Juneau, Alaska

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

Comparing the 7 Ideas to Change the PFD – PFD Part 5

Last week, I laid out the ideas that seem to pop up whenever conversations turn to the Permanent Fund Dividend (PFD). Please refer back to that article for descriptions of these alternatives. This week, I want to attach some numbers onto those ideas.

Please remember that I am not advocating for a change in the PFD (and I’m not getting paid for this work by anyone). I’m merely trying to help provide context to a conversation that is already going on. So, here goes.

Problem Statement

We should probably start from the beginning. Here’s the bottom line:

Given the most recent forecast of oil production, oil prices, existing taxes, and investment earnings, there is simply not enough projected revenue to pay for the current size of government (adjusted for inflation) and the traditionally calculated PFD. As a result, something needs to change.

To bring those lines together, Alaska will need to accept some combination of reducing the expenditure line (budget cuts or PFD reductions) and/or raising the revenue line.

The 5 Approaches

There are a few ideas out there to solve the current “fiscal crisis.” And, there is a near-infinite number of combinations of these approaches that could work. They boil down to this:

  1. Reduce the budget
  2. Pass a broad-based tax
  3. Cut the PFD
  4. Spend savings
  5. Tax others

The last approach is the most tempting. But, before buying it, we need to make sure it’s not a bag of magic beans. While that is certainly a discussion that we should have, we won’t have it today.

In some ways, the first option could be a mirage. While a common talking point, it’s easier said than done. We won’t have that conversation today either.

But, if the administration can find additional budget reductions; or, if an increase in oil taxes passes at the ballot box; either would reduce the need for broad-based taxes, PFD reductions, or savings draws in the near-term.

However, understanding the long-term implications of those options is not the objective today. Instead, we will focus on those other three appraoches in this analysis.

Input Assumptions

For the purposes of this analysis, we are using the DOR published forecast numbers from the Spring 2019 Revenue Sources Book and the investment return projections from the APFC.

Next week, we will look a little closer at how changing those forecasts would alter the results. But, for today, we assume that those projections are accurate and that further budget cuts are unattainable.

For the budget, we will use the FY20 budget numbers as enacted, adjusted by the HB2001 additions that survived the veto pen. That generates an FY20 budget of $5.1 billion in General Fund spending (not including the PFD).

We will assume that the legislature will maintain that level of spending, allowing agency operations to grow with inflation (at an assumed 2.25% inflation rate). Debts will be paid according to their payment schedules.

Because the budget is static, the model will require a tax to cover any shortfall in revenues. We don’t attempt to design that tax here. We just acknowledge that the gap must be filled somehow, and all other options are off the table.

In the model, all laws will be followed – unless the scenario calls for a deviation in one of those laws. The full PFD will be paid, the POMV limit will not be breached, and the inflation proofing of the Permanent Fund Principal Account will occur each year (technically, the FY20 budget says inflation proofing won’t happen for the next few years, but the model follows the current statute).

We also assume that the legislature will not use the balance of the Constitutional Budget Reserve (CBR) after the next fiscal year unless the balance exceeds $2 billion (this assumption resolves some near-term distortion between scenarios that just create confusion).

Developing the Metric

In order to compare options, we need a way to capture all the moving pieces. Some options pay larger dividends today, but draw down savings to do so. Other options require some form of taxation to balance the budget. And some alternatives change the way we calculate the PFD altogether, redirecting some of those funds to the general fund.

To compare all of these moving pieces, we will convert the size of the PFD and the burden of taxation into one metric. Basically, PFD receipts count as positive values that are offset by taxes (which are negative values).

To determine the amount of the PFD, the total distributed amount is calculated based on each scenario’s approach. That number is divided by an estimate of the number of eligible Alaskans for that year (growing with population growth).

For the tax burden, the budget deficit is calculated under each option – based on the given input assumptions. That number is divided by the total Alaska population (growing each year) to get a per capita tax burden.

Subtracting the tax burden per capita from the PFD per resident gets you the net annual impact per Alaskan.

Distributional Impacts and Tax Exportation

It should be noted that the “distributional” impacts of such taxes are not explicitly captured here. That is because we are not designing the broad-based tax that would be used. Different taxes will impact low-income and high-income people differently, depending on the structure. We are only looking at the “average” impact today.

But, the approach used here does implicitly capture some level of tax exportation. That is, raising $100 million in taxes has a smaller burden on Alaskans than an equivalent PFD reduction. This happens because taxes are spread beyond those eligible for a PFD.

