An Introduction to Alaska Fiscal Facts and Choices Gunnar Knapp Director and Professor of Economics Institute of Social and Economic Research University of Alaska Anchorage Alaska Government Finance Officers Association Anchorage, Alaska November 16, 2015

Alaska faces an extremely serious fiscal challenge 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.

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

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 changes in what we spend or how we pay for it—or both.

We face two big choices: How will we fill the funding gap We face two big choices: How will we fill the funding gap? When will we fill the funding gap?

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. We will probably need to use all three options.

WHEN WILL WE FILL THE FUNDING GAP WHEN WILL WE FILL THE FUNDING GAP? We have enough savings to put off the hard choices for 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 rating The greater the risk to investor confidence The lower our future investment earnings from savings The less savings we leave for future generations

What most states’ revenues and spending flows look like Non-Oil Revenues Savings Fund General Fund Government spending

Major Alaska state revenues and spending flows, FY16 Permanent Fund realized earnings Non-Oil Revenues Oil taxes Oil royalties Constitutional Budget Reserve Fund General Fund Permanent Fund principal Permanent Fund earnings reserve Government spending Dividend spending

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

Our fundamental fiscal challenge: Alaska oil production is falling and our population is rising. Falling oil production can’t keep paying for most of state government for a growing population.

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

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. From 2005 to 2012 oil prices and revenues rose dramatically $7.2 billion drop in oil revenues from 2012 to 2015 (81% drop) Historical Projected

In just three 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.

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. Historical Projected

Before 2013 we saved surpluses in the Constitutional Budget Reserve Fund and other funds. Since 2013 we have paid for deficits from those funds. Permanent Fund realized earnings Non-Oil Revenues Oil taxes Oil royalties Constitutional Budget Reserve Fund General Fund Permanent Fund principal Permanent Fund earnings reserve Government spending Dividend spending

We have been rapidly drawing down our reserves We have been rapidly drawing down our reserves. Continued deficits of this year’s level could drain our reserves in 2-3 years. Our reserves are projected to be about $7.6 billion at the end of FY16.

This year’s (FY16) projected deficit is huge. FY16 unrestricted general fund spending $7,100 per Alaskan $5.2 billion Projected deficit $3.0 billion (58% of spending) $4,100 per Alaskan Projected revenues $3,000 per Alaskan $2.2 billion

But the actual deficit could be even bigger, because oil prices are a lot lower than DOR projected last spring. Last spring DOR projected an average FY16 price of $66/barrel The October 27 price was $45/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. Hoping that oil prices rise is not a realistic or responsible solution to our fiscal challenge.

At $70-$90/barrel, how much total revenue would we get? We are spending $5.1 billion this year. $3.4 billion @ $90/barrel $2.3 billion @ $70/barrel $2.2 billion projected for this year @ $66/barrel (the actual average price through 10/27 is $51/barrel)

How we are spending $5.2 billion in FY16

Trends in General Fund spending, FY07-FY16

The most unusual, complicated and least understood part of state finances is the Permanent Fund and the Dividend Program. Permanent Fund realized earnings Non-Oil Revenues Oil taxes Oil royalties Constitutional Budget Reserve Fund General Fund Permanent Fund principal Permanent Fund earnings reserve Government spending Dividend spending

Permanent Fund realized earnings about $2.7 B in FY16 Constitutionally mandated contributions from oil royalties to Permanent Fund principal about 30.5% of oil royalties about $0.9 B in FY16 Permanent Fund Principal $47.3 B May not be spent Permanent Fund earnings Reserve $7.6 B May be spent Inflation proofing about $0.9 B in FY16 Dividend spending about $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 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.

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.

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

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.

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. Historical Projected

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

It would be very difficult to close our funding gap by only cutting spending. It would be very difficult to cut debt & retirement spending Cutting oil tax credits could affect future production and revenues Very little capital spending is left to cut 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.

It would be very difficult to close the funding gap with only spending cuts or new revenues. That’s why there is a lot of interest in using Permanent Fund earnings.

Earnings are projected to grow over time as the principal grows. 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 History/background Use part of the funds currently going to dividends to pay for government The legislature could do this by a simple majority vote Spend 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

Percent of Market Value (POMV) approach Permanent Fund earnings Non-Oil Revenues Oil taxes Oil royalties Constitutional Budget Reserve Fund General Fund Permanent Fund No more distinction between principal and earnings Annual payouts formula would be based on market value of the fund rather than earnings Government spending Dividend spending

SB 114 approach: “Swap” funding for dividends and government Permanent Fund realized earnings Non-Oil Revenues Oil taxes Oil royalties Permanent Fund principal Permanent Fund earnings reserve Constitutional Budget Reserve Fund General Fund A payout would go from Permanent Fund earnings to the General Fund based on 5% of average market value over the past 5 years. Government spending Dividend spending Dividends would be paid from 75% of oil royalties

Dividends would be paid from 50% of oil royalties Sovereign wealth fund approach: Almost all oil revenues would go to the Permanent Fund, which would make a fixed payout to the General Fund. Permanent Fund realized earnings Non-Oil Revenues Oil taxes Oil royalties Permanent Fund Constitutional Budget Reserve Fund General Fund A fixed annual payout would go from the Permanent Fund earnings reserve to the General Fund (estimated @ $3.2 B) Government spending Dividend spending Dividends would be paid from 50% of oil royalties

None of the approaches increase state income or 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

Our fiscal options aren’t so bad compared with 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