real rate of return anticipated to be earned in the future. That requires projections not only of the future overall rate of return that will be earned on the Permanent Fund, but also future inflation rates as well.

Generally speaking, the reason that projections are used under the POMV approach is because the goal of using a real rate of return is to keep the relevant fund protected against inflation into the future.  Thus, projections of future rates (both of return and inflation) are perceived to be more relevant than past experience.

But there also is a problem with using projected returns and inflation rates.

In a nutshell, that problem is that the future may not turn out as anticipated. Overall returns may turn out to be more or less than projected, and inflation rates may turn out to be more or less than projected.

For example, rather than the 7.5% overall return and 2.5% inflation rate anticipated by those who recommend using a 5% draw rate, the future may result in an 8% overall return and a 2% inflation rate, or a 7% overall return and a 3% inflation rate.

In the first case (8% overall, 2% inflation), a 5% draw rate will understate the 6% draw rate that actual experience demonstrates could have been used, leaving money "on the table" (i.e., in the Fund) that could have gone to support the current generation through higher PFD's and government support without penalizing those that come after.

In the latter case (7% overall, 3% inflation), a 5% draw rate will overstate the 4% draw rate that actual experience demonstrates should have been used, distributing money to the current generation that, instead, should have been retained in the Fund to protect future generations.

Normally, endowments and other institutions that use a POMV approach do not worry that much about inaccurate projections. As conditions change proving the original projection wrong, the boards of the relevant institutions simply change the draw rate to better reflect revised projections.

But the potential (even likelihood) that the future does not match projections creates a special challenge for establishing a draw rate for the Permanent Fund.  Especially if the draw rate is "constitutionalized," as proposed by HJR 23, for example, it may be hard, if not impossible, to make adjustments as conditions change, locking in permanent over or under draws and with it, potentially significant intergenerational consequences.

As a result, the more we have thought about it the more we have come to the conclusion that the better way to set a draw rate for the Alaska Permanent Fund is to use past experience, rather than a projected look. 

Using actual, past experience protects against over- or under-stating the amount which each generation may draw without impairing others. If the investment policies of the Permanent Fund Corporation result in higher than the anticipated real rate of return, as they have at many times in the past, both current and future generations will share in the resulting benefit, rather than shifting all of the benefit to future generations (and potentially leaving the current generation with higher tax rates than necessary).

If, on the other hand, those investment policies result in lower than the anticipated real rate of return, both current and future generations will share in the resulting burden, rather than shifting all of the burden to future generations.

One legitimate question about such an approach is what past period should be used in calculating the realized real rate of return. Actual real rates may vary substantially from year-to-year depending on a variety of circumstances. As with statutory earnings used in the current calculation, it is better to use an average calculated over time to smooth those out.

Changes in averages determined over time also tend to be gradual, providing the Permanent Fund Corporation with more predictability about what the draw is likely to be -- a key argument behind the use of a permanently fixed rate -- and government and residents receiving the PFD also with more predictability about what their receipts are likely to be.

In the following chart we have calculated, by year, the actual real rate of return realized by the Permanent Fund in every year since its inception, along with a rolling 5-, 10-, 15-, 20- and 25-year average.
Two things leap out (to us, at least) from charting the results in that way. The first is that the longer the time period over which the average is calculated, the smaller the year-to-year changes and the smoother the adjustments. 

The second is that every measure -- 5-year, 10-year, 15-year, 20-year, 25-year and full life (some 40 years) -- averages out to an actual, real rate of return of somewhere in the 6+% range. To us, the second point is important and raises significant questions about the substantially lower percentages (4.75 - 5.25%) that have been proposed in the current round of discussions for use in connection with the Permanent Fund.  

Recall that the lower the percentage, the lower the PFD and government draw (and the greater the potential need for finding other sources of "new revenues"). Given the intergenerational issues resulting from using a draw rate significantly lower than the actual real rate of return, to us these results add even more weight to our proposal to use a draw rate based on the actual real rate of return realized over some period of time, rather than one based on anticipated future real rates of return.

Because it generates the least amount of change year-to-year, we believe the 25-year average is the best approach, but likely could be convinced as well of the suitability of the 15- or 20-year averages. Looking at the results, we are concerned that the use of 5- and 10-year averages could generate an unnecessary amount of year-to-year change.

