Alaska’s Finances Aren’t as Bad as You Think

If you happen across some information about Alaska’s current financial situation, you probably get the impression that we are in dire straights. When oil prices crashed 77% in late 2014, the State’s oil revenues collapsed – leaving a gaping hole in the budget. By all accounts, we’ve been deficit spending ever since. But that is not the whole story. There’s an inconvenient truth hidden beneath the headlines. What if I told you Alaska isn’t actually in as bad of financial shape as you’ve been led to believe?

Last Year’s Numbers – FY19

As I write this, we are slogging toward the end of an ugly fiscal year 2020. The stock market is down, the economy is reeling, people are afraid to leave their homes, and oil prices are inching toward zero. There’s no doubt that things don’t look good right now. Things will get better, but it will take time. For now, let’s take a step back and consider how bad things were in FY19.

According to the Legislative Finance Division, Alaska authorized a total of $11.6 billion of expenditures in FY19. Meanwhile, it reports revenues of $11.2 billion. The implication is that there was a deficit of over $400 million – which came out of the state’s financial reserves. This deficit spending served as justification for withholding half of the PFD from Alaskans.

Now, flip over to the audited financial statements from the Division of Finance. Scroll down to page 26, which lays out the State’s cash flow activities. It reports total actual expenditures of $10.1 billion and revenues of $12.4 billion – a surplus of $2.3 billion.

What’s gives? How can the division advising the legislature claim we ran a deficit while the division producing the official audited financial statements report something different? Are we in a financial crisis or are we stocking away surplus revenues?

The answer is both. And, that’s crazy to think about.

Explaining the Surplus

Despite what we often hear, and the state isn’t completely dependent on oil revenues. Of the $12.4 billion in total revenue, only $2.6 billion came from current year oil production (21%) in FY19. Even if we had no oil revenue, we would still have an average of almost $10 billion a year available to the State government. Of course, we are taking a high-level view of the State’s revenues. Some of those dollars (those federal grants for example) are attached to restrictions on how they can be used.

Investment Revenue Limit

Part of the confusion stems from the fact that the State’s investment income has a revenue limit attached to it. That is due to a law that passed in 2018 called the Percent of Market Value (POMV). Basically, we aren’t allowed to spend more than 5% of the fund balance in any given year, regardless of what actual earnings look like (technically, it’s more complicated that that).

For some reason, the Legislative Finance Division has opted to treat earnings above the limit as though they don’t exist – hence the biggest difference in reports. In FY19, the POMV imposed a limit of $2.7 billion, forcing over $1 billion of earnings to hide from public view.

And that was on top of the constitutionally required royalty deposits, which placed another $385 million of revenues out of reach. Placing that $1.4 billion off-limits created a deficit in accessible cash. Meanwhile, total revenues were greater than expenditures.

Designated General Funds

In addition, the General Fund itself also grew in FY19. The net change in fund balance worked out to $875 million. This issue is a little harder to grasp, but let’s explore the matter a bit.

To understand what’s going on, imagine budgeting your personal finances with a series of envelopes. On one, you write “food.” On another, you write “clothes.” Imagine you have dozens of these envelopes for all of the different things you spend money on. Now, pretend that each time you get paid, you split the money up between those envelopes. And, imagine that if you get certain kinds of money, like a $20 bill in a birthday card, you place that money in a specific envelope – maybe the clothes one.

When you need to buy groceries, you take money out of the envelope reserved for food. When you need to buy a new outfit, you tap into that clothes budget. If you run out of money in one envelope, you have to wait until you get paid. And, if you don’t need to buy any new clothes this month, the money for clothes just sits in that account until you do.

This is how you can end up telling your friend you can’t afford to go to the movies (because your “entertainment” envelope is empty) while you have hundreds of dollars set aside for other purposes. It’s Schrödinger’s budget – You’re both broke and have money.

This process is basically what’s going on with these designated funds. According to the FY19 audited financial report, there was a total of about $4.8 billion spread out across these “envelopes” on June 30, 2019. That’s $875 million more than when the year started.

General Fund Surplus/Deficits

When people talk about the state budget, they usually ignore everything that gets paid out of one of those “envelopes.” What they focus on is the money that doesn’t pass through a designated account. These are called unrestricted general fund (UGF) revenues/expenditures.

In FY19, Alaska collected about $2.5 billion in UGF revenues (excluding the Permanent Fund earnings). Meanwhile, the items in the budget that didn’t have separate funding sources totaled about $4.8 billion (excluding the PFD). That gap is the UGF deficit. Here is how it has changed over time.

Notice that the UGF deficits started in 2012 (FY13) – while oil was over $100 per barrel, and ACES was still in effect. That’s how high our spending was. But, it is undeniably true that even with the more sustainable budget levels we have today, there are not enough traditional revenues to cover unrestricted spending.

The current budgeting process has been hiding this fact a bit since 2018. It does that by counting a draw from the Permanent Fund Earnings Reserve Account (ERA) as though it is UGF revenue – while ignoring the actual investment gains.

