Juneau, Alaska

(907) 699-6788 ed.king@kingecon.com

Adding Uncertainty to Those 7 PFD Changes: PFD – Part 6

In this final article on the PFD, let’s explore how uncertainty changes the conclusions we arrived at in Part 5. Today, we will insert alternate projections into the model. From there, we can see how much the outcomes change.

To keep this from getting out of hand, I’m only looking at the three input assumptions that move the needle the most – budget growth, oil price, and investment earnings (oil production and oil company costs would be next on the list).

Please remember that the goal here is not to predict the future. It’s just to understand how the options compare under different inputs. If someone wants a more formal analysis, shoot me an email and we can discuss what it would cost.

If you haven’t read the last two articles, this one will probably make more sense if you do that first.

Budget Growth

Last week, I held the budget at the FY20 spending level and let agency operations grow with inflation. But, that is actually a fairly conservative assumption. The cost of government has grown by more than inflation over the last 20 years (on average).

So, we should look at what happens if the demand for government services grows at a faster clip. On the other hand, if a lack of revenues provides resistance to budget growth, perhaps the problem is less dire. And, if it is possible to ensure that the budget cannot grow, we should look at what that would do as well.

Higher Budget Growth

In this “higher budget growth” case, agency operations grow at 3% per year (versus 2.25% inflation in the base case). This will give us some insight into how impactful growth in spending could be.

And, this might still be a conservative estimate. If employees wages and benefits grow the way they have been for the last 10 years, only a reduction in staffing could hold growth to this level.

Since we didn’t change anything on the revenue side, we just see the expenditure line get further detached from the money to pay for it. This results in an even bigger problem that needs to be addressed.

As a result of the larger budget, the amount of taxes required goes up. With the POMV limit in place, the net income impact on Alaskans is still the total erosion of the PFD by 2042.

Without the POMV limit (and bigger PFDs in the near term) that outcome is accelerated to 2037. In every year thereafter, the benefit of the PFD is overcome by taxes.

Lower Budget Growth

Alternatively, we should look at what happens with more fiscal restraint.

In this “lower budget growth” scenario, we assume the legislature passes a constitutional spending limit that restricts budget growth to the rate of inflation after a 10-year flat-funding period.

The flat-funding is assumed to be a compromise that avoids further near-term reductions to agency budgets. Instead, agencies are asked to absorb inflation impacts for a decade rather than face dramatic single-year cuts. This allows the departments to transition to a smaller effective spending level without facing any nominal budget cuts.

In this scenario, revenues catch up to expenditures over the next decade. This is because oil prices, investment earnings, and other revenues will still increase with inflation. But this doesn’t quite get rid of the whole problem.

As a result, temporary taxes or PFD reductions are needed.

But, by removing the POMV limit – while demonstrating adequate fiscal restraint – there is no fiscal crisis (although something still needs to change in the distant future).

Budget Growth Uncertainty Results

As clearly demonstrated here, the budget growth assumption is a key driver in how serious a financial problem we are facing. Therefore, we should be careful not to make drastic changes to our livelihood, simply based on someone changing a cell in a spreadsheet by 1%.

The following table shows the optimizing strategies for the four different types of people, under the three different budget growth assumptions:

Lower BudgetBaseline BudgetHigher Budget
Tax-Neutral, Long-TermCurrent PFD, No POMVCurrent PFD, No POMVCurrent PFD, No POMV
Tax-Neutral, Near-TermCurrent PFD, No POMVPension Payoff, Follow POMVCurrent PFD, No POMV
Tax-Averse, Long-TermExclude ERA, No POMVHB132, No POMVLeftover PFD, No POMV
Tax-Averse, Near-TermCurrent PFD, No POMVInflation First, No POMVInflation First, No POMV

For the tax-neutral person, keeping the current law is always the favored approach. It wins in almost any budget scenario.

For the tax-averse, the aggressiveness of the PFD reduction changes with the rate of budget growth. With smaller future budgets, only a small change is needed (Exclude ERA) for the near-term focused. No change to the current law is needed to satisfy the long-term focused person. In the baseline budget scenario, a bigger change is required.

For the long-term focused, tax-averse person, HB132 is a big enough reduction. For the near-term, HB132 would reduce the current PFD too much. The “Inflation First” option goes far enough.

But, if the budget is growing faster, more drastic action is required for the long-term focused. That puts the “Leftover PFD” in the lead. For the near-term focused, the “Inflation First” option still does enough.

Regardless of the scenario, the implication is clear. The more aggressive you see the budget growing over time, the more dramatic the near-term changes need to be. But, if you envision fiscal restraint as a viable alternative, minimal taxes or PFD changes are required.

