The Monthly Lead: Retaining SB 21 is the right decision, if …

Through last month, I wrote a monthly op-ed column on oil, gas and fiscal policy issues for the Alaska Business Monthly.  I have suspended that column while some talk about me running for Governor (ABM’s policy understandably is to discontinue any “writings” by formally announced, or potential candidates).   In the meantime I am continuing to write a lead monthly article for the blog, called “The Monthly Lead.”  This is the first such piece.

Parnell SB 21

With certification this fall by the Division of Elections, the question of whether to repeal Senate Bill (SB) 21 – the oil tax reform enacted and signed by the Governor earlier this year – will be put to a statewide vote next August.  The issue on the ballot will be “Should this law [SB 21] be rejected?”  A “yes” vote will be to repeal SB 21; a “no” vote will be to retain it.

If SB 21 is rejected, Alaska’s oil tax approach will revert to ACES (Alaska’s Clear and Equitable Share), the state tax policy enacted in 2007, which virtually all legislators last session agreed was in need of reform, although many argued for different approaches.

Retaining SB 21 is the right decision if the Governor and legislature enact needed budget reforms this coming legislative session.  This piece explains why.

The reasons to vote to retain SB 21

There are two arguments in favor of retaining SB 21.

Jobs and the economy.  The first is that SB 21 will increase jobs and other private economic activity in Alaska.

Proponents argue that by reducing taxes, SB 21 will lead to increased investment in Alaska oil and gas development, and as a result, increased demand for oil field and other support services.  That, in turn, will result in increased activity also elsewhere in the Alaska economy, and as a consequence of both, increased jobs.

Those who oppose SB 21 and seek its rejection argue that oil patch job levels in the state have never been higher than under ACES (Alaska’s Clear and Equitable Share) and that rejecting SB 21 will not change that.

The statistics indeed show that oil field job levels are high currently, but that is because Alaska currently is going through a type of bubble.  Current oil field job levels are high primarily for two reasons.

One, there has been a significant amount of maintenance, repair and replacement activity ongoing on the North Slope since the 2006 oil spill.  That has employed a large group of people and generated a great deal of economic activity.  Two, the number of workers – and expenses – required to support oil field production tend to increase as fields age.  It simply takes more workers to deal with the issues raised by aging fields.

Both of those are temporary conditions, however.  The activity resulting from the 2006 oil spill is winding down and so will general employment as the existing oil fields continue to produce less and less.  If declining production is not replaced by new drilling and production activity, the number of workers will start to scale down in the relatively near future.

SB 21 is a reasonable effort to incentivize ongoing investment in new drilling and production efforts so that the current level of economic activity remains relatively constant into the future.

Increased production.  The second reason to support SB 21 is that it will increase production levels to the point where state revenues also increase.

Previous columns on these pages have referred to a report published earlier this year by the University of Alaska-Anchorage’s Institute of Social and Economic Research (ISER) on the fiscal health of state government.

After analyzing current revenue and spending rates, the report concluded that “[r]ight now, the state is on a path it can’t sustain. … Reasonable assumptions about potential new revenue sources suggest we do not have enough cash in reserves to avoid a severe fiscal crunch soon after 2023, and with that fiscal crisis will come an economic crash.”

SB 21 is intended to help address this situation, again by encouraging increased investment in oil and gas development.  While the tax rates per barrel are lower under SB 21 than under ACES, the state nevertheless will realize increased revenue if overall production increases (i.e., the number of barrels produced) more than offset the lower tax rates.

During the legislative session earlier this year both the legislature’s and Administration’s experts testified that they thought SB 21 would likely result in production increases over time at levels sufficient to produce higher overall revenues, improving the state’s long term fiscal outlook.  I agree with their assessment if tax reform results in higher, sustained investment levels.

Budget reform is needed to make SB 21 work

But both of the above reasons supporting SB 21 depend on the law resulting in sustained and ongoing increases in oil field investment.  Without that, the reforms will not result in increased long-term economic activity, and will not result in the levels of increased production necessary to achieve higher state revenues.  Without sustained investment, the law will only have a limited effect and fail in its primary objectives.

Attracting sustained investment, in turn, depends not only on reasonable tax rates, but also depends on the perception that the reduced tax rates are durable.  My column in the May 2013 edition of Alaska Business Monthly, titled “Understanding Investment,” explains why.

