We’ve looked at Alaska’s budget for the past month. In part 1, we learned some terminology. Then, in part 2, we explored what we buy with all that money.

In parts 3 and 4, we analyzed where the budget growth occurred during the high oil price years, and how we got the budget back under control when prices fell.

Now it is time to look at the budget issues the legislature will face in the Spring as they work on the FY20 budget.

Upward Pressure

In every budget cycle, there are three forces that push up on the budget – inflation, population growth, and expanded services.

Inflation puts continual pressure on the budget, as buying the exact same things costs more each year. This isn’t government growth, but it is budget growth. And it’s very hard to fight.

An increasing population also drives up the budget. A growing population requires more schools, more roads, more police, more public health programs, more Medicaid, and more staff to manage all these growing programs (and then more staff to support those staff).

The third is the one that requires the most attention. There is normally a check on our  unlimited wants – limited resources. So, resisting growth is easy when money is tight. But is difficult when there are additional resources available, and there is no shortage of good ideas to spend more money.

We saw some of this type of growth occur in 2006-2013, and we saw an effort to reduce that growth in the years that followed.

Expected FY20 Budget

A lot of people are approaching the FY20 budget with the FY19 budget as the base. But, I can tell you that approach will miss the mark.

As we look at FY20, we must recognize these sources of upward pressure on the budget and account for them. We must also account for the known changes in circumstances that will impact the budget. 

Here is how I see the baseline budget for FY20 (in millions):

Unrestricted General Funds

Accounting for these known factors, the baseline budget for FY20 is $360 million bigger than last year.

	FY19 UGF Budget	Projected FY20 UGF Budget	Change	Reason
Agency Operations	$3,937.30	$4,115.40	+$178.10	Inflation, population growth, reinsurance reverts to UGF
Oil Tax Credits	$127.10	$250.70	+$123.60	Higher revenues = Higher calculation
Retirement Contributions	$271.00	$302.70	+$31.70	Actuarial plan increases each year
Debt Service and Fund Capitalizations	$216.70	$237.00	+$20.30	Payments on bonds increase
Capital Budget	$147.80	$153.40	+$5.60	Inflation
Total UGF Expenditures	$4,699.90	$5,059.20	+$359.30

In addition, there is anecdotal evidence that Medicaid costs will be increasing by a lot more than this. I’ve heard a number as high as $200 million due to complexities around the Medicaid Expansion implementation.

We can also expect Education to request additional funding to cover rising energy costs and health insurance premiums.

Designated General Funds and Other Funds

The DGF and other funds have picked up a larger share of the tab in the last few years. If we assume that process is complete, the DGF and other funds should be relatively flat next year.

	FY19 Budget	FY20 Budget	Change	Note
Total DGF Expenditures	$974.6	$940.8	-$33.8	Reinsurance costs revert to UGF
Other Fund Expenditures	$741.4	$761.5	+$20.1	Inflation
Total DGF/Other State Funds	$1,716.0	$1,702.3	-$13.7

Total Budget Needs by Major Category

Adding up all the costs that the State pays, we get a clearer picture of what the “real” budget number will be.

If we are going to cover these increases, support the same level of services, and pay a full PFD, we need to prepare to spend about $8.9 billion (an increase of $1.4 billion from last year, mostly from following the PFD statute).

Note that Federal pass-through money is also layered on top of these expenditures, some of which require a State match (included here).

Required State Funds	FY19 Budget	FY20 Budget	Change
Total Agency Operations	$5,338.2	$5,498.3	+$160.1
Total Statewide Items	$740.3	$915.9	+$175.6
Total Capital Budget	$337.4	$347.3	+$9.9
PFD*	$1,023.5	$2,100.0	+$1,076.5
Total Required State Funds	$7,439.4	$8,861.5	+$1,422.1

When you hear a budget number in the $4-5 billion range, just remember that they aren’t talking about the big picture. But either way, it’s looking like we will need at least $1.4 billion in additional funding over FY19, without adding any new government services.

*Technically speaking (due to the Supreme Court ruling) unless the PFD comes directly from the APFC through a constitutional amendment, it is most accurate to include it as a budget item. 

