Why we need to halt the reimbursement of oil credits — and how …

Fiscal CliffThis column will not be popular with some readers. But it needs to be written.

As readers realize, Alaska is facing a significant financial challenge.  Part of that is self-inflicted by not tapping all available revenue sources.

Untapped revenue

As we have previously discussed on these pages, part of the Permanent Fund earnings stream always has been intended to be used to support government.  As former Governor Jay Hammond said when discussing his vision behind the Permanent Fund:

“I wanted to transform oil wells pumping oil for a finite period into money wells pumping money for infinity.”  Once the money wells were pumping, “[e]ach 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.”

Inexplicably, instead of establishing a mechanism for doing just that, Governor Walker instead has done the one thing Governor Hammond strongly cautioned against — tapping the Permanent Fund Dividend, the portion of the “account’s earnings [otherwise to] be dispersed among Alaska residents.” This year the result is to have left roughly $1 – $1.25 billion in potential new government revenues on the table (50% of FY 2016 statutory net income), while at the same time taking roughly $650 million out of Alaska’s private economy.

The larger part of the problem

But the much larger share of the problem is driven by continued overspending.

As most readers will know, some legislators have claimed that the budget passed this session holds FY 2017 spending to $4.3 billion.  If true, that would represent a significant reduction from previous years and a large step toward a sustainable budget.

But as we have explained elsewhere the claim isn’t true.  Adjusted for reimbursable oil tax credits and other things the FY 2017 spend passed by the legislature was more in the range of $5.3 billion.

Of course, following the passage of the legislature’s budget Governor Walker line item vetoed a portion of the oil tax credits and some other items, reducing the size of the budget back to $4.3 billion.  But as many have commented, that feels somewhat ephemeral.  Rather than representing a permanent reduction in spending, many view the veto of oil tax credits as being more a deferral, with the resulting obligation simply shifting from one year to the next.

Indeed, the Administration’s presentation made two weeks ago at the start of the fifth Special session embodies exactly that.

Tax Credits (7.12.2016)As the far right column shows, the amount of oil tax credits coming due in FY 2018, if rolled over as many have assumed, will approach $1.2 billion. On the current trajectory, that means even if the Governor and Legislature maintain all other spending at something approaching $4.3 billion — a Herculean task in itself —  total FY 2018 spending still will reach, if not exceed $5.5 billion.  That compares with a likely, long term sustainable budget number for the same period falling somewhere in the range of $4- $4.25 billion and cash revenue (including 50% of PF earnings, assuming the state chooses to include those in revenue) somewhere in the range of $3 – $3.25 billion.

As we have said repeatedly over the past 5 years, Alaska state finances should not be permitted to continue on that way.

Some will argue Alaska continues to have some capacity to do so. According to the most recent forecast from Legislative Finance, even after paying for this coming fiscal year the state still will have over $14 billion (about $14.2 billion to be precise) in available fiscal reserves as of June 30, 2017, down only 8% from the $15.5 billion as of June 30, 2016.  But the size of the reserves masks the underlying story.

Of the $14 billion only $3.6 billion (down from $6.6 billion at the end of the past fiscal year) will remain in the CBR and SBR.   Of the remainder, $1.4 billion will sit in accounts held for designated purposes (PCE, AHEIF) and $9.2 billion in the Permanent Fund earnings reserve.  But if the state had paid out the full PFD rather than capping it at $1000, the amount in the earnings reserve would only be $8.55 billion and if the state had used its 50% share of earnings to help fund government, as envisioned by Governor Hammond, the amount would be down to roughly $7.3 billion, reducing total, non-designated reserves to $10.6 billion.

That represents a 22% decline in non-designated reserves between FY 2016 and 2017. Spending in FY 2018 has to be reduced significantly in order to avoid a repeat.

Dealing with the core of the spending problem — oil credits

So what can be done to reduce FY 2018 spending to sustainable levels?  One way or another it requires dealing with oil credits.

One approach is to reduce government spending elsewhere in order to make room for the $1.2 billion payment in oil credits coming due next year.  That would require significant, across the board cuts to virtually all other spending categories and the potential elimination of some programs entirely, at least on a one time basis to account for the FY2018 impact.

