Alaska Fiscal & Oil Policy| Now the really hard work begins …

The election results from last week have put Alaska Republicans clearly in charge of the Governorship, state House and state Senate for the first time  since 2006, when the Senate coalition was first formed.

As difficult as the election battles may have been, however, the hard work is only now beginning.

Most successful R candidates said during their interviews on local television stations election night that oil tax reform is their highest priority.  The Governor said the same.

If this was still 2007, when Alaska’s Clear and Equitable Share or “ACES”, Alaska’s current oil tax structure was passed, or even 2008 or 2009, achieving oil tax reform might be relatively easy.  Eliminate the excesses and substantial distortions of the current tax structure, hold a victory party, call it a day and adjourn.

Unfortunately, however, the intervening years have gotten in the way.  

Flush with increased state revenues produced by ACES, many legislators — including many Republicans — have given in to various special interests and constituent requests and increased spending over the intervening years.  The increased spending largely has tracked the increased revenues.

As a result, state spending has grown to the point that enacting oil tax reform now, six years after the passage of ACES, will first require significant budget reform.

The responsibility for the current budget situation starts at the top, and continues through to the legislature.  Under Alaska law, the Governor proposes the budget, the legislature modifies it and then the Governor signs it.  Through the use of the “line item veto” granted by the Constitution, the Governor has exceptional power to keep spending under control, by vetoing projects added by the legislature that he believes exceed prudent levels.

During the intervening years since the passage of ACES, however, the Governor has led in the opposite direction — proposing increased budgets at the beginning of each session (click on “Budget Reports” at the top of the page to see the year by year progression), watching as the legislature added even more, and then signing the result, at most with only token vetoes at the end.

As a consequence, in order to achieve what many call their first priority — oil reform — the Governor and legislature now are first going to need to relearn what they should have already been practicing all along — fiscal restraint.

That harsh reality was made clear at the end of last year’s special session. On what became effectively the last day of the session, the Director of the state’s Office of Management and Budget (OMB), Karen Rehfeld, was asked to testify on the effect of the Governor’s proposed oil reform legislation on the budget.

The chart summarizing her testimony is below.  It stunned many, including this observer.  According to Rehfeld, the passage of the Governor’s proposed oil tax reform would have caused the state budget immediately to turn into a deficit.

The chart contains four lines.

The first – in red – is OMB’s forecast of revenues under the status quo, before the potential implementation of “HB 3001,” the Governor’s proposed oil tax bill.

The second, in blue, is the level of state spending from the General Fund as projected in OMB’s FY 2013 10-year plan.  The third, in green, is OMB’s forecast of revenues in the event the legislature passed HB 3001.  The fourth, at the bottom in black, shows the projected deficits each year in the event the Legislature had passed HB 3001.

The fourth line clearly shows that the state budget would have started running a deficit immediately this Fiscal Year if HB 3001 had passed.  To repeat, the Governor’s own OMB Director testified that if the legislature had passed the Governor’s proposed tax reform legislation as proposed, it would have put the state budget immediately more than $600 million into the red.

The chart projected that the deficit would grow to more than $1 billion annually by FY 2018.

A number of candidates supporting oil tax reform glossed over this issue during the course of their recent campaigns.  Repeatedly, they talked about the need to reduce oil taxes to stabilize the continued decline in the state’s production.  But also repeatedly, they failed to explain how they would reconcile that action with the increased levels of state spending a number of them had approved over the intervening years since the passage of ACES.

The few who did address the issue appeared to allude to some sort of Reagan-era “Laffer curve” effect, where the reduction in taxes would result in an undefined, increased level of production that would ultimately produce sufficient additional revenues to offset any budget impact.

But no candidate ever attempted to define when the increase would take place, or how much it would be.

Certainly, I am among those who believe that oil reform will produce long term benefits to the state.  As I have written previously, done right I believe that oil reform ultimately is capable of moving the decline curve from the current status quo of something over 6 %, to as low as 3%.

The potential is demonstrated on the slide to the left, which was included in testimony given  to the legislature in 2006 — before the distorting effects created by ACES — and I have used in this blog since its beginning.  (An updated version of this slide used in the last legislative session is available here).

But even that curve demonstrates that any sort of supply response to increased investment will start slow and only build in significance over time.  It is unrealistic to think that the response will be so immediate to cover the level of deficits identified in Rehfeld’s testimony anticipated over the next few years.

We should anticipate that some, intent on continuing the current spending spree, will attempt to argue in the coming legislature that its acceptable to incur budget deficits in the short term, funded with draws from the Statutory and Constitutional Budget reserves.  Suggesting a Laffer-curve effect, they will argue that a supply response to oil reform “will” occur, which then can be used to pay back the reserves “over the long term,” when the supply response produces revenues in excess of then year spending levels.

But that is a deeply flawed approach, for two reasons.  First, even with oil reform, revenues will not keep pace with current spending levels, either over the short or long term.  In short, even if there is a “Laffer curve” response in production, it won’t be enough to stay even with long-term spending levels, much less make up any deficits occurring in the short term.

Second, the approach undermines the fiscal stability of future generations.

The chart to the left makes both points starkly.

The chart is from a recent study by the University of Alaska Anchorage’s Institute of Social and Economic Research (ISER).   The chart projects the continued effects of current state spending and revenue policies –“Business as Usual.”