Revenues

The question is, do we have the money to pay for those costs? The answer is a hesitant yes.

I say yes, because the forecast suggests we will have enough total revenues to cover total costs. But, I hesitate because several sources of revenue are highly volatile. There is a reasonable chance that things will change before we get to June, 2021.

And if you’re one that only likes to look at UGF income and expenses, it’s looking like we are going to run about $900 million short.

Here is how things are currently looking:

Expected State Revenues	FY19 Budget	FY20 Budget	Change	Note
Oil Revenues	$2,729.4	$2,759.7	$30.3	Assumes $80 oil
Non-Oil Revenues	$516.2	$580.2	$64.0	Insurance Premium Tax reverts to UGF, and inflation
DGF and Other State Revenues	$1,743.4	$1,726.0	-$17.4	Insurance Premium Tax reverts to UGF, and inflation
Permanent Fund Earnings	$6,200.0	$4,069.0	-$2,131.0	FY19 based on YTD, FY20 from APFC
Other Investment Earnings	$114.4	$124.1	$9.7	From DOR Spring 2018 RSB
Total State Revenues	$11,303.4	$9,259.0	-$2,044.4

Change in Net Position

Technically, there will need to be some shuffling of money between accounts to follow all the rules. But, the net cash flow position of the State in FY20 is looking positive, even with a full PFD, the expected increases in budget items, and a reduced investment return expectation.

The expected cash calls look like they will be lower than expected revenues in FY20. Of course, we don’t know what will happen with oil prices or with investment returns. So, this projection could turn out to be very wrong.

That is precisely why budgeting based on annual cash flows is not the best way for Alaska to manage its finances (more on this another day).

Starting Place

The FY20 budget will have at least $360 million of UGF budget growth, without increasing the size of government at all. That places the UGF budget at $5.1 billion, unless the new administration can find cuts. A full PFD pushes the UGF budget to $7.2 billion.

With $3.3 billion in UGF revenues and a $2.9 billion POMV draw, the UGF budget will be almost a billion short of balancing.

But there is good news. The FY19 UGF revenues are looking like they will beat the Department of Revenue projections by about $900 million. And, the investment earnings on the Permanent Fund should come in better than their forecast.

While this doesn’t solve the underlying problem, it does make the short-term issue easy to manage. There’s enough spill-over money from FY19 to fill the FY20 gap without much difficulty.

Budget Cuts

There has been a lot of talk this election cycle about cutting the budget. Let’s take a quick look.

Statewide Items

It is possible to trim about $550 million from this year’s UGF budget number, by not purchasing tax credits or making retirement contributions. But I wouldn’t recommend it.

Making those “cuts” just to hit some target number does more harm than good. The bill on those items will still come due. It is better to just take responsibility for these obligations and pay them now.

Staffing Reductions

To get a feel for where staffing reduction opportunities may exist, let’s compare the FY06 cost of employees (adjusted for inflation), to the FY19 budget.

While there are complications to this approach, it should give us an idea of where to look and how much opportunity may exist.

It looks like an upper limit to staff reductions is around $350 million. However, not all of those cuts would be UGF money. Additionally, some programs have grown faster than inflation due to population growth, Federal matching requirements, rising benefit costs, and increasing longevity pay.

So, while this doesn’t tell you where to cut, it does tell you where to look. And it also set’s an expectation level for the size of cuts we can find. All told, it looks like it will be difficult to find more than $100 million of UGF cuts by reducing staff.

Contract Renegotiation

We currently spend about $1.5 billion a year paying for contractual services (leasing office space, facility maintenance, etc.). That’s about $500 million more than we were paying in 2006.

Inflation adjustments to those contracts account for around half of that growth, leaving $250 million in non-inflation growth.

Here is where to find it:

But don’t get too excited about those $250 million as potential cuts. The top 3 items are

1. Investment management fees, which increase as the fund increases and are paid from the managed fund
2. University campus maintenance fees, which are largely paid from tuition
3. Building leases, which are paid with interagency receipts

That doesn’t mean we shouldn’t take a look at these items. But, it does mean that making these cuts won’t touch the UGF budget.

