Juneau, Alaska

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

Projecting Alaska’s Budget

The Alaska State Legislature will gavel in tomorrow at 1pm. It should be a busy session, but the primary responsibility of the elected officials is to pass a budget.

The governor submitted a starting place for them to consider – $4.5 billion of UGF spending. The finance committees will get to work and ultimately pass something similar to what is in front of them. But, the changes from last year are relatively small.

Regardless of what the final tally is for FY21, the budget is probably going to be less than inflation. This brings up something I think is important. How will the budget change moving forward?

Current Projection

In reality, we don’t have a single good estimate of that number. Take the governor’s current 10-year plan for example.

It isn’t built from expected changes in program needs, labor agreements with unions, step increases of employee pay, step reductions of new employees replacing retirees, rising healthcare costs, improved efficiencies, new debts to deal with deferred maintenance, a changing student population, or any other adjustment that you can expected to occur.

In other words, we don’t actually have a budget forecast. We have a simple extrapolation of current spending plus inflation. Legislative finance uses the same simple projection in its models.

But, if you look at the 10-year plan from FY12, it was projecting a FY21 UGF budget of $7.1 billion. In the narrative, it says:

“…it assumes relatively modest spending growth of 3.0% annually beginning in FY2013, and no change to the revenue forecast that was developed in the fall of 2010. The expenditure growth rate assumption in this scenario would be challenging to meet, and implies that the delivery of state services will become more efficient over the 10-year period. Inflation is assumed at 2.75% and population growth will be slightly above 1.0% annually. That implies that state spending on a per capita basis will decline over the next ten years in real terms”

FY12 10-Year Plan

Clearly that assumption that it would be “challenging” to limit budget growth to inflation and population growth was wrong. When prices crashed in 2014, the budget outlook drastically changed. Suddenly, the administration put plans in motion to reduce the budget and 0% budget growth seemed more than feasible. In fact, the budget did not grow with inflation over the next few years. It decreased in spite of inflation.

This means that all of the financial scenarios that paint a picture of growing budgets might be exaggerating reality. Consequently, the large deficits on the horizon may not be as large as we think.

Let’s briefly look at our history to try to understand what the future may hold.

Breaking down the budget

We have to be careful when we talk about the budget. There are many ways that the numbers get sliced and diced. So, to be clear, the numbers we are using here are only the unrestricted general fund dollars. I know my budget-hawk friends hate this simplification, but it’s good enough for today’s discussion.

Here is the state’s spending history, without any inflation or population adjustments. We will get to that. But, let’s learn what we can from the nominal data first.

There are a couple things that stand out. First, there were two periods of large capital budgets. One in the early 80s. The other in the 2006 – 20015 time frame. Other than that, capital budgets have historically been pretty small – Like the ones we are seeing now.

Second, statewide items (debt payments, oil tax credit purchases, retirement contributions, community funding, etc.) were fairly small until 2008. That growth had to do with ACES tax credits and the change in the state pension program. There is more to this story, but let’s leave it for another day.

Agency Operations

When we think about government, it is agency operations that captures your mental image. This is where employee salaries, government programs, and all the recurring costs of government live. Capital projects ebb and flow, statewide items are financial transactions, but agency operations are programs run by the government.

If anything the state does is impacted by inflation, it would be here. Debt payments are structured. Capital projects might cost more due to inflation, but they only happen if we can afford them.

Agency operations should be more stable. They should adjust based on fulfilling needs and the cost providing those services. Theoretically, they should not change a lot based on revenues. Rather, revenues should change to meet needs.

If this were the case, we should see a flat line once we adjust for inflation. And, we should not see a correlation to revenues. Here is how they look:

If you’ve ever asked me about the budget while sitting on a barstool, I’m sure you got an earful about how the budget is reactive to revenues. Spending usually doesn’t occur out of necessity. Rather it grows out of opportunity.

That’s what we see here. When money falls in our lap, we spend it. And when oil prices crash, we cut back. An inflation adjusted projection is a terrible assumption of what the future will hold.

Inflation as a predictor variable

Again, if inflation were the cause of budget growth, we should see some relationship between the budget and inflation. We don’t. While there is a spurious relationship, it only exists because inflation tends to be positive and the budget has grown more often than not. But, inflation is not a good predicter of how much the budget will grow.

Agency operations have failed to keep up with inflation in 20 of the last 44 years. In other words, using inflation as a prediction tool is about as effective as flipping a coin. In the years that the budget did grow by at least inflation, it grew by a lot more than that. And those years almost all correspond to years of higher than normal revenues.

Population growth as a predictor variable

Another argument that is often made about budget growth is that a larger population requires a larger government. Therefore, we should expect to see a correlation between population growth and budget growth.

The bottom line is, we don’t. The population grew in every year of Alaska’s history, except for right after the oil pipeline was finished, during the 1980’s recession, and during the last three years. The budget has not grown proportionally.

There are some programs that are likely to have responded to population changes. The Department of Transportation needs to maintain more roads, the Public Safety needs to patrol more people. Corrections probably sees an increase in inmates as the population goes up. But, a 10% increase in people does not require 10% more roads, police, and prisons.

Likewise, some departments only serve a sector of the population, not the whole thing. So, Education sees greater need when the student population rises, but not as the elderly population does. Medicaid responds to the number of low-income people, but not the population. Pioneer homes and senior benefits programs react to changing demographics, but not to changes in the total number of Alaskan residents.

And some agencies don’t react to population at all. I wouldn’t expect the Departments of Natural Resources, Environmental Conservation, Revenue, Administration, or Veterans’ Affairs to need to adjust their employee counts a whole lot as the population grows (perhaps a little, but not a lot).

And so, using population growth as a predictor for budget growth doesn’t pan out. While it is probably a good variable in select programs, applying population growth to all agency operations provides no predictive power.

Putting it together

Understanding that agency operations will not simply grow with inflation and population changes, we can generate a better guess about what future budgets will look like.

Naturally, this is not an analysis of what spending needs are, or what budget should be. Rather, this is a discussion of what might actually happen in the future based on what has happened in the past.

At some point in the future, I may look at the different agencies and programs to get a better decomposition of where the budget will go. I may even go further and evaluate the cost-effectiveness of some individual programs. But, that work would require resources. And I don’t have anyone ready to pay for that effort so far.

But, here is what I can see. Look again at that inflation adjusted agency operations graph.

It would appear that there is still some room to cut. We are still spending nearly $1 billion a year more than we were living with just 16 years ago (inflation adjusted). But, it’s unlikely that we can just cut that out. Look back at the history lesson provided by our past.

History as a Guide

When we lived through this process before, rapid budget growth eventually stopped when revenues fell. There were then three years of budget cuts, followed by strong resistance to go further (including a recall effort). From there, budgets were basically held flat for over a decade. We allowed inflation to eat away at the budget rather than making cuts.

Then, when revenues spiked, We blew past the statutory spending limit without blinking. The budget ballooned with pent-up desires. When revenues collapsed, we again saw three years of cuts. Then, strong resistance to further reductions (including a recall effort). From there, the proposal has now shifted to flat funding.

If the rest of this cycle plays out like the last one did (and if we don’t see a dramatic increase in revenues before then), it would take about 10 more years for inflation to eat away at the growth still in the system. Agencies would have to find ways to become more efficient, knowing that they will absorb inflation each year. But, we would not see nominal reductions to funding.

That’s where I see this going. And using an inflation adjustment in the financial projections does not seem to comport to what is likely to happen.

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