Interestingly, following the POMV limit is rarely preferred in any budget scenario. Removing the POMV almost always provides better results over the 30-year period than following it. That is because using the ERA balance to avoid near-term taxes or PFD reductions outweighs the future benefits of a larger Fund.

Oil Price

The one thing that we know for sure is that we don’t know what oil prices will do in the future. At every point in our past, we have assumed oil prices 10 years from now would look about like they look today.

And, at every point in the present, we’ve been able to look back and see unpredictable events destroy our forecasts. The bottom line is that we don’t know what the future will look like. So, we should at least understand what happens if our current view of the future turns out to be very foolish.

Higher Oil Price

In this “higher oil price” case, let’s just assume that oil prices average more like $80 per barrel.

With these higher prices, the revenue line grows faster than before. As a result, the gap between spending and revenues narrows. The royalty deposits to the Permanent Fund also increase, providing a little more money in the POMV.

These higher oil prices close the gap over the next decade. But, the problem reappears when those new fields also start to decline (unless we find some more before then).

But, the increase in revenue does leave more of the PFD available for Alaskans to enjoy. While there is still a gap, it is much more manageable. If we stick to the POMV limit, a small tax or PFD reduction is required until more production comes online.

If we ignore that POMV limit, the retained earnings still sitting in the reserve account can fill the gap. In this case, we don’t actually have a financial problem to solve for about 25 years.

And these results don’t even consider that oil production may be higher than the most recent forecast.

Lower Oil Price

Conversely, with the rise of electric vehicles, carbon-fiber airplanes, improved alternative energy technologies, and reduced oil production costs, it is possible that the future price path for oil is a downward trend.

To capture this possibility, we will use an oil price of $60 per barrel, then hold that number flat (don’t let it grow with inflation). The result is a strikingly different outcome.

Revenues only grow with the growth of the Permanent Fund (and a little from non-oil sources) while the budget needs continue to grow with inflation. The disconnected is alarming.

As a result, massive broad-based taxes would be required to replace falling oil revenues. By 2035, the small remaining net benefit of the PFD would be consumed – if the POMV is followed.

Without the POMV, the future is bleak. Those next few years of large PFDs are met with enormous taxes once the Earnings Reserve Account is empty.

Oil Price Uncertainty Results

The following table shows the optimizing strategies for the four different types of people, under the three different oil price assumptions:

Lower Oil PriceBaseline Oil PriceHigher Oil Price
Tax-Neutral, Long-TermCurrent PFD, No POMVCurrent PFD, No POMVCurrent PFD, No POMV
Tax-Neutral, Near-TermCurrent PFD, No POMVCurrent PFD, No POMVCurrent PFD, No POMV
Tax-Averse, Long-TermLeftover PFD, No POMVHB132, No POMVCurrent PFD, No POMV
Tax-Averse, Near-TermHB132, No POMVInflation First, No POMVCurrent PFD, No POMV

Again, those that don’t mind taxes prefer them to PFD reductions across the board. Even with a much larger budget gap due to lower oil price, those taxes are preferred. And, the POMV never generates a better outcome than drawing down the ERA. Although this increases the need for future taxes, those draws are justified at even a zero percent discount rate.

For the tax-averse, the depth of the PFD reduction is dependent on the size of the budget gap. Lower oil prices require more drastic reductions. But, higher oil prices remove the need for any change.

Investment Earnings

With the Permanent Fund growing to over $66 billion, and with the legislature viewing the earnings from that fund as the primary funding source for the budget going forward, the income from the fund draws a lot more attention these days.

The Alaska Permanent Fund Corporation is currently projecting a 10-year average return of 6.55%. Taking away the inflation estimate of 2.25% per year, the Corporation is projecting a “real” return of 4.3%.

But, predicting the stock market is like trying to juggle in outer space. It just doesn’t work. So, what happens if that projection is wrong?

Higher Investment Earnings

For this scenario, I use the Corporation’s target return of 5% above inflation (7.25% total return) after a 0% return next fiscal year. For grounding, the Corporations historic average return is closer to 6% above inflation. So, this is not an aggressive assumption.

The justification for this scenario would be that any negative outlook is a temporary issue that will correct itself within the next couple of years. From there, higher rates of growth would return.

With the higher returns, the Fund grows each year. However, the higher earnings result in more significant PFD distributions. Meanwhile, the POMV limit doesn’t allow the increase in earnings to close the budget gap. Instead, it results in an expanding ERA balance while a deficit persists.

So, more investment earnings actually create a very strange problem under the current laws. It actually makes the budget gap bigger, as more of the allowable draw gets eaten up by the PFD calculation.