Complications

First, this is not a predictive model. Therefore, these are not predictions of what will actually happen if a certain choice is made. This is only an analytical tool to provide strategic insight, which should help us make informed decisions.

Non-analytically oriented people sometimes dismiss long-range outputs due to a lack of understanding of this difference. That’s unfortunate. Just remember that we care about how the alternatives compare, not the value of each option itself.

Regardless, comparing outcomes is difficult. That’s because every person values different things differently. So, if we are to understand “which option is best?” we have to tackle the “it depends” issue.

The answer boils down to a two key issues:

Time Preference

Uncertainty in future revenues leaves room for two types of potential errors. The first error would be taking too large a PFD today (or too much government spending), which ends up leaving future Alaskans with a smaller PFD, higher taxes, or both.

The second type of error would be cutting our PFD today (or passing a tax, or cutting the budget too much), only to find out that there was enough money all along.

If you care more about avoiding that first error, you have a lower time preference and you are “long-term” focused. But, if you want to ensure we don’t make that second error, you have a high time preference and are “near-term” focused.

In the former case, we can just add up all the annual benefits to see which one is better (after adjusting for inflation). But, in the latter case, we need to give a premium to the near-term.

The tool for that is called “discounting.” I use a 10% discount rate here so that we can see the difference. However, every individual has a unique personal time preference. So, your results will vary.

Tax Aversion

The second complication is how you feel about taxes.

Some people philosophically oppose taxation. To them, a smaller PFD may be better than a larger PFD plus a tax. Not because of the math or any actual personal implications. Just a general aversion to the government taking a piece of the fruits of their labor (these people probably don’t view smaller PFDs the same as personal taxes).

But there’s another dynamic at play that is worth pointing out. A low-income individual might pay $500 in taxes while a high-income individual pays $5,000 – under the same tax system. This is true of almost any tax type (even regressive taxes) simply because there is more money to tax. Therefore, it would be natural to see a correlation between income and tax aversion.

Meanwhile, the PFD is a flat dollar amount for all recipients. So, if we set the PFD at $2,000, that low-income person feels their net income increase by $1,500 while the high-income person sees a net income reduction of $3,000.

And so, the net impact of personal taxes and PFD payments would be a progressive system. That fact may play into how a person feels about reducing the PFD versus implementing a broad-based tax.

But, this issue doesn’t always fall along party lines or personal finance implications. Some people simply value the “fairness” of the net impacts. That may result in a preference for taxes (if looking in percentage terms) or a distaste for them (if looking in total dollar terms).

To capture the different ways people think about taxes, we will weight the tax impact in two different ways. From the “tax-neutral” perspective, receiving $1 as a PFD is exactly offset by paying $1 in taxes.

In the “taxaverse” case, we assume it takes $2 of increased PFD payment to offset $1 in income lost to taxes. Whether your own value metric treats these as equal or unequal impacts is up to you. I’m presenting both here to understand why we see different people come up with different answers.

In general, if you care about the distributional effects, you’ll want to stay in the “tax-neutral” case (which will actually understate your preference).

Breaking the POMV Limit

It is interesting to realize that if the Percent of Market Value (POMV) limit is followed, the amount of the PFD has no impact on the Permanent Fund balance. The same amount of money is withdrawn, so the same balance exists, and the same earnings flow from it.

Therefore, if we abide by the POMV limit, any reduction to the PFD simply reduces the amount of broad-based taxes that are required. There are no other ramifications to consider.

But, so long as that POMV rule is statutory, it does not bind the legislature. If we relax the assumption that the legislature will follow its rules, the outcomes change.

Suddenly, the amount of the PFD does alter the size of the draw from the Fund. And a bigger draw means a smaller balance from which to earn a return.

So, without the POMV, bigger PFDs today (without taxes or budget cuts) result in smaller PFD calculations tomorrow. That trade-off matters both in terms of your time preference and your tax aversion.

How the Options Stack Up

In each alternative, the combined total of the stacked column is the calculated PFD. The red portion is the amount of the PFD that would be offset by taxes to fill the budget gap. The black portion is effectively what each Alaskan gets to keep after paying taxes.

You’ll notice that more significant PFD calculations result in more taxes. That’s because if more revenues go to pay for a larger PFD, those revenues must be replaced to fund the budget. Since we are not allowing for more budget cuts today, it requires a more substantial tax.