Education

Education funding is the largest item in the budget and is difficult to manage. Here is how education funding has changed since 2000:

Notice the flat funding since oil prices tanked in 2014. If you adjust for inflation and student population, funding looks like this:

This highlights a few things. First, flat funding is actually a budget cut, as the districts must absorb those cost increases. With that understanding, education funding has been cut for the last 4 years.

However, the current level of spending per student is 17% higher than the FY06 level, after adjusting for inflation and student population.

If we assume that FY06 spending levels are adequate, we can get a feel for the magnitude of potential cuts.

When you do the math, that number works out to $164 million. It would be difficult to expect cuts deeper than that.

Health and Social Services

The HSS budget has been the fastest growing part of the State budget for years.

 

 

The challenge is that Medicaid expenses have Federal matching requirements. This is a complex issue with huge ramifications on the economy, the general population, and the budget.

While there may be some cuts available, I’m not sure how likely they are to occur. But the maximum savings to UGF is probably limited to something in the range of $100 million from cutting optional Medicaid programs.

Another $100 million might be available by cutting other HSS public support programs, but those would be politically challenging.

Total Cuts

With a lot of hard work and tough decisions, the new administration and the legislature might be able to make real cuts to agency operations. But, I am skeptical. Although it can be done, it’s a much harder job than it sounds.

If they can get the total agency operations number under $5.3 billion (i.e., make real cuts to government and not just move expenses around), I’ll be impressed.

If they can do that, the UGF budget might get down to $4.7 billion. A budget number lower than that would be very difficult to achieve this year (unless you play a shell game to get there).

There are ways to get that number down. But doing so would require several years of transition, some upfront investment in technology, a detailed audit of every line item in every department, new leadership that is not motivated to protect their employees, and a ruthless assessment of the cost effectiveness of programs.

Other Issues to Watch

I’m sure that budget watchers are eyeing Education, Medicaid, and the University system for cuts next year. Those are big-ticket items that are sure to be under the microscope next session. But, there are a few other things we should talk about.

Oil Tax Credit Purchases

The really tricky item in the FY20 budget will be dealing with the $800 million or so worth of tax credits that are still out there.

The legislature thought they solved this issue when it passed HB331 (to borrow the money to buy these credit certificates). But, that bill was challenged in court. While a decision is expected in December, it will likely be appealed to the Supreme Court either way.

So, during the next budget cycle, there will be a question of whether to appropriate money to purchase these credits according to the formula, to issue the bonds without a court decision, or to wait and see how things play out.

Using versus Selling

To complicate the issue, some credit holders have now entered production, which allows them to use these credits against their taxes.

And rising oil prices have also changed the dynamics. Companies are now paying above the minimum tax, giving rise to opportunities to purchase some of these outstanding credits to use against their own taxes. 

Additionally, the higher tax liability also increases the formula for how much the legislature is supposed to set aside for purchases.

That number will likely be around $250 million in FY20. On top of that, the FY19 formula will work out to about $100 million more than the budgeted number last year (which could be included in a supplemental budget request).

All of this means that if the legislature follows the formula while they wait for resolution from the Supreme Court, the outstanding credits may be cleared before a ruling is made.

Range of Possibilities

For these reasons, I can imagine the full spectrum of outcomes during FY20.

They might just purchase all the credits, just to “clear the deck.”  Or, they might decide not to buy any more credits at all, allowing the situation to work itself out.

But, my baseline forecast is that $250 million will be appropriated (a $120 million increase over FY19).

Capital Budget

The capital budget has been very small for the last few years. This raises two questions as we move into FY20.

First, are there costs that have been deferred by those small budgets, which are now becoming urgent?

And second, will the higher oil price and optimism around future oil production lead to a feeling of “affordability” for some projects that would be nice to have (and some that might generate long-term value)?

My forecast will be for a $150 million capital budget from UGF. I have a hard time believing it will be less than that, and can imagine many scenarios where it is much higher.

Permanent Fund Dividend

The FY20 PFD will need between $1.8 and $2.4 billion to pay the statutory formula (depending on statutory earnings over the next year and a half).