The green on the chart represents projected oil revenues, taken from recent forecasts by the Department of Revenue.  (As demonstrated in a recent guest column on these pages, these forecasts are premised on production forecasts which consistently and significantly overstate reality.)

The black line represents the continuation of the current trend in state spending rates.  The red indicates the use of current state reserves — the Statutory and Constitutional Budget Reserves — to fill the gap until they are exhausted.

The white area below the black line after the end of the red — after the Statutory and Constitutional Budget Reserves are exhausted — is the deficit, the difference between projected spending and revenues.

As the chart clearly demonstrates, based even on the current, already likely overstated revenue forecasts, Alaska’s current spending policies are inexorably leading the state to a point where, at some time in the not too distant future, current fiscal reserves will be exhausted and remaining revenues will be insufficient even remotely to match spending.

At that point, Alaska either will have to implement income, sales and statewide property taxes in order to maintain even a reduced level of state services, or accept an unprecedented cut in those services.  Either way, it will leave future Alaskans with a standard of living much lower than that being enjoyed currently.

Extrapolating from the chart, even if oil revenues (the green area on the chart) ultimately increase 25% over currently projected levels after several years as a result of oil reform, at current rates of growth spending will continue to far outstrip revenues — both in the near future and over the long term.

In short, at current and projected spending levels any reasonably anticipated revenue increases from increased oil production will never catch up with the size of the deficit.    The budget hole into which Alaskans will fall may be smaller than indicated on the chart and come a little later, but a substantial hole will exist nonetheless.

More importantly, the chart clearly demonstrates that the shortfall will be felt disproportionately by future generations.   Alaska ‘s Governor and its legislators owe a duty to both current and future Alaskans.  The current generation shouldn’t take actions that allow them to reap all of the benefit from the state’s oil resources, leaving future generations with a lower standard of living.

Yet, that is exactly what continuing the state’s current spending spree would do.

The current generation won’t see the economic consequences because, under existing state fiscal policy, the currently available state savings accounts, shown in red on the chart, will be used to supplement current revenues to maintain spending.

But as the chart also shows, even with increased oil revenues, at some point those savings will run out, leaving future Alaska generations with no savings and substantially reduced revenues from which to fund state government.

As I have explained elsewhere on these pages, Alaska is unlike other states in a number of respects, but most important for this purpose is that Alaska funds virtually its entire General Fund from a single, ultimately non-renewable source — oil.  As oil production inevitably tapers off over time, so will state revenues.

The current generation of Alaskans have an obligation to future generations to manage the wealth being produced by oil production in a way that will provide financial stability both for current and future Alaskans.

As the chart makes clear, continuing the current spending spree violates that obligation.

The future doesn’t have to be this way.  As the ISER report explains, by reducing current spending and investing the remainder  — along with the current balances of the Statutory and Constitutional Budget reserves — in a manner similar to the Permanent Fund, the state can produce a future revenue stream which permits a stable level of spending — a “sustainable” level — for the benefit of both current and future Alaskans.

But as I have explained elsewhere, in order to produce that result the Governor and legislature need to reduce spending now.  They need to reduce spending in order to avoid oil tax reform resulting in immediate budget deficits.  And, they need to reduce spending in order to avoid future Alaskans being left holding the bag for the overuse by current Alaskans of the state’s oil wealth.

In order to achieve these results, the cuts will need to be substantial.

The Governor and legislature will have to eliminate state funding to pet projects like the Moose Federation, putting Astroturf on middle school soccer fields, rebuilding at state expense parking lots at privately owned sports facilities, building elite baseball fields, subsidizing airline tickets to basketball games in Anchorage and about $2 billion more of other spending.

But, by combining these steps with others I have discussed elsewhere, the budget can be brought under control and a reasonable level of spending preserved for both current and future Alaskans.

As I have observed in a companion piece today, the new organization in the state Senate appears to understand the issues and has set its priorities accordingly.  At this point, however, the House appears to be lagging behind and the Governor doesn’t appear to have addressed the issue.

As incoming Senate President Charlie Huggins might say in this situation, “failure is not an option,” but there are examples of where failure has occurred.

The same sort of conduct, for example, occurred under the leadership of Tom DeLay, the Majority Leader of the U.S. House during the early years of the Bush Administration.   In perfecting the culture of Congressional “earmarks,”  DeLay added substantially to the U.S. debt.

As the Wall Street Journal said in 2010, reflecting back on DeLay’s term,

 …the number of earmarks multiplied from nearly 1,500 in 1994 to a little under 14,000 in 2005—before voters ousted what had become the Grand Old Pork Party. It isn’t easy to spend so much money so egregiously that even Nancy Pelosi could campaign as a relative fiscal conservative, but the Tom DeLay Republicans managed the feat in 2006.

It’s true that earmarks make up only 2% to 3% of all federal spending, but that spending is what greases the political skids for passing trillion-dollar-plus budget bills. Members get what they want in return for voting “aye” on what the Administration and Congressional leaders want.

The results of recent state budgets — with their repeated and extensive earmarks for pet projects — demonstrate that Alaska’s legislators have followed the same path since the enactment of ACES.

If Alaska is to achieve oil reform and provide financial stability for future Alaskans, that approach must change — beginning now.