Is the current formulation of the PFD what Governor Hammond intended?

As we spend more and more time on the issue, increasingly we are coming to the view that the current formulation of the PFD is not entirely as Governor Hammond intended, once the state starts taking its "other half" of the earnings stream.

Here is what Governor Hammond said in Diapering the Devil, a book which, while published posthumously, was taken from manuscript and notes he had been working on before his passing and is consistent with his earlier writings in other books on fiscal policy.

The first relates to the creation of the Permanent Fund itself (at p. 15):

I wanted to transform oil wells pumping oil for a finite period into money wells pumping money for infinity. …

The second focuses on what to do with the earnings, once the “money wells” were pumping (at p. 19):

Each year one-half of the account’s earnings would be dispersed among Alaska residents …. The other half of the earnings could be used for essential government services.” 

Given the backdrop of how Alaska's mineral interests are owned, the so-called 50/50 split makes sense and is one we have -- and will continue to -- defend strongly on these pages.

But that is not entirely how the current formulation of the PFD works.

Instead, using FY 2016 numbers (the last year the Governor or the legislature didn't override the current statute), this is how the current statute (AS 37.13.145) operates:

• Overall earnings (5-year average): $2.746 B
• PFD: $1.373 B (50%)
• Retained in the Earnings Reserve Account (i.e., the state's share): $0.749 (27%)
• "Inflation proofing" (i.e., returned to the corpus): $0.624 B (23%)

As noted, under the current formulation the state's share was only 27% of the earnings stream, not the "other half" envisioned by Governor Hammond.

The reason for the shortfall is that, under the current statute, the portion used for "inflation proofing" -- purportedly the amount necessary to keep the Fund whole against inflation -- is taken entirely from the "other half" of the stream, instead of being divided equally between the "residents'" share and the "state's" share.  As we wrote on these pages in November, we believe inflation proofing benefits both sides (residents and state) of the split, and thus, should be borne equally. See "Notes from the Alaska Fiscal Cliff: Our Proposed Fiscal Solution" (Nov. 2017).

Before the past two years the fact that the split wasn't entirely as envisioned by Governor Hammond didn't make much of a difference.  Because the state wasn't using it's share of the split anyway, there really wasn't any significant, current harm from the way that the statute operated.  It simply took some of the state’s share and transferred it to Permanent Fund principal, not a bad place for surplus earnings.

Now that the state is beginning to take a share of the earnings, however, the formulation of the statute does make a significant difference. It reduces the state's share substantially below the "other half" envisioned by Governor Hammond.

As we also wrote in our November piece, we believe that the current inflation proofing formula overstates the current costs of inflation and should be revised as well.  We believe that a POMV approach could be a good solution to that (as long as the resulting earnings available for distribution continue to be split 50/50 between the private sector (residents) and state).

But that is a secondary point.  The primary point is that, even if inflation proofing is reduced to a more appropriate level and works perfectly, the current statute still won't reflect Governor Hammond's 50/50 split because all of whatever portion is set aside for inflation proofing comes from the state's share.

As we approach implementing Governor Hammond's full vision -- splitting the use of earnings from the state's "money wells" evenly between the private sector (residents) and state government -- we believe it's important to ensure that the split is done right.

For that reason, and as we outlined in our November piece, we favor making changes to the statute both to revise the manner in which inflation proofing is calculated and to ensure that the resulting transfers to the principal are shared equally between the residents' 50% (the PFD) and the portion made available for state spending.

And for that same reason we also will oppose simply moving the current statute to the Constitution.  As we explain above, once the government starts taking its share of the earnings the current statute doesn't fully achieve Governor Hammond's original intent.  Until it is corrected we believe locking that approach into the Constitution would be a significant mistake.

Analyzing the Governor's Proposed FY 2019 Budget: Part 2 (formula spending)

Right click to enlarge

Last week we walked through an overview of the Governor's proposed FY 2019 budget. See Analyzing the Governor's Proposed FY 2019 Budget: Part 1 (an overview).  

In this column we take a deeper dive into the major formula programs that, as occurs also at the federal level, drive a large part of state government spending.

What are the "formula programs'

For purposes of its 10-year forecast (above), OMB lumps three "Agency Operations (formula)" categories together.  The included categories are:

• Education (K-12) Foundation and Pupil Transportation (which together are referred to by OMB as the Education Formula programs), 
• Medicaid, and 
• What OMB refers to as the "Other Formula" programs (which are composed of three fairly small programs administered each by the Departments of Health & Social Services (non-Medicaid), Administration and Military & Veterans Affairs). 

In the above spreadsheet, we have hi-lited in yellow the combined, projected spending number for the three programs. They constitute approximately 45% of total FY 2019 UGF spending ("Budget (before Dividend)").

For purposes of this column we also treat expenditures for debt, retirement (PERS/TRS) and oil tax credits -- which are categorized in the budget as "Statewide" expenditures -- as formula programs, as they are driven also by formula calculations external to the annual budget process. We have hi-lited those in blue.

Those additional, "Statewide" programs constitute 11% of total FY 2019 UGF spending. 

Combined, all of the formula programs -- those included in the "Agency Operations" and those included in "Statewide" -- account for approximately 56% of total FY 2019 UGF spending.