But at the end of the day we believe that the use of some sort of averaged actual rate of return is more appropriate than the use of anticipated rates.  The potential for significant intergenerational problems resulting from the use of a constitutionally or even statutory fixed rate is too great.

Monday, March 19, 2018

Just who is the Alaska Senate Majority trying to protect?

In an article in this Sunday's edition of the Anchorage Daily News ("New forecast of Alaska oil revenue takes chunk out of state’s deficit"), the Senate Majority's fiscal position is summarized this way:
The Senate majority ... favors lower [Permanent Fund] dividends ... Senate leaders have said taxes would hurt Alaska's economy and aren't needed ....
But the Senate isn't really concerned about the overall Alaska economy; if it was, its position would be the reverse.

According to a study from the University of Alaska-Anchorage's Institute of Social and Economic Research (ISER) last March, "the PFD cut ... has the largest adverse impact on the economy" of all of the so-called "new revenue" sources it analyzed, including sales, income (progressive and flat) and property taxes. If the Senate was truly concerned about the overall economy, cutting the PFD would be the last option taken, not the first, and certainly not ahead of taxes.

The Senate also isn't really concerned about Alaska families.  According to a second study from ISER in early 2017, a "cut in PFDs would be by far the costliest measure for Alaska families."  As in the earlier study, the analysis included also sales and income taxes. If the Senate was truly concerned about Alaska families, cutting the PFD would be the last option taken, not the first, and again, certainly not ahead of taxes.

The Senate also isn't really concerned about the amount of money Alaskans are required to pay to support government. As both the first and second ISER studies make clear, "[n]on-residents would pay a share of any of the potential taxes, reducing the burden on Alaska households." Because PFDs are only paid to residents, however, "the impact of the PFD cut falls almost exclusively on residents." 

Using ISER's numbers we have estimated that Alaskans will be required to pay more than $500 million more overall under PFD cuts over 10 years than would be the case under any of the tax cases. Again, if the Senate was truly concerned about limiting the amount of money Alaskans are required to support government -- and optimizing contributions from non-residents receiving income in the state -- cutting the PFD would be the last option taken, not the first, and again, certainly not ahead of taxes. 

So, if the Senate doesn't really care about the overall Alaska economy, Alaska families or limiting the amount of money Alaskans are required to pay overall to support government, what does it care about. 

Put another way, just who is the Senate trying to protect by putting PFD cuts ahead of taxes.

To analyze that we compared the effect of PFD cuts with that of a flat tax on a family of four. We have previously discussed the type of flat tax we envision. ICYMI: Designing a Flat Tax (Sept. 2017).

To identify just who the Senate is trying to protect we calculated the crossover point at which a flat tax would take more from a typical family of four than the Senate's proposed PFD cuts.

Those below that point would fare better under a flat tax. Those above fare better under a PFD cut; as a result, they are the ones the Senate's actions are protecting. Our analysis is here (the crossover point by year is in the yellow column):

The answer was higher than even we guessed off the top of our head; roughly, those with incomes above $160,000-$170,000.  

Only those receiving above that amount would pay more under a flat tax; all those receiving less than that amount lose more under the Senate's proposed PFD cut plan.

So, using a family of four as the measure, who is the Senate trying to protect?

The answer: families with incomes greater than $160,000 - $170,000, about the Top 10%.

At whose expense? Families earning less than $160,000 - $170,000 -- the Remaining 90%.

Let that sink in -- in order to save the Top 10% of Alaska families from paying a bit more under a flat tax, the Alaska Senate Majority is prepared to hurt the overall Alaska economy, the Remaining 90% of Alaska families, and make Alaskans pay more for government overall.

Just wow.  Their upper income donors must be so proud. The Remaining 90% of Alaska families? Not so much.

Wednesday, March 7, 2018

Maintaining the PFD is important to achieving real spending cuts ...

Some ask why we are so focused on preserving the PFD. 

There are a number of reasons -- the significant adverse effect of cuts on the overall Alaska economy & families, its critical role in protecting against raids on the corpus, its role in creating a private sector economy similar to those in other oil producing states.

But another, similarly important reason is the significant role maintaining the PFD plays in restraining government spending to long-term sustainable levels.

Because PFD cuts largely don't affect their donor class, some legislators from more affluent parts of the state (or more affluent themselves) have made clear that they have no problem cutting the PFD to zero. Their willingness to do so enables them to avoid focusing on the hard work of constraining spending.