Baseline with POMV

If further budget reductions are off the table, the result is clear. As oil production declines, while the budget grows, the PFD will eventually be consumed. This will either happen directly (with smaller PFD distributions each year, aka a “PFD tax”) or it will happen indirectly (with broad-based taxes offsetting the PFD distributions). Whether you prefer the direct or indirect approach depends on how you feel about taxes and the PFD.

Under these assumptions and constraints, payment of a “full PFD” can only occur if taxes are collected to fund the budget (remember, we are assuming no more budget cuts for now).

The graphic above shows how those impacts net out. Although the PFD calculation is above $3,000 per person, the “average” Alaskan doesn’t actually get to keep $3,000.

If the full PFD is paid, $2,000 of it must be recouped as taxes (this number goes down as oil production ramps up over the next several years). Again, the preference between receiving a $1,000 PFD, or a $3,000 PFD with a tax bill attached, will depend on how you feel about taxes (and how big that tax bill is for you).

Implications of Ignoring the POMV

By repealing or ignoring the POMV limitation put in place in 2018, the ERA can support a “full PFD” and the “full budget.” But only until 2026 (under the current revenue projections and size of government).

At that point, future Alaskans would have larger budget gaps to manage, leaving them worse off than the current “generation” (unless the projections are wrong).

But, this implies that Alaska does not actually have a “fiscal crisis” today. It’s just that focusing on the present could create a bigger problem on the horizon. If you have a high personal time preference, that future problem may not concern you. But, for anyone concerned about the intergenerational equity of the situation, it probably does.

Option Outcomes

Here is how the other options stack up:

Comparing the Alternatives (Following the POMV Limit)

Next, let’s see how the alternatives compare to one another.

For this analysis, larger numbers are better. Therefore, when comparing options, the higher line is “winning.” If one option is above another in every year, we would say that it “dominates” the other option. A dominated option can be eliminated from the conversation.

However, if the lines cross, then a timing trade-off is present. How those trade-offs are handled will depend on your “time preference.”

Tax Neutral Case

The graph is a little difficult to read, but it boils down to a race between leaving the current law in place or paying off the pension obligation. All of the other options are inferior to the current law to the tax neutral person.

The “Pension Payoff” option provides a slightly higher near-term outcome. But, it does create smaller PFDs in the future due to the smaller Permanent Fund balance.

Here is how the options finish:

Option Ranking Table Long-TermNear-Term
Current Law12
Exclude ERA23
Pension Payoff31
SB 10344
Inflation First55
HB 13266
Leftover PFD77

For the tax-neutral, long-term focused person, the current law generates the best outcome. Therefore, the numbers suggest that the PFD law should be left alone (and followed). Instead, some form of tax should be used to fill any budget gap that can’t be closed by reducing the size of government.

For the tax-neutral, near-term focused person, the analysis suggests leaving the formula alone, paying off the pension obligation to reduce the budget, and passing a tax to fill any remaining budget deficit.

Notice that the “Leftover PFD” and HB132 are the worst options here, discounted or not. That’s because they generate the smallest PFD. Let me explain.

Remember, a tax neutral person only cares about their own bottom line. They don’t care how you get to it. So, from this perspective, taxes are better than PFD reductions because the same budget gap is filled by more people. This always pushes someone that is tax neutral to prefer passing a new tax (and/or cutting the budget) over reducing the PFD.

Tax Averse Case

The result is drastically different if you have a fundamental dislike for taxes. In this case, it is HB132 that wins hands down.

The “leftover PFD” option is a close second. It’s actually better in the far-off years, but it takes away too much in the mid-term to win.

All of the other options are strictly dominated and not worthy of further consideration from this perspective.

Option Rank Long-TermNear-Term
HB 13211
Leftover PFD22
Inflation First34
SB 10345
Pension Payoff53
Exclude ERA66
Current Law77

It’s also worth pointing out that the current law is the worst option for a person that hates taxes. That happens for the same reason that the current law won in the tax-neutral case. It provides the biggest PFD across the time period (which implies higher taxes).

Comparing the Alternatives (Ignore POMV Case)

Because the POMV is not in the Constitution, the legislature doesn’t really need to follow that limit. They could pass legislation that removes the limit at any time. Or, they can lean on their powers of appropriation to simply ignore the limit.

This turns out to be an important distinction. Without the POMV, the legislature could draw more money out of the Permanent Fund Earnings Reserve to pay the bills (to the extent funds are available). As a result, the amount of income in every year thereafter is reduced by the smaller asset base.

So, here is how the options compare without that POMV law being followed.