After that 0% return year works its way through the 5-year averaging, the higher return creates the bigger PFD calculations you see if the graphic. And, with the POMV, the bigger balance combines with the larger return to have meaningful impacts.

Lower Investment Earnings

Alternatively, some people believe that the era of economic growth is coming to an end. They argue that productivity has plateaued and that emerging markets will not obtain the growth rates of the past.

If this turns out to be true, it may be difficult to hit the return target of 5% over inflation, or even the lower near-term projected rates of return. For this scenario, to be consistent in magnitude, I use a 5.85% return (3.6% above inflation).

With the lower returns, both the size of the POMV transfer and the size of the PFD decrease. However, the net impact is still a budget gap that persists over time.

With smaller earnings come smaller PFD calculations. But, that doesn’t solve the budget problem. There is still not enough money to pay the bills. As a result, the PFD is effectively gone by 2049 if we stick to the POMV and 2045 if we don’t.

Investment Return Uncertainty Results

The following table shows the optimizing strategies for the four different types of people, under the three different investment return assumptions:

Lower ReturnsBaseline ReturnsHigher Returns
Tax-Neutral, Long-TermPension Payoff, Follow POMVCurrent PFD, No POMVExclude ERA, No POMV
Tax-Neutral, Near-TermCurrent PFD, No POMVCurrent PFD, No POMVCurrent PFD, No POMV
Tax-Averse, Long-TermLeftover PFD, No POMVHB132, No POMVHB132, No POMV
Tax-Averse, Near-TermInflation First, No POMVInflation First, No POMVInflation First, No POMV

For the tax-neutral person, no change to the current PFD is required if the person is near-term focused. And, the POMV is better ignored than followed.

In the long-term view, things change. If returns are expected to come in lower, the POMV is better followed and the “Pension Payoff” plan has appeal. If returns are higher, excluding the ERA has more impact (seeing as the bigger returns create a bigger balance).

For the tax-averse, a near-term focused person is content with the “Inflation First” option – regardless of investment returns. The long-term focused person prefers deeper cuts to the PFD. And lower returns require more aggressive reductions.

Conclusions

Although there is not a definitive answer, there are several observations we can make from this analysis:

  1. A future problem appears real…
    • Even with higher oil prices or investment returns, declining production and growing budgets will likely create a systemic failure at some point in the future.
    • Higher oil prices or investment returns reduce the problem but don’t solve it on their own.
    • Increased production levels would shift the problem into the future.
  2. …but the problem is not urgent…
    • The State’s financial problems won’t rise to “crisis” levels for at least five years.
    • There is no risk of default due to insolvency while we have financial reserves.
    • If oil prices, oil production, and/or investment earnings beat current projections, there might not be any real problem at all.
  3. …and the budget problem doesn’t exist if there is sufficient fiscal restraint.
    • The “fiscal crisis” is a temporary problem if budget growth is limited.
    • If restraint is combined with a higher oil price, more oil production, and/or better investment earnings, there is no problem at all.
    • Immediate budget reductions are helpful but will be fruitless if future growth is not controlled.
  4. The risk of an impending fiscal crisis is alarming…
    • Reduced oil prices, oil production, and/or investment returns pose a significant financial risk.
    • Some type of immediate action appears to be prudent.
  5. ..but, the uncertainty around the future warrants making several incremental adjustments rather than sweeping changes.
    • Taking some action before reaching a crisis point provides a glide-path rather than a possible fiscal cliff.
    • The need for action should be reviewed each time better information becomes available.
    • HB132 and the “leftover PFD” options appear to be too aggressive given the level of uncertainty we currently have.
    • SB103 appears to be a reasonable compromise bill (if the POMV is maintained).
    • The “Inflation First” and “Pension Payoff” options could help solve the problem without changing the PFD formula.
    • Passing a broad-based tax is a viable alternative to any PFD change.
  6. The POMV might be solving problems by creating others.
    • In almost every scenario, ignoring the POMV provides better results for Alaskans than following it. That finding raises questions that should be explored.
    • Using the existing balance of the ERA can fill a temporary budget gap.
    • The POMV is unnecessary if an effective spending limit is in place.
    • However, the POMV provides some protection to the Earnings Reserve Account, which many people view with the same resolve as the Permanent Fund principal.

While we do not advocate for specific policies on this website, I hope that the outputs from this analysis shed some light on how the options presented here compare to one another.

I acknowledge that many other options exist, many other variables are unknown, and many other value metrics are held by Alaskans.

As such, I don’t pretend to be in a position to provide definitive answers to these complicated matters (and question the integrity of anyone that claims they can).

However, I would be happy to provide further insight as the issue is debated and additional questions are raised. Just give me a call.

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