… producer[s] commit a large part of the money required for a major project in the first few years.  Most production – and revenue – come later.  Despite the fact that it comes later, however, it is that anticipated revenue stream on which the investment is based in the first place. … Because the revenue stream is still several years into the future at the time the investments are made, the investor must make projections about what the revenue stream will look like …. One of the factors in making that projection – indeed, often the largest factor other than the price of oil – is the amount the applicable governments will deduct from the stream in royalty, taxes and other assessments over the first 15 years or so of the project.  … Projects where the government reserves the right to change the [tax] level during the life of the project present special problems in projecting the level of the anticipated return.

In short, significant and sustained investment depends on the expectation of durable tax rates and other elements of government take.  If investors anticipate there is a risk that tax rates are likely to increase significantly during the major revenue producing years of the project – undermining the return on which the investment is to be based – they will look for other, more certain opportunities elsewhere.

That is where the need for significant budget reform enters the picture.  As the ISER analysis makes clear, on its current path Alaska is headed for a “fiscal crisis” and “economic crash.”  While increased revenue levels may help delay the date of the crash slightly, the only way to avoid the crash entirely is through reduced spending.

The reason is that current state spending levels are substantially in excess of what Alaska can afford based on any set of projected revenue levels.  As I have discussed in previous columns on these pages, state spending for Fiscal Year 2013 (which ended on June 30, 2013) was $7.9 billion.  State spending for the current Fiscal Year is projected to be in the range of $6.8 billion, and in April the Governor announced a “fiscal plan” which continues spending at that level also for the next five years.

Against that, the ISER report concludes that based on current savings and other levels, “Alaska’s state government can afford to spend about $5.5 billion” per year.  Spending above that level – which the state has done consistently since FY 2011 and the Governor now proposes to continue for an additional five years – runs the state through all of its savings and leads to the dire prediction contained in the ISER report.

As a result, when current and potential investors look at the ISER report, they also see something more.  They see a situation developing where they become concerned, as the state approaches the “fiscal crisis,” that the Administration and legislature likely will consider re-raising taxes on oil production, well within the period during which the investors otherwise are counting on earning the return on their investment.

That potential creates significant uncertainty, which causes investors to hesitate.   As a result, the very investments that SB 21 is designed to attract are in danger of going elsewhere, not because of a failed tax structure, but because of the state’s failure to create a budget structure which ensures the durability of the tax structure.

What type of budget reform is needed

To avoid this result and demonstrate durability, Alaska needs to adopt two significant budget reforms.  The first is required in the near term; the second is more long term in nature.

Near term budget reductions. The near term step is straightforward.  In order to create a durable fiscal structure, state spending levels need to be reduced to the sustainable levels outlined in the ISER report, beginning this coming legislative session.

The reason the process needs to start this session is simple.

In order to develop a durable fiscal structure, the state needs to create savings of a sufficient size to produce the revenues required to maintain state spending at sustainable levels when oil revenues are no longer capable of doing so alone.  The longer the state delays putting revenues into savings, the smaller the size of the savings account – and the future revenues it is able to produce.

As the ISER report puts it, “[i]f Alaska had $117 billion in cash reserves and the Permanent Fund by 2023, the state would be on the path to sustainable spending far into the future. But … that’s twice what the state has in financial assets today. So the state needs to sharply step up its savings rate, starting now.”

Long term budget plan.  The long term step is also straightforward.  Alaska needs to put in place a budget process which provides assurances that future spending levels will remain within sustainable levels.  It does not do the state any good to restrain spending for one year, if the perception is that future spending levels – and thus, likely tax levels – quickly will return to unsustainable levels.

Several states have enacted “budget acts” which provide mechanisms for maintaining long-term spending within sustainable levels.  Alaska needs to do the same to reassure both investors and future Alaska generations that ongoing state spending levels will continue to be maintained within sustainable levels.

Conclusion

While reasonable tax levels are a necessary component of attracting investment, they do not act in isolation.  Investors must be assured as well that the tax levels are durable.  A balanced, sustainable and predictable fiscal structure is crucial to achieving that durability.

To achieve a sustainable fiscal structure, Alaska must enact both near and longer term budget reforms.  Failing to do that will undermine the rationale supporting SB 21 and with that, will put its retention at significant risk. 

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