As Governor Hammond well understood, "the best therapy for containing malignant government growth is a diet forcing politicians to spend no more than that for which they are willing to tax." 
Diapering the Devil at p. 31. Cutting the PFD enables the legislators to put off the date they have to do so even longer. 

It provides a cushion of an additional $750 million - $1 billion (and growing) in revenue before they have to begin confronting the need for taxes. They can continue to say "yes" to their constituents -- particularly including those corporations tied to government spending which make up a significant part of their donor class -- to a much greater extent and for a lot longer than if they were confronted instead with the need to raise new revenues through taxation now.

That delay has significant, long-term adverse consequences to Alaska, however. 
As is the case at the federal level, all that resulting increase in spending ultimately will do is bring Alaska closer to economic peril. 

Enabling spending to increase up to the level it can be funded through current revenues plus conversion of the PFD to government revenue will put the overall Alaska economy at even greater risk the next time oil revenues decline or, once we start relying on that source of revenues, investment returns drop.

A significant portion of the Alaska economy is already built on a somewhat artificial base of free government services funded by oil revenues. We have seen the last four years how unreliable that is.

Expanding spending to include the PFD simply will double up on that artificial base by including free government services dependent on projected investment returns. Those with long-term experience and a long-term perspective in financial markets know how unreliable those are as well. See, e.g., Financial Times, "Norway’s oil fund could lose over $420bn in next big market crash" ("The $1tn fund said that it could lose more than 40 per cent of its value in a single year because of a combination of a plunge in stock markets as well as a potential strengthening in the Norwegian krone.")

From our perspective it is important to draw a line in the sand on state spending now. We may need more than our current revenue base can sustain, but as Governor Hammond said, the revenues to fund any addition should only come to the extent "politicians ... are willing to tax." 

Going beyond that -- by converting the PFD to government revenue -- only walks Alaska's economy farther out on thinning ice, so that Alaska is over deeper water and farther from shore when the ice inevitably fails. It also removes the safety net that the PFD provides to the Alaska economy and Alaska families during challenging economic times, making the economy and those families entirely dependent on government when those times come.

That, inevitably, will lead to an even larger crash and burn for the overall Alaska economy and Alaska families than if we start to face up to the hard work of reigning in spending now.

The Alaska Senate started hearings yesterday on SB 196, a bill that would purportedly impose statutory limits on spending. They will tell you that approach is the solution to Alaska's spending binge. 

But as we have seen with the PFD, Alaska statutes dealing with fiscal issues are nearly as worthless as the paper on which they are written. They don't even have to be repealed; they can just be ignored.

What we need instead are hard, real world limits on spending. 

As Governor Hammond wisely understood, those are only created when government spending is put on a "diet forcing politicians to spend no more than that for which they are willing to tax." Cutting the PFD enables them to dodge that diet yet again, allowing them to continue to fatten government spending, putting the Alaska economy and families at even greater long term peril.

We have the opportunity to stop that now by preserving the PFD, and from the perspective of building a sustainable economy and budget that is exactly what we should do.

We would suggest the results of the Governor's and legislature's proposed spending levels would look much different if we do. Regardless of what the Alaska Senate tries to tell you about SB 196, we doubt it will if we don't.

Wednesday, February 7, 2018

Hmmm, a POMV approach may produce a higher PFD than the current statute after adjusting for inflation proofing

Recently, we wrote a piece in which we explained that the current formulation of the PFD is not entirely as Governor Hammond intended, once the state starts using the "other half" of the earnings stream for "essential government services." See "Is the current formulation of the PFD what Governor Hammond intended?" (Jan. 2018).

Our point was that due to how the so-called "inflation proofing" provisions work, under the current statute the earnings available after inflation proofing are not split 50/50 between residents (through the PFD) and government (through the earnings reserve) as Governor Hammond intended.

Instead, using FY 2016 as an example, we demonstrated that while residents receive 50% of the current distributions, government received only 27%. The remaining 23% was available to neither residents nor government but instead reinvested in the Permanent Fund corpus.

As a result, between the portion split between residents and government, residents received roughly 65% of the earnings made available for distribution and government 35%. This departs from Governor Hammond's vision, expressed in Diapering the Devil, that once the "money wells" created by the Permanent Fund started pumping,

Each year one-half of the account’s earnings would be dispersed among Alaska residents …. The other half of the earnings could be used for essential government services.