"Agency Operations" formula spending grows substantially over the 10-year period

OMB's forecast contemplates a significant increase in the three categories of "Agency Operations" formula spending over the 10-year period.

Based on OMB's 10-year forecast, combined the three formula categories increase by 22% over the 10-period, a compound growth rate of 2.25%, OMB's assumed inflation rate.

But OMB readily admits that may be too low. 

In an earlier version of the 10-year forecast included as part of the Governor's support in October's Special Session (the "October 10-year forecast"), OMB admitted  that:

... if health care costs including Medicaid grow at historic rates rather than simply tracking inflation; if K-12 spending grows at historic rates rather than inflation; if the federal government shifts health care costs onto states ... the budget gap [could widen] by hundreds of millions of dollars ....

All of those contingencies are governed by the formula programs. Under the current formula approach, if those costs go up so will spending, automatically by simple operation of the formulas.

As noted above, as it is the Agency Operations formula programs already represent approximately 45% of total FY 2019 UGF spending.  Because OMB escalates all spending in that budget segment (both formula and non-formula) by roughly the same percentage, in the forecast the percentage of overall Agency spending arising from the formula programs remains fairly constant throughout the entire 10 year period.

If, as noted in the October 10-year forecast, however, spending determined by the formula programs escalates more rapidly, on its current trajectory it will not be surprising to see Agency Operations formula spending alone drive more than half of overall spending by the end of the period.

"Statewide" formula spending also rises

Unlike "Agency Operations" formula spending, OMB does not tie changes in "Statewide" formula spending to inflation.  Each of those programs have separate drivers.

Projected contributions to the state's "retirement" accounts (PERS/TRS) over the 10-year period, for example, increase by roughly 75%.  That is because the state currently uses an amortization approach which enables it largely to kick the retirement spending "can" down the road, imposing a greater share of retirement costs in later years.

The result is to make current spending levels artificially lower.  

Even that increase potentially understates the rise in costs, however.  Unlike most other programs across the country, Alaska continues to assume an 8% rate of return in the portion of its investment portfolio set aside for the retirement accounts. If -- as other programs increasingly assume -- the realized rate turns out instead to be in the range of 6%, the shortfall required to be made up in future years will be substantially higher.

Payments into the oil tax credit program similarly rise over the 10-year period, increasing by roughly 433% between FY 2019 and FY 2028.  As with the retirement contributions, the reason is because of the proposed adoption of a method (the Administration's proposed "Oil & Gas Exploration Credit & Repayment Plan") which defers current spending required under the existing statute to future years.

Funding the oil tax credit program through the Administration's proposed plan reverses the change over time which otherwise would result under the current oil tax credit statute. If the current statute remains in place, spending on oil tax credits will drop to zero by the end of the period (from a projected FY 2019 level of $206 million to zero in FY 2028) rather than rise.

Offsetting the trend of rapidly rising spending in other categories, projected debt costs decrease over the same period by 55%.  But that is somewhat misleading.  As OMB's October 10-year forecast admits, that amount assumes "[n]o new debt is issued - payments fall as outstanding obligations are paid off."  If new debt is issued -- as likely will be the case if for no other reason that to refinance existing debt -- the projected spending levels will rise.

Even after factoring in the reduction in debt costs, the three formula programs included in the "Statewide" spending category still rise by roughly 34% over the 10-year period.  If, as likely, new debt is issued or retirement spending rises (due to a restatement of the assumed rate of return on invested assets) the growth in spending will be even greater.

What does that mean for this coming session

Based on the assumptions made in OMB's10-year forecast, combined formula spending already accounts for approximately 56% of overall UGF expenditures in FY 2019, increasing slightly to 57% by FY 2028.

But if -- as OMB put it in the October 10-year version -- "health care costs including Medicaid grow at historic rates rather than simply tracking inflation; if K-12 spending grows at historic rates rather than inflation; if the federal government shifts health care costs onto states," or if "the retirement system misses earnings targets or has other negative experiences," formula spending easily could  exceed -- and perhaps substantially exceed -- 60% of overall UGF expenditures by FY 2028.

As OMB's 10-year forecast admits, the amount of overall spending that is formula driven is unsustainable even at projected levels without support by significant amounts of "new revenues." The level of "new revenues" required to support overall spending if any of the "ifs" occur will be even greater.

As recent history has demonstrated it takes a substantial amount of time and effort to address state spending of any sort, much less the challenges presented by reevaluating the formulas that underlie much of it.  The fiscal challenges created by permitting the current formulas to continue unabated are clear, and should be addressed now, before the problems they present become even worse.

If it were us, we would dedicate a substantial part of the upcoming legislative session specifically to "looking under the hood" of each of the various formula programs and finding ways to bring them under control.  If the legislature chooses not to do that (or even if it does but fails to produce significant results) we would make "formula reform" a significant part of our campaign during the upcoming election cycle.  

We know that Alaskans for Sustainable Budgets will do precisely that.

In our next installment of this series we will look at the Administration's proposed "Oil & Gas Exploration Credit & Repayment Plan."  As we said in our first column in this series, questions along the way are encouraged. Feel free to post them either in the comments section of this page, or on any of the Facebook or Twitter pages where we will be posting links to this and future columns.