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Oil Reform Requires Fiscal Reform

Bradford G. Keithley

Bradford G. Keithley

Any opinions expressed herin are the author’s own.

Most Alaskans are familiar with efforts by Governor Parnell the last two years to reform Alaska’s current oil tax structure. The most recent effort ended earlier this year, when the Governor withdrew the revised oil tax reform bill that he had submitted at the beginning of the special legislative session.

What many are not aware of is something that happened at the end of the special session, immediately before the Governor withdrew the bill.

The Office of Management and Budget is the state agency responsible for preparing and administering the state budget. In an appearance before the House Resources Committee, the head of OMB, Karen Rehfeld, testified that if the Governor’s tax reform bill passed, the reduction in revenues could cause the state budget, which otherwise was projected by OMB to run a surplus for several more years, to turn to a deficit virtually immediately.

Rehfeld estimated that the deficit would be roughly $615 million for Fiscal Year 2013, which began July 1, 2012. If all other things remained equal, Rehfeld estimated that the annual deficit would grow to roughly $1.03 billion by Fiscal Year 2018.

The Governor withdrew the bill later the same day.

Some took Rehfeld’s testimony as an indication that the Governor’s proposed oil reforms were overly generous. For example, Senator Bill Wielechowski, an opponent of the Governor’s plan, said at the time that Rehfeld’s testimony “makes crystal clear the disastrous impact the Governor’s bill would have on the state treasury.”

Actually, Rehfeld’s testimony showed the reverse, what a disastrous impact recent state fiscal policy is having on Alaska’s ability to regain competitiveness in the oil industry.

Axed Investment,
Exploded Spending

In 2007, Governor Palin and the Legislature passed significant revisions to Alaska’s oil tax, termed “Alaska’s Clear and Equitable Share,” or “ACES” for short. By some estimates, ACES increased oil taxes by 400 percent and many have argued that ACES has significantly diminished Alaska’s competitiveness in attracting new oil investment.

Prior to the passage of ACES, Alaska state spending was relatively moderate. During Fiscal Years 2004 through 2006, for example, spending from the General Fund was only $2.3 billion, $2.3 billion and $3 billion.

After the passage of ACES, however, state spending exploded. Spending from the General Fund for Fiscal Year 2008, the first year following the passage of ACES, was $4.25 billion, nearly double what it had been only four years earlier.

In the following three fiscal years, spending generally continued to creep upward, but at a reduced pace. Spending from the General Fund for Fiscal Years 2009 through 2011 averaged slightly over $4.75 billion.

In the last two years, however, spending has exploded again. In Fiscal Year 2012, the Legislature appropriated and the Governor approved $6.72 billion in General Fund spending, a new record for state spending. That record lasted only one year, however.

The General Fund spending level approved for Fiscal Year 2013, the current Fiscal Year, is $7.6 billion, a new record.

In short, in the last six years since the passage of ACES, state spending from the General Fund has more than doubled, from $3 billion before ACES, to $7.6 billion this year. Since Fiscal Year 2004, General Fund spending has more than tripled, from $2.4 billion, again to $7.6 billion this year.

With the Governor’s concurrence, those in the Legislature that favor oil tax reform have spent themselves into a corner. As the OMB Director made clear in her testimony, the Legislature cannot now pass oil tax reform without creating a budget deficit.

Of concern, some in the Legislature appear to suggest that is a corner from which there is no exit.

 

Special Committee

For the past two years, the House “Special Committee on Fiscal Policy” has been working on, among other things, a website to explain—and provide insights into—the state budget. The website recently was completed and made available to the public.

One part of the website is devoted to discussing various alternatives available to the Legislature for dealing with situations where revenue levels are not sufficient to cover expenses. One alternative listed under that is “Cut Spending.”

In the discussion of that alternative, however, the Special Committee appears to suggest that the solution is only of limited effect. According to the Special Committee, “Alaska’s operating budget has been increasing at about 9 percent per year for the last decade and is expected to continue on this path. Even with tighter budget control, the budget will need to increase as population increases and to adjust for inflation just to maintain current levels of service.”

That is an odd explanation given that, only six years ago with a population level only slightly lower than at present, the state maintained service with much lower spending levels.

The much more likely explanation is that, by dramatically increasing spending after the passage of ACES, the Legislature has created a public expectation that the spending levels will continue. Having done so, at least the Special Committee appears to argue that the Legislature cannot now revert to the spending levels that existed only six years ago.

The Special Committee adds support to this view in the last paragraph of its explanation of why cutting the budget is a limited option. The Special Committee argues that Alaskans “are used to receiving high levels of service from our government. In a recent statewide telephone survey, Alaskans from all political parties chose maintaining state services over balancing the budget for nearly all state services.”