While not our principal point, in the course of writing the piece we commented, based on some prior work, that in addition to imbalancing the split between residents and government, the current statutory inflation proofing mechanism also appeared to overcompensate for inflation. We speculated -- as we had also in an earlier November piece -- that the percent of market value (POMV) approach favored by some to calculate distributions from the Permanent Fund might actually result in a more accurate assessment, and thus a better net result.

In response, some readers of the January piece appropriately challenged us to prove that latter statement. Over the course of the past couple of weeks we have worked to analyze the results under the two approaches.

It turns out, based on what we believe is an appropriate methodology for comparing the two, the POMV approach, in fact, results in a higher overall level of net distribution after inflation proofing than the current approach.

Put another way, assuming a 50/50 split in distributions between residents and government, PFD's would be higher under a POMV (5%) approach than under the current statute, once adjusted to reflect an equal split of the earnings remaining after current inflation proofing.

Largely because of the lingering effects of FY 2009 on Statutory Net Income (when SNI was a -$2.51 B), looking back over the last 5 years (FY 2014-2018) the difference would have been significant. The annual distribution net to the PFD would have averaged roughly $245 million higher under POMV (5%) than under the current statute, once adjusted to reflect an equal split of the earnings remaining after inflation proofing.

Going forward the projected differences are not as significant. Using Permanent Fund Corporation (PFC) projections, for example, over the 10-year period between FY 2019 and 2028 (a copy is available here), the difference between the two, net to the PFD, would average roughly $60 million per year (or, at 650,000 applicants, a little less than $100 per PFD check).

But the fact there is some difference both demonstrates that the current methodology likely is, in fact, overcounting for inflation and that, far from being adverse to the PFD, the use of POMV may actually be helpful, if the split remains as intended by Governor Hammond and other founders, equally between residents and government.

Of course, the results depend on the approach taken.

In calculating the POMV distribution we largely adopted the approach reflected in SB 26, using a rolling five year average of the market value of the Permanent Fund as the base, with a draw rate of 5.25% for 2019 and 2020, and 5% before (for the lookback) and thereafter. We calculated the average value of the Permanent Fund using the PFC's most recent estimates for such balances between now and 2028. The average for each year was calculated by averaging the end of the previous year and the end of the current year.

In calculating the distribution under the current statute we used the PFC's most recent estimate of Statutory Net Income (SNI) and Inflation Proofing (IP). To determine the net available for distribution after inflation proofing we subtracted the number for Inflation Proofing from Statutory Net Income. To avoid timing distortions, we used the five year rolling average for each, as the current statute requires for the calculation of the PFD.

As should be expected, the results are heavily influenced by the POMV draw rate used. As noted above, we used the 5% rate included in SB 26. Using a 4.5% rate reverses the results, with the current approach producing a better result, even after subtracting the inflation adjustment.

But at a 5% draw rate a POMV approach produces a higher PFD than under the current statute, once adjusted to reflect an equal split of the earnings remaining after inflation proofing.

We believe that is a significant fact to keep in mind as we continue the current discussions.

For those interested, the detailed calculations are available at the spreadsheet below, or available also for download here.

Thursday, January 25, 2018

Is the current formulation of the PFD what Governor Hammond intended?

As we spend more and more time on the issue, increasingly we are coming to the view that the current formulation of the PFD is not entirely as Governor Hammond intended, once the state starts taking its "other half" of the earnings stream.

Here is what Governor Hammond said in Diapering the Devil, a book which, while published posthumously, was taken from manuscript and notes he had been working on before his passing and is consistent with his earlier writings in other books on fiscal policy.

The first relates to the creation of the Permanent Fund itself (at p. 15):
I wanted to transform oil wells pumping oil for a finite period into money wells pumping money for infinity. …
The second focuses on what to do with the earnings, once the “money wells” were pumping (at p. 19):
Each year one-half of the account’s earnings would be dispersed among Alaska residents …. The other half of the earnings could be used for essential government services.” 
Given the backdrop of how Alaska's mineral interests are owned, the so-called 50/50 split makes sense and is one we have -- and will continue to -- defend strongly on these pages.

But that is not entirely how the current formulation of the PFD works.