A second is to amortize the credits due next year over a number of years, evening out — and lowering — the payments in the earlier years by increasing them in later years.  For example, amortizing the total amount of estimated payments forecasted above through FY 2025 ($2.4 billion) over the same time period would result in a series of $300 million annual payments, rather than a $1.2 billion payment in FY 2018 and smaller payments in subsequent years.

This would still require some reductions in other spending, however. To fit within a sustainable budget in the range of $4 – $4.25 billion, other spending would still need to be reduced significantly below the $4.3 billion spending level forecast by Rep. Neuman for FY 2018 in order to make room for the additional $300 million in oil credit related spending.

The third option is the one that will make this column unpopular with some, but needs to be discussed.  That is to stop attempting to keep up with reimbursing all credits, and converting them instead largely to deductions against taxes once production begins.

Actually the statutes already provide for this result.  AS 43.55.018, which establishes and governs the fund from which payments are made, provides as follows (as most recently modified by HB 247):

Sec. 43.55.028. Oil and gas tax credit fund established; cash purchases of tax credit certificates.

(a) The oil and gas tax credit fund is established as a separate fund of the state. The purpose of the fund is to purchase transferable tax credit certificates issued under AS 43.55.023 and production tax credit certificates issued under AS 43.55.025 and to pay refunds and payments claimed under AS 43.20.046, 43.20.047, or 43.20.053.

(b) The oil and gas tax credit fund consists of

(1) money appropriated to the fund, including any appropriation of the percentage provided under (c) of this section of all revenue from taxes levied by AS 43.55.011 that is not required to be deposited in the constitutional budget reserve fund established in art. IX, sec. 17(a), Constitution of the State of Alaska; and

        (2) earnings on the fund.

(c) The applicable percentage for a fiscal year under (b)(1) of this section is determined with reference to the average price or value forecast by the department for Alaska North Slope oil sold or otherwise disposed of on the United States West Coast during the fiscal year for which the appropriation of revenue from taxes levied by AS 43.55.011 is made. If that forecast is

(1) $60 a barrel or higher, the applicable percentage is 10 percent;

(2) less than $60 a barrel, the applicable percentage is 15 percent.

(d) The department shall manage the fund.

(e)  The department, on the written application of a person to whom a transferable tax credit certificate has been issued under AS 43.55.023(d) or former AS 43.55.023(m) or to whom a production tax credit certificate has been issued under AS 43.55.025(f), may use available money in the oil and gas tax credit fund to purchase, in whole or in part, the certificate. The department may not purchase a total of more than $70,000,000 in tax credit certificates from a person in a calendar year. Before purchasing a certificate or part of a certificate, the department shall find that

(1)  the calendar year of the purchase is not earlier than the first calendar year for which the credit shown on the certificate would otherwise be allowed to be applied against a tax;

(2)  the application is not the result of the division of a single entity into multiple entities that would reasonably be expected to apply as a single entity if the $70,000,000 limitation in this subsection did not exist;

(3)  the applicant’s total tax liability under AS 43.55.011(e), after application of all available tax credits, for the calendar year in which the application is made is zero;

(4)  the applicant’s average daily production of oil and gas taxable under AS 43.55.011(e) during the calendar year preceding the calendar year in which the application is made was not more than 50,000 BTU equivalent barrels; and

(5)  the purchase is consistent with this section and regulations adopted under this section.

(f) Money in the fund remaining at the end of a fiscal year does not lapse and remains available for expenditure in successive fiscal years.

(g) The department shall adopt regulations to carry out the purposes of this section, including standards and procedures to allocate available money among applications for purchases under this chapter and claims for refunds and payments under AS 43.20.046, 43.20.047, or 43.20.053 when the total amount of the applications for purchase and claims for refund exceed the amount of available money in the fund. The regulations adopted by the department

(1)  may not, when allocating available money in the fund under this section, distinguish an application for the purchase of a credit certificate issued under former AS 43.55.023(m) or a claim for a refund or payment under AS 43.20.046, 43.20.047, or 43.20.053;

(2)  must, when allocating available money in the fund under this section, grant a preference, between two applicants, to the applicant with a higher percentage of resident workers in the applicant’s workforce, including workers employed by the applicant’s direct contractors, in the state in the previous calendar year; in this paragraph, “resident worker” has the meaning given in AS 43. 40.092(b);

(3)  must provide for the purchase of the amount equal to the first 50 percent of the credit repurchase limit for each person under (e) of this section at a rate of 100 percent of the value of the certificate or portion of the certificate requested to be purchased and the amount equal to the next 50 percent of the credit repurchase limit for each person under (e) of this section at a rate of 75 percent of the value of the certificate or portion of the certificate requested to be purchased.