Change in Net Position

Whether or not you want to include the Permanent Fund earnings as state revenue is really a matter of semantics. The constitution clearly defines them as general fund revenues. Unless we change the constitution, there is no requirement to save the earnings from the fund for future generations. Nor is there a requirement to hold onto unspent investment earnings from previous years. Those retained earnings sit in the ERA. But, they are still earnings – by definition.

The balance of the ERA is accessible to cover budget deficits, PFDs, and debt service payments. Regardless of how we might want to think about that money, from a financial analysis perspective, the ERA is no different than any other savings account. Anyone treating that balance as though it is part of the constitutionally protected money we set aside for future generations is wrong. If we want to save that money for our kids and grandkids, we would need to transfer it to the principal account. There’s a good case for doing that, but that is not where things sit today.

Therefore, the idea that we have been depleting our balance sheet over the last several years is also wrong. Here is what Alaska’s actual financial picture looks like:

The data from the figures above come from the audited financial statements of the state. You can find them here. As you can see, we haven’t been truly deficit spending since 2016 (although 2020 will be an exception). Even if the legislature had appropriated the statutory PFDs in 2017, 2018, and 2019, there would still have been surpluses.

Notice what really happened to our finances. We have basically just been moving the balance of our savings accounts over to the Earnings Reserve Account (ERA). The State’s total investment account balances are nearly at a record high. Things aren’t as good as they would have been with more fiscal discipline a decade ago, but the current situation is not nearly as bad as is it made out to be.

This Year’s Numbers – FY20

We are in currently in the tenth month of fiscal year 2020. It’s already been a turbulent time. The year will end with some of the lowest oil prices since statehood (inflation adjusted). Our investment earnings are probably going to be negative on the year. And, the economy is sliding toward one of the worst recessions in the state’s history.

As things stand today, it appears that the year will end with about $6.8 billion of state revenues (plus any COVID funding). About half of that is federal grant money. That revenue compares to a budget of $10.6 billion of unduplicated spending (plus any additional COVID funding).

The $3.8 billion shortfall comes from negative investment earnings on top of severely depressed oil values. Filling that gap requires funding from two financial reserves – the constitutional budget reserve and the permanent fund earnings reserve.

That deficit is larger than what you might have heard elsewhere. That’s because those budget reports classify a $2.9 billion draw from the earnings reserve as “general fund revenue.”

Next Year’s Numbers – FY21

The legislature isn’t technically adjourned quite yet, but the budget for the fiscal year that starts in July is complete. There will probably be additions to that budget when the next legislature arrives. But, for now, the state is expecting to spend $10 billion. Meanwhile, oil prices are expected to remain low next year (but will recover from there). However, investment earnings should return to positive territory.

All told, total revenues in FY21 are projected to come in at $11.6 billion. The average of reasonable futures suggest we will take in about $1.6 billion more than we are planning to spend. That’s a stark contrast to the numbers provided by state agencies. That’s because when you apply the revenue limit, only $3.1 billion of earnings will count in the budget reports.

That approach makes it appear that there will be a deficit of around $1 billion. Even if the stock market goes crazy and we make $10 billion in investment earnings next year, the budget reports will warn of a billion budget gap that makes paying the statutory PFD “unaffordable.” In reality, it may merely be a deficit of good accounting practices.

Looking Forward

So, how bad is our real financial situation? By that I mean, how much risk is there to our ability to pay our bills. The answer to that question depends on two things we can control (the size of the budget and the rate of taxation) and two things we cannot (the price of oil and the return on investments).

First, we should acknowledge that there is a financial problem. But, that problem is not what it is made out to be. The real problem is that we aren’t growing our revenues enough. With declining oil money and growing budgets, there’s an increasing UGF deficit that will consume all of our investment earnings – including the PFD.

We need to figure out how we are going to address that issue. Growing the Permanent Fund balance is one option. Raising taxes is another. Limiting budget growth is a third. We probably need a combination of all three. The current approach of simply limiting investment revenues without consideration of other revenue volatility won’t accomplish anything but killing the PFD.

However, there is no risk of Alaska not paying its bills. It just looks that way because the current accounting of revenues is a misrepresentation of reality. The truth is we have ample cash reserves and adequate revenues to pay our bills for a long, long time – even with the precarious position we find ourselves in today.

Final Point

With oil prices in the toilet today, it’s easy to think we are doomed. But, the state’s financial situation is not nearly as bad as you’ve been led to believe. Anchoring our perspective to current oil prices makes for an overly grim assessment. And, our confusing accounting system creates a bigger looking crisis than there is.

Of course, there is a problem looming over the hill. If we don’t address it, it will get larger every year. But, there is no reason for legislators to put a death kneel on the dividend. There’s no reason for credit analysts to paint a gloomy picture over our strong balance sheet. And, there is no reason to assume we can’t solve the problems that lie ahead.

Even though it got harder over the last couple of months, it’s not really that difficult to accomplish. All we need is a better fiscal structure to replace the broken one we have today. Then, it’s just a matter of deciding what level of service we are willing to pay taxes to support.