Instead, using FY 2016 numbers (the last year the Governor or the legislature didn't override the current statute), this is how the current statute (AS 37.13.145) operates:
  • Overall earnings (5-year average): $2.746 B
  • PFD: $1.373 B (50%)
  • Retained in the Earnings Reserve Account (i.e., the state's share): $0.749 (27%)
  • "Inflation proofing" (i.e., returned to the corpus): $0.624 B (23%)
As noted, under the current formulation the state's share was only 27% of the earnings stream, not the "other half" envisioned by Governor Hammond.

The reason for the shortfall is that, under the current statute, the portion used for "inflation proofing" -- purportedly the amount necessary to keep the Fund whole against inflation -- is taken entirely from the "other half" of the stream, instead of being divided equally between the "residents'" share and the "state's" share.  As we wrote on these pages in November, we believe inflation proofing benefits both sides (residents and state) of the split, and thus, should be borne equally. See "Notes from the Alaska Fiscal Cliff: Our Proposed Fiscal Solution" (Nov. 2017).

Before the past two years the fact that the split wasn't entirely as envisioned by Governor Hammond didn't make much of a difference.  Because the state wasn't using it's share of the split anyway, there really wasn't any significant, current harm from the way that the statute operated.  It simply took some of the state’s share and transferred it to Permanent Fund principal, not a bad place for surplus earnings.

Now that the state is beginning to take a share of the earnings, however, the formulation of the statute does make a significant difference. It reduces the state's share substantially below the "other half" envisioned by Governor Hammond.

As we also wrote in our November piece, we believe that the current inflation proofing formula overstates the current costs of inflation and should be revised as well.  We believe that a POMV approach could be a good solution to that (as long as the resulting earnings available for distribution continue to be split 50/50 between the private sector (residents) and state).

But that is a secondary point.  The primary point is that, even if inflation proofing is reduced to a more appropriate level and works perfectly, the current statute still won't reflect Governor Hammond's 50/50 split because all of whatever portion is set aside for inflation proofing comes from the state's share.

As we approach implementing Governor Hammond's full vision -- splitting the use of earnings from the state's "money wells" evenly between the private sector (residents) and state government -- we believe it's important to ensure that the split is done right.

For that reason, and as we outlined in our November piece, we favor making changes to the statute both to revise the manner in which inflation proofing is calculated and to ensure that the resulting transfers to the principal are shared equally between the residents' 50% (the PFD) and the portion made available for state spending.

And for that same reason we also will oppose simply moving the current statute to the Constitution.  As we explain above, once the government starts taking its share of the earnings the current statute doesn't fully achieve Governor Hammond's original intent.  Until it is corrected we believe locking that approach into the Constitution would be a significant mistake.

Tuesday, January 2, 2018

Analyzing the Governor's Proposed FY 2019 Budget: Part 2 (formula spending)

Right click to enlarge
Last week we walked through an overview of the Governor's proposed FY 2019 budget. See Analyzing the Governor's Proposed FY 2019 Budget: Part 1 (an overview).  

In this column we take a deeper dive into the major formula programs that, as occurs also at the federal level, drive a large part of state government spending.

What are the "formula programs'

For purposes of its 10-year forecast (above), OMB lumps three "Agency Operations (formula)" categories together.  The included categories are:
  • Education (K-12) Foundation and Pupil Transportation (which together are referred to by OMB as the Education Formula programs), 
  • Medicaid, and 
  • What OMB refers to as the "Other Formula" programs (which are composed of three fairly small programs administered each by the Departments of Health & Social Services (non-Medicaid), Administration and Military & Veterans Affairs). 
In the above spreadsheet, we have hi-lited in yellow the combined, projected spending number for the three programs. They constitute approximately 45% of total FY 2019 UGF spending ("Budget (before Dividend)").

For purposes of this column we also treat expenditures for debt, retirement (PERS/TRS) and oil tax credits -- which are categorized in the budget as "Statewide" expenditures -- as formula programs, as they are driven also by formula calculations external to the annual budget process. We have hi-lited those in blue.

Those additional, "Statewide" programs constitute 11% of total FY 2019 UGF spending. 

Combined, all of the formula programs -- those included in the "Agency Operations" and those included in "Statewide" -- account for approximately 56% of total FY 2019 UGF spending.

"Agency Operations" formula spending grows substantially over the 10-year period

OMB's forecast contemplates a significant increase in the three categories of "Agency Operations" formula spending over the 10-year period.