(h) Nothing in this section creates a dedicated fund.

(i) In this section, “qualified capital expenditure” has the meaning given in AS 43.55.023.

(j)  If an applicant or claimant has an outstanding liability to the state directly related to the applicant’s or claimant’s oil or gas exploration, development, or production and the department has not previously reduced the amount paid to that applicant or claimant for a certificate or refund because of that outstanding liability, the department may purchase only that portion of a certificate or pay only that portion of a refund that exceeds the outstanding liability. After notifying the applicant or claimant, the department may apply the amount by which the department reduced its purchase of a certificate or payment for a refund because of an outstanding liability to satisfy the outstanding liability. Satisfaction of an outstanding liability under this subsection does not affect the applicant’s ability to contest that liability. The department may enter into contracts or agreements with another department to which the outstanding liability is owed. In this subsection, “outstanding liability” means an amount of tax, interest, penalty, fee, rental, royalty, or other charge for which the state has issued a demand for payment that has not been paid when due and, if contested, has not been finally resolved against the state.

As is clear from a reading, nothing in the statute requires that the state repurchase all of the credit certificates it issues.  In fact the statute specifically contemplates and provides for procedures to address the potential that “the total amount of the applications for purchase and claims for refund [may] exceed the amount of available money in the fund.”  AS 43.55.028(g).

The fund from which the purchases are made is filled according to AS 43.55.028(b).  That provides for a minimum annual contribution tied to oil prices and the amount of production taxes collected during the year, plus “money appropriated to the fund.” Under current conditions the “minimum” required to be deposited is not significant. In FY 2017, for example, the required minimum is $30 million.

Historically the additional amount required to fully fund the reimbursable credits has come from additional “money appropriated to the fund.”  Up until last year (FY 2016) the legislature and the Governor regularly contributed whatever amount was required to purchase all of the outstanding credits. Beginning with the Governor’s line item veto last year specifically limiting the appropriation of additional monies, however, reality has started to deviate from that practice, leaving the fund at levels below that required to cover all of the potential claims.

When some talk about “deferring” the repayments of the credits to later years, they assume that, consistent with historic practice, at some point the legislature will refill the fund to an amount sufficient to cover all of the outstanding credits.

But there is no obligation to do so.  Neither AS 43.55.028 nor any other statute mandate that the legislature or Administration either in the current year or any subsequent year provide sufficient funds to cover all of the credits.  Indeed, as noted previously AS 43.55.028(g) provides specific guidance for payment priorities when the legislature fails to do so.  Nothing in that subsection or elsewhere requires as part of that process that the legislature then or later inject additional amounts to enable the fund to cover any remaining deficiencies.

And if it doesn’t, the producers aren’t entirely left in the lurch. The credits are not extinguished, but continue to be available to reduce a taxpayer’s obligations once production begins. True, the credits might end up having no — or less — value if the taxpayer never finds oil or gas.  But reading through the statutes Alaska never undertook the obligation to make those engaged in such activities whole.

Halting oil credit reimbursements does not break faith or undermine the economy

Some will argue that taking this third approach —  to cease efforts to keep up with reimbursing all credits and converting them instead largely to deductions against taxes once production begins — breaks faith with those who have invested in such projects.

We disagree.  Subsection (g), which expressly provides that “the amount of available money in the fund” may not be sufficient to cover all claims, has been in the statute from the outset.  And the certificates themselves all contain language that both reference the statutes and provide that payment of any claims made under the certificate is subject to available funds.

As a result, any investor knew or should have known from the outset that some or all of any credits they earned would need to be used against taxes rather than reimbursed.  The occurrence of that event is not breaking faith; it is something they knew might happen from the outset.

Moreover, we don’t agree with those that argue taking this third approach somehow unacceptably undermines Alaska’s economy.

As  the report issued earlier this year by the University of Alaska- Anchorage’s Institute of Social and Economic Research (ISER) on the “Short-Run Economic Impacts of Alaska Fiscal Options” demonstrates, of all the fiscal tools available to the state the most harm to the overall Alaska economy occurs from cutting the PFD.   Taking into account the knock on effects, the overall Alaska economy loses roughly $1.40 in income for every $1 cut from the PFD.