If the next administration wants to distribute “back-pay” of the last three years of reductions, that would require another $2 billion or so.

If the legislature decides to distribute that money, the most likely scenario is to simply pay that out of the earnings reserve (where that money is currently sitting).

Right now, it’s looking like we would have to draw down our savings account to pay the full PFD. That draw would be even larger with a “back-pay” appropriation.

Since it is the legislature, and not the new governor, that gets to make this decision, I’m not sure where things will land.

Repaying the CBR

Another outstanding issue is the repayment of the Constitutional Budget Reserve which allowed the State to balance the previous six budgets.

However, this might not be as big an issue as people think. Look at the State’s saving account balances:

Notice that although we used up most of the CBR and SBR (part of the General Fund), the Earnings Reserve Account balance has grown a lot since 2010.

Since the ERA is not part of the constitutionally protected money, it is possible for it to act as a budget reserve in the future (although they would have to break SB26 to do it).

This will be a big part of the conversation surrounding the PFD during the next legislative session.

One option would be to simply move that ERA money to the CBR. Another option is to just leave it where it is in case we need it (and allow it to contribute to the PFD calculation in the meantime).

However, moving that money to the Principle of the Permanent Fund would put us in a real pinch. If we do that, the chances of needing taxes go way up.

We need to make sure we have a budget stabilization fund in some form. And that fund needs to have a sufficient balance to weather poor revenue years. But, we can’t access those funds too often, or else they will run out.

We need a plan and the tools to implement it.

Wrap-up

It is looking like the fiscal situation for FY20 will be a manageable deficit.

Even with the higher oil prices, the UGF budget will likely be short next year. And, even with the POMV draw, there won’t be enough money to pay for the anticipated budget needs and the full PFD.

I honestly can’t imagine the legislature making enough cuts to bring the UGF budget into balance. So, I expect a draw from savings to get us there.

The good news is, the unanticipated higher revenues from FY19 will result in a larger than expected budget balance going into FY20. And, there will probably be enough earnings from the Permanent Fund to take a bigger draw than the POMV if we need to do go there.

Therefore, I put the chances of new taxes very low, the odds of a full PFD pretty high, and the likelihood of a $4.3 billion UGF budget close to zero.

While the underlying question of whether future budgets will balance has not been addressed, I’m skeptical that issue will take center stage during the next session. We need to decide the future of the PFD first.

Budget Target

I know people think hitting that $4.3 billion target is necessary, but there is something fundamentally wrong with this simplistic approach.

It opens us up to misunderstanding the needs of the public. It pushes us to make poor policy decisions to hit that number and motivates us to disguise what should be a transparent process.

Doing so mistakes temporary expenses for budget growth. It also opens us up to “revenue neutral” budget growth when those temporary items are paid off. And, it fails to address the underlying issues by solving the wrong problem.

My Advice

As long as we plan to a target number, we maximize the budget within that constraint. But that is fundamentally the wrong way for a government to operate.

The correct way is to minimize the budget, by first deciding what the population needs from the government. Only then should we have a conversation about what we can afford.

At that point we can address the difference between expenses and revenues. Either by cutting the least needed items, or by raising additional revenues to pay for them.

But, a decision to raise new revenues needs to be based on a long-term, strategic plan. It cannot be a reactive response to temporary market conditions, like we’ve seen in recent years.

I say, let’s stop talking about a target budget number altogether. It’s bad public policy. Instead, let’s debate the merits of the things we intend to buy and the cost effectiveness of those items. And then let’s talk about revenues based on long-term projections, rather than volatile annual cash flows.

When we do talk about the budget, let’s stop breaking it into smaller accounts that allow things to get lost in the shuffle. Let’s talk about total State costs and revenues. These designated and other funds are not helping the situation.

Thanks!

I hope you enjoyed this series on the budget and learned something along the way. I know I did.

If you did, consider showing a little support so I can keep this blog running.

I’ll be working on some of these topics again in the future. But for now, I’m diving back into oil production, taxes, and jobs. I look forward to sharing what I find.

Thanks for reading!