Such a poll is largely meaningless, however.

The oil industry currently provides roughly 90 percent of General Fund revenues. As a result, government services to current Alaskans appear to be a “free good”—Alaskans don’t pay for them in the form of income, sales or even significant property taxes. As long as they don’t have to pay for them, consumers always want “free goods,” and the more of them they can get, the better.

Whether Alaskans want those free goods to continue isn’t the right question to be asking. The question is whether Alaskans want to continue to receive those goods at the expense of continued investment in development of the state’s oil resources.

 

The Bigger Problem

Moreover, acceptance of a view that the budget cannot be cut sows the seeds of an even larger problem.

A recent study by the Institute of Social and Economic Research at the University of Alaska Anchorage demonstrates the extent of the larger problem.

In the study, “Managing Alaska’s Petroleum Nest Egg for Maximum Sustainable Yield,” ISER analyzes the effects of Alaska’s current spending levels on future generations. The study concludes that, through the Permanent Fund, other forms of savings and including the future stream of state earnings from oil yet to be produced, Alaska has built up a “nest egg” of assets.

The study suggests that if managed properly, earnings from the “nest egg” can sustain government services indefinitely into the future.

Part of the management plan, however, requires limiting current draws from the “nest egg” to “sustainable” levels in order to ensure that the nest egg is capable of producing a consistent level of earnings in the future. The study defines “sustainable” as the level of spending which can be maintained indefinitely into the future, adjusted for inflation and anticipated population growth.

The study examines the effect of spending beyond sustainable levels and concludes that, depending on the rate of unsustainable spending, the nest egg can be depleted in a number of years. As the nest egg is depleted, future generations will be required to find other sources of revenue—such as an income, sales or property tax—to continue to fund state government.

Stated on the same basis as the spending levels discussed above, the study concludes that the current level of “sustainable” spending is in the range of $5.35 billion per year. That is slightly more than the level of spending approved by the Legislature and Governor for Fiscal Years 2009 through 2011.

That level is significantly less than what the Legislature and Governor have spent annually during the last two years, however.

Analyzing Fiscal Year 2012 spending levels, the study concludes that “spending above the sustainable level in FY 2012 means Alaskans are passing on an $800 million fiscal burden to future generations and similarly reducing the size of the nest egg.”

The study took place before the Fiscal Year 2013 budget was finalized. Because that spending level is nearly $1 billion larger than for Fiscal Year 2012, however, it seems safe to assume that the “fiscal burden to future generations” from current spending decisions is expanding.

The study concludes that the “fiscal burden will grow every year and the nest egg will shrink at an accelerating pace, until the state reduces spending or finds an alternative source of revenue.”

As a consequence, even if the Legislature is unconcerned about oil tax reform, the need for fiscal reform remains important in order to address the increasing burden current spending levels are creating for future Alaskans.

 

Incapable of Control?

The theoretical solution to these problems is apparent. The state needs to reduce spending to “sustainable” levels in order to remove itself from the fiscal corner into which it has painted itself.

The practical solution to these problems is less apparent. Recent Alaska state budgets have become full of spending earmarks. In the current year’s budget, for example, state money is appropriated for repairing a parking lot at a privately owned sports facility, to install AstroTurf at middle school and privately owned sports complexes, and to subsidize airplane tickets for Alaskans outside of Anchorage to fly to Anchorage in the hope that they will attend a basketball tournament during Thanksgiving.

Legislators issue press releases at the end of the legislative session taking credit for the various pieces of state spending that will occur in their district. No individual legislator appears able to avoid participating in the system out of concern that his or her constituents will deem them ineffective if they do not arrange for as much spending in their district as any other.

In short, from a practical standpoint it may be that a slightly modified version of the conclusion reached by the Special Committee is correct—given the higher revenue levels resulting from ACES, it may be that the Legislature and Governor, who originates the budgets and signs the final appropriations bills, may be incapable of controlling state spending levels.

If that is the case, more structural limitations, such as a hard cap on state spending levels, may be required.

What is clear, however, is that given the significantly higher spending levels that have become customary since the passage of ACES, some form of fiscal reform will be necessary before the Legislature is positioned to proceed with “meaningful” oil tax reform and future Alaskans can feel safe that they are being treated equitably.          R

 

Brad Keithley is a Partner and Co-Head of the Oil & Gas Practice at Perkins Coie LLP. He maintains offices in both Anchorage and Washington, DC, and is the publisher of the blog “Thoughts on Alaska Oil & Gas.” (http://bgkeithley.com)

 

This commentary first appeared in the September 2012 print edition of Alaska Business Monthly magazine.

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