While the report does not specifically analyze cuts in the oil credit program, the characteristics of oil credit expenditures — such as the division between what is spent in-state and what goes immediately out-of-state — look much like state capital spending, which is analyzed in the report.   Again, taking into account the knock on effects, the overall Alaska economy loses only roughly $.65 in income for every $1 cut from capital spending.  Put another way, of each $1 spent by the state on capital spending, $.35 goes immediately out of state and only $.65 stays in the Alaska economy.

As a consequence, for each $1 cut from the PFD and spent instead by government on capital goods, or oil tax credits, the Alaska economy suffers a net loss.  For example, if the $655 million in PFD cuts are used to pay toward oil credits, now or later, the Alaska economy will suffer a net loss of roughly $500 million.

Frankly, cutting the PFD — especially if used to pay for capital spending or oil credits — does much, much more to undermine the Alaska economy than halting oil tax reimbursements.  While halting payments for oil credits may affect some segments of the Alaska economy, the alternative of cutting PFD’s instead to continue to fund oil credits — which is the implicit tradeoff being made in the fiscal proposals suggested by others, including the Governor and the Senate Majority — hits the overall Alaska economy much, much harder.

In that sense, oil credits don’t improve the overall Alaska economy, they harm it.

Finally, we don’t believe, as some argue, that oil credits legitimately are justified as “investments” in the future.

When making investments, an investor chooses the best option from among alternatives.   Here, there is a ready made alternative.  If the dollars are not spent on oil credits, they will be retained in savings and invested by the Permanent Fund Corporation along with the remainder of its assets.  And there also is a ready made target.  The Permanent Fund Corporation has made clear that its “investment goal … is to produce an average annual real [after inflation] rate of return of 5 percent over the long term,” and that including inflation, “the Fund has earned over 10% historically.”

Oddly, those who argue that oil credits are justified as an investment have never offered a target return on investment (ROI) on which to base a comparison with alternatives. Some argue that is somehow “impossible” as the returns will only be realized once production begins.  But that is just silly.  Oil projects always have projected ROI’s in order to permit producers and other investors to weed out good opportunities from bad. Those making the argument simply are trying to obfuscate the issue in order to avoid the fact that either they haven’t calculated an ROI or that it’s bad.

Others suggest that certain projects — the Cook Inlet Cosmopolitan projects seems to be a favorite for this approach — have outstanding ROI’s. That may or may not be the case. But one project does not justify the overall oil credit program.

Doing that is like an investment adviser with a losing track record coming to a client and suggesting that the client should put even more money with the adviser because one stock picked by the adviser (out of 20 in the portfolio) had performed well.  Nice try, but in evaluating an adviser — or an investment program — investors look to overall results, not the random success in an otherwise losing effort.  Perhaps that argument might have merit if the oil credit program were reformed to include a filter that funded only the most promising projects — a process that oil companies call “high-grading” — but the current Alaska oil credit program is anything but that.

Instead, the available evidence suggests that the current Alaska oil credit program is a losing proposition.  Not only is it not producing an ROI competitive with the readily available alternative, in fact it is on track not even to pay the state back the money that has been invested in it.  In short, it looks a lot more like the failed — and now discarded — film tax credit program than anything a reasonable investor would call an “investment.”


Alaska is facing a significant financial challenge.  Part of the solution is to tap revenue sources intended to help the state meet “essential needs” but which, for unexplained reasons, the state has thus far overlooked.

But a larger part of the problem — and thus, a necessary part of the solution — is the state’s spending levels.  And given its size, a key part of the problem — and thus, a necessary part of the solution — is the oil credit program.

We believe the mechanisms already exist to reduce spending significantly — if not entirely — on oil credits and that doing so will not break faith with investors’ reasonable expectations, undermine the economy, or forego a productive investment alternative.

Indeed, given the tradeoffs being made for continued funding of the program — cutting the PFD — we believe that terminating oil credit reimbursements will actually improve the overall Alaska economy.

When asked this coming election cycle where they would reduce spending, addressing oil credits in some fashion needs to be part of each candidate’s answer.  If it isn’t they are being disingenuous about actually wanting to find solutions.

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