Notes from the Alaska Fiscal Cliff: Our Proposed Fiscal Solution

Yesterday we posted a comment on a presentation made Thursday of this week by David Teal, the head of the Alaska Legislature's Legislative Finance Division (LFD). 

The presentation discussed the projected status of the state's fiscal situation over the next eight years (FY 2019 - 2026) based on the most recent revenue and spending projections.  Teal's presentation is available here: https://goo.gl/jw5pmE.

We expressed both surprise and disappointment at certain aspects of the numbers and analysis. Our comment is here:   https://goo.gl/sanZ1k.

The baseline

Nonetheless, in this piece we use Teal's presentation as a springboard to discuss our proposed solution to the state's fiscal situation. Using the same revenue and spending numbers, and format, as Teal used during LFD's presentation, our solution is summed up in the chart below.

Right click to enlarge

The numbers for the first two lines -- "Traditional Revenue" and "Expenses" -- are taken directly from LFD's presentation.  

The "Traditional Revenue" number is the projection of unrestricted general fund revenues by the relevant fiscal year taken from the Department of Revenue's Preliminary Fall 2017 Revenue Forecast, https://goo.gl/kEFWzN. 

The "Expenses" are LFD's representation of the projection of unrestricted general fund spending by the same year taken from the Office of Management and Budget's Ten Year Budget Forecast Relative to Preliminary Fall 2017 Revenue Projections,   https://goo.gl/GTaLtM. 

For some reason the numbers used in LFD's presentation consistently are about $50 million higher per year than those in the OMB presentation. To make our analysis match up with LFD's, we nonetheless have used their numbers.

The "Initial Deficit" number is the simple difference between the "Traditional Revenue" and "Expenses" numbers for each year.  Adjusted for the $50 million added to the "Expenses" line in LFD's presentation, the deficit numbers used here correlate to the deficit numbers also shown for each year in the OMB Forecast.

The Initial Deficit forms the baseline of the state's fiscal situation.

The first part of the proposed solution:  Hammond 50/50

Starting with the baseline, we propose two steps in our effort to develop a balanced budget.

The first is to implement what we have referred to previously as the "Hammond 50/50 plan," an equal split of the earnings from the Permanent Fund between the PFD and government. See "Implementing Governor Hammond’s “50/50” Plan for the use of Permanent Fund earnings," https://goo.gl/5kZg2x.

With one adjustment, the "50/50 Government Revenue" number in the above spreadsheet is the "other half" of the annual Permanent Fund earnings stream calculated in the manner required for the Permanent Fund Dividend (AS 37.13.140), based on the levels of Statutory Net Income most recently projected by the Permanent Fund Corporation.  Alaska Permanent Fund Financial History & Projections as of September 30, 2017, https://goo.gl/awaekb.

For purposes of this proposed solution we reduce the earnings stream by the amount of the current statutory inflation adjustment factor before dividing the remaining earnings stream equally (50/50) between the PFD and government.  We believe that the current statutory adjustment factor overcompensates for actual inflation, but recognize that some inflation adjustment is appropriate and so, utilize the current adjustment factor until a more accurate approach is developed.

The effect of making the adjustment before calculating the 50/50 split is to charge the inflation adjustment equally to the PFD and government shares of the Permanent Fund earnings stream, rather than take it entirely out of the government's share as historically has been the approach. We include that as part of our proposed solution because both future PFD and government revenue levels benefit from inflation proofing the Permanent Fund principal.

For those interested in that level of detail, our approach to calculating the "other half" used in the analysis is summed up below:

Right click to enlarge

The "Remaining Deficit" in the previous chart is the deficit remaining after applying the "other half" of the Permanent Fund earnings stream as government revenue.  

The second part of the proposed solution, if we need to go there:  A Flat Tax

At the projected spending levels used in LFD's analysis, while the adoption of the Hammond 50/50 approach reduces the deficit to lower, more manageable levels it does not eliminate the deficit entirely.

As a result, in order to balance the budget we calculate the "Flat Tax" required to raise the additional revenue needed to close the remaining deficit. The Flat Tax is equal to the amount of the deficit divided by $27 billion, roughly the amount of Adjusted Gross Income (AGI) currently received by Alaskans, adjusted to reflect the additional amount of AGI estimated to be received from Alaska sources by non-residents.  See "ICYMI: Designing a Flat Tax," https://goo.gl/o8f4jt.

Under a flat tax, all Alaska families -- upper, middle and lower income -- would bear the costs of government proportionately.  No Alaskans would be required to bear a higher cost in order to subsidize the proportionate share of others.  As we have explained previously, there also are other significant benefits of the approach. See "Why a flat tax," https://goo.gl/trVzaQ.

Further adjustments

The level of flat tax required to close the remaining deficit is influenced significantly by two factors.  The first is the level of government spending ("Expenses"); the second is the level of the inflation adjustment used in the calculation of the "Hammond 50/50" revenue contribution.

The lower the level of government spending, the lower the deficit and as a result, the lower the level of flat tax required to offset the remaining deficit.

Similarly, the lower the level of the inflation adjustment, the higher the level of the "Hammond 50/50" revenue contribution, the lower the remaining deficit and, as a result, the lower the required level of flat tax.

Substantial effort has gone into -- and we assume, will continue to go into -- efforts to reduce the level of government spending.  Despite those efforts, however, both legislative bodies and the Governor essentially have concluded that there are limits to making further reductions in spending levels and that some source of "new revenues" is required.

To avoid becoming bogged down in that issue we have used the LFD's projection of future government spending levels in the above analysis.  Suffice it to say that the required flat tax levels will be lower if government spending levels are reduced further.

Some effort also has gone into -- and we assume, will continue to go into -- efforts to more accurately calculate the adjustment mechanism necessary to keep the Permanent Fund whole against inflation. 

To date, most efforts have centered around converting the basis for the calculation of the Permanent Fund earnings stream from Statutory Net Income to a Percent of Market Value (POMV) approach.  We are not necessarily opposed to that change if the POMV approach is proven to be more accurate than other inflation proofing approaches, but we have not been convinced yet that it is.

As a result, again to avoid becoming bogged down in that issue in this piece we have simply continued to use the inflation adjustment factor incorporated in the current statute at the future levels projected by the Permanent Fund Corporation.  Suffice it to say that the required flat tax levels will be lower if the inflation adjustment is reduced.

One final adjustment also is appropriate.  

In the above analysis we have calculated the level of the flat tax, required to close the deficit remaining after the implementation of Hammond 50/50, on an annual basis.  In practice, we believe the level of tax should be averaged over an extended period based on periodic projections.  

Using the projections contained in the LFD analysis, the appropriate level of flat tax averaged over the eight year period, rounded to the nearest quarter percent, is 4.75%.