Tax Neutral Case

Here, it is much harder to spot the winner. The only thing that is clear is that the “leftover PFD” option is dominated by HB132. All of the other options end up in similar places – after a few early years of different PFD sizes.

Without the POMV, larger PFDs are paid in the near-term in most of the alternatives. That requires additional draws to balance the budget, which results in worse future outcomes.

Option Rank Long-TermNear-Term
Current Law11
Exclude ERA22
Pension Payoff35
SB 10344
Inflation First53
HB 13266
Leftover PFD77

Again, the current law wins over options that pay smaller PFDs today. This is because the tax-neutral person is ok with the broad-based taxes that will be needed.

And, once again, the leftover PFD is the worse option here, discounted or not. All of the other options are various shades of grey.

Tax Averse Case

Again, there are a lot of options whose paths cross. This means that time preference is going to matter. Notice that the “leftover PFD” and HB132 are both substantially better in the long run for this person. And, again, HB132 dominates the “leftover PFD” option.

Option Rank Long-TermNear-Term
HB 13215
Leftover PFD27
Inflation First31
SB 10342
Pension Payoff56
Exclude ERA63
Current Law74

So, once again, HB 132 wins the day for the tax-averse, long-term focused person. The leftover PFD comes in a close second. That is because these are the most aggressive reductions to the PFD. As a result, they minimize the need for broad-based taxes. And, again, the current law comes in dead last.

However, for the tax-averse, near-term oriented person, those options go too far too fast. A more measured approach is preferred. In this case, the simple change to the net income calculation does the trick and SB103 is in the hunt.

Conclusions

First, it should be obvious that there is not an obvious answer. If this issue were easy to solve, we wouldn’t need to discuss it.

But, we did learn how the options line up. They end up falling into three buckets:

  1. Maximize PFDs (Current Law, Exclude ERA, Pension Payoff)
  2. Moderate Changes (SB103, Inflation First)
  3. Minimize Taxes (HB132, Leftover PFD)

Here is a cheat sheet of optimizing PFD strategies, under the assumptions and constraints we’ve imposed:

Follow POMV Near-Term Long-Term
Tax Neutral Pension Payoff Current Law
Tax Averse HB 132 HB 132

And here are the optimal strategies if we don’t follow the POMV rule:

Ignore POMV Near-Term Long-Term
Tax NeutralCurrent LawCurrent Law
Tax Averse Inflation First HB 132

While we don’t have a definitive answer to the question, here are some takeaways that should help us understand the dynamics at play:

  1. There are no “good” options – because there is not enough money under the current projections. A broad-based tax, PFD reduction, and/or budget cuts appear necessary (and they all hurt).
  2. If we can’t find the budget reductions to balance the budget, a change to net income is required. It can either be a small change now or a larger change later. In that case:
    • If you don’t mind taxes, pass one. Spreading the pain beyond PFD eligible Alaskans is better for them than PFD reductions.
    • If you despise broad-based taxes, change the PFD formula. Because the budget gap is large, a big change is probably necessary.
  3. If you are long-term focused, concentrate on protecting the Permanent Fund. That means minimizing draws from it.
    • Pushing for stronger protection of the Fund is a good idea. That probably means passing a constitutional amendment.
    • Alternatively, sweeping the ERA balance could protect it (this also gets rid of the need for the POMV limit).
  4. If you are near-term focused (or don’t believe there is a long-term problem), forget the POMV limit. Future Alaskans can deal with any future problems.
  5. The “Leftover PFD” option is too aggressive under these projections. It avoids future taxes, but it requires excessive sacrifice from the current “generation.” It can be eliminated.
  6. The “Exclude ERA” option doesn’t do enough. This is because the current system will naturally move the ERA to the principal account over time. Once that happens, this option has no effect. So, this alternative can be eliminated.
  7. Although SB103 didn’t beat HB132 in any of the outputs here, it’s not an inferior design. It’s just that the split needs to change in order to compete.
  8. It is possible that the combination of a small PFD change and a broad-based tax is a compromise solution. In that case:
    • HB132 is too drastic a change, SB103 may be more a reasonable approach.
    • If a formula change is off the table, the “Inflation First” option is worth considering.
    • If all legislation is off-limits, maybe the “Pension Payoff” option is worthy of some thought.

Adding Uncertainty

All of the conclusions drawn today are a result of the projections that were used as inputs. However, I have talked before about how the seriousness of the “fiscal crisis” changes dramatically if those projections turn out to be wrong.

Next week (in the final installment of this series) we will test some of those assumptions and see how much the outcomes change.

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