Based on OMB's 10-year forecast, combined the three formula categories increase by 22% over the 10-period, a compound growth rate of 2.25%, OMB's assumed inflation rate.

But OMB readily admits that may be too low. 

In an earlier version of the 10-year forecast included as part of the Governor's support in October's Special Session (the "October 10-year forecast"), OMB admitted  that:
... if health care costs including Medicaid grow at historic rates rather than simply tracking inflation; if K-12 spending grows at historic rates rather than inflation; if the federal government shifts health care costs onto states ... the budget gap [could widen] by hundreds of millions of dollars ....
All of those contingencies are governed by the formula programs. Under the current formula approach, if those costs go up so will spending, automatically by simple operation of the formulas.

As noted above, as it is the Agency Operations formula programs already represent approximately 45% of total FY 2019 UGF spending.  Because OMB escalates all spending in that budget segment (both formula and non-formula) by roughly the same percentage, in the forecast the percentage of overall Agency spending arising from the formula programs remains fairly constant throughout the entire 10 year period.

If, as noted in the October 10-year forecast, however, spending determined by the formula programs escalates more rapidly, on its current trajectory it will not be surprising to see Agency Operations formula spending alone drive more than half of overall spending by the end of the period.

"Statewide" formula spending also rises

Unlike "Agency Operations" formula spending, OMB does not tie changes in "Statewide" formula spending to inflation.  Each of those programs have separate drivers.

Projected contributions to the state's "retirement" accounts (PERS/TRS) over the 10-year period, for example, increase by roughly 75%.  That is because the state currently uses an amortization approach which enables it largely to kick the retirement spending "can" down the road, imposing a greater share of retirement costs in later years.

The result is to make current spending levels artificially lower.  

Even that increase potentially understates the rise in costs, however.  Unlike most other programs across the country, Alaska continues to assume an 8% rate of return in the portion of its investment portfolio set aside for the retirement accounts. If -- as other programs increasingly assume -- the realized rate turns out instead to be in the range of 6%, the shortfall required to be made up in future years will be substantially higher.

Payments into the oil tax credit program similarly rise over the 10-year period, increasing by roughly 433% between FY 2019 and FY 2028.  As with the retirement contributions, the reason is because of the proposed adoption of a method (the Administration's proposed "Oil & Gas Exploration Credit & Repayment Plan") which defers current spending required under the existing statute to future years.

Funding the oil tax credit program through the Administration's proposed plan reverses the change over time which otherwise would result under the current oil tax credit statute. If the current statute remains in place, spending on oil tax credits will drop to zero by the end of the period (from a projected FY 2019 level of $206 million to zero in FY 2028) rather than rise.

Offsetting the trend of rapidly rising spending in other categories, projected debt costs decrease over the same period by 55%.  But that is somewhat misleading.  As OMB's October 10-year forecast admits, that amount assumes "[n]o new debt is issued - payments fall as outstanding obligations are paid off."  If new debt is issued -- as likely will be the case if for no other reason that to refinance existing debt -- the projected spending levels will rise.

Even after factoring in the reduction in debt costs, the three formula programs included in the "Statewide" spending category still rise by roughly 34% over the 10-year period.  If, as likely, new debt is issued or retirement spending rises (due to a restatement of the assumed rate of return on invested assets) the growth in spending will be even greater.

What does that mean for this coming session

Based on the assumptions made in OMB's10-year forecast, combined formula spending already accounts for approximately 56% of overall UGF expenditures in FY 2019, increasing slightly to 57% by FY 2028.

But if -- as OMB put it in the October 10-year version -- "
health care costs including Medicaid grow at historic rates rather than simply tracking inflation; if K-12 spending grows at historic rates rather than inflation; if the federal government shifts health care costs onto states," or if "the retirement system misses earnings targets or has other negative experiences," formula spending easily could  exceed -- and perhaps substantially exceed -- 60% of overall UGF expenditures by FY 2028.

As OMB's 10-year forecast admits, the amount of overall spending that is formula driven is unsustainable even at projected levels without support by significant amounts of "new revenues." The level of "new revenues" required to support overall spending if any of the "ifs" occur will be even greater.

As recent history has demonstrated it takes a substantial amount of time and effort to address state spending of any sort, much less the challenges presented by reevaluating the formulas that underlie much of it.  The fiscal challenges created by permitting the current formulas to continue unabated are clear, and should be addressed now, before the problems they present become even worse.

If it were us, we would dedicate a substantial part of the upcoming legislative session specifically to "looking under the hood" of each of the various formula programs and finding ways to bring them under control.  If the legislature chooses not to do that (or even if it does but fails to produce significant results) we would make "formula reform" a significant part of our campaign during the upcoming election cycle.  

We know that Alaskans for Sustainable Budgets will do precisely that.

In our next installment of this series we will look at the Administration's proposed "Oil & Gas Exploration Credit & Repayment Plan."  As we said in our first column in this series, questions along the way are encouraged. Feel free to post them either in the comments section of this page, or on any of the Facebook or Twitter pages where we will be posting links to this and future columns.

Tuesday, December 26, 2017

Analyzing the Governor's Proposed FY 2019 Budget: Part 1 (an overview)

Right click to enlarge. Also available from the OMB website (p. 16).

Over the past week we have taken the time to work through the Governor’s proposed FY 2019 budget. Following up on that, over the next couple of weeks we intend to write a series of columns taking a deeper dive into various aspects we think are important.

Today, however, we start with a simple overview, using as the baseline a spreadsheet from among the various materials published on the OMB website in support of the budget. The spreadsheet we are using (above) -- and will continue to use throughout -- is the Administration's 10-year fiscal forecast. The reason we are using that is because Alaska’s current fiscal situation isn’t a one-year phenomenon. Instead, as with the federal budget, there are various structural issues that, if not addressed in the near term, will cause the problems we currently are experiencing to continue to occur year after year. 

Using OMB's 10-year forecast as a baseline enables us to put those in perspective.

But using OMB’s 10-year forecast comes with its own issues. For the first time OMB’s materials include what they refer to as a “transparent budget” which attempts to eliminate the accounting tricks used in the past to understate UGF spending. We commend them for the effort, but unfortunately they have not used that approach in crafting the 10-year forecast. As a result, we will need to make some adjustments to the 10-year forecast as we walk through it in this and subsequent columns in order to remove the effects of the various accounting tricks.

The spending level we will focus on throughout this effort is referred to on the spreadsheet as the “Budget (before Dividend).” We have hi-lited that in yellow on the above sheet. We are using that both because it best aligns with the so-called UGF numbers used in the past, and avoids the various distorting effects created by including all or a portion of the statutory PFD in the state spending numbers.

Focusing on that, the Governor’s 10-year forecast proposes to set FY 2019 spending at $4.58B, which rises to $5.10B by FY 2023 (5-year) and $5.60B by FY 2028 (10 year).

But as mentioned above, those numbers need to be adjusted for accounting tricks.

The footnote to the spreadsheet indicates that after adjusting for those, FY 2019 spending rises to about $4.7B. But that number still largely excludes oil tax credits (which the Governor assumes are covered by a yet-to-be-approved bond issuance, and as a result, are essentially removed from his proposed FY 2019 spending levels). Including those adds an additional $180 million to FY 2019, bringing adjusted FY 2019 spending to around $4.9B.

There also is a question about how to treat the additional spending included in the Governor’s proposed “Alaska Economic Recovery Act.”

The Governor proposes to fund that with a so-called “temporary” payroll tax, which would make the expenditures DGF (designated general fund) spending. But we have heard some talk about agreeing to all or part of the spending (as “needed” capital spending), but without the tax. If so, that would raise adjusted FY 2019 UGF spending by another $280 million, to roughly $5.2B, or approximately $600 million (13%) more than the initial level shown on the spreadsheet.

While not all of those adjustments carry through to future years, some do, which likely means projected adjusted FY 2023 (5 year) spending exceeds $5.25B and projected adjusted FY 2028 (10 year) spending exceeds $5.75B.

That compares with adjusted FY 2018 spending (i.e., excluding accounting tricks) of roughly $4.9B. That means the Governor's proposed adjusted FY 2019 spending is roughly $100 million to $300 million (2 - 6%) above adjusted FY 2018 levels, and adjusted FY 2023 (5 year) and FY 2028 (10 year) spending is roughly 7% and 17%, respectively, above FY 2019 levels.

That’s enough to digest for now. We will follow up next by focusing on where we are -- and where we are headed -- under various of the current formula programs.

Questions along the way are encouraged. Feel free to post them either in the comments section of this page, or on any of the Facebook or Twitter pages where we will be posting links to this and future columns.