Editor’s note: This is the first in a series of periodic reports on state finances and the Permanent Fund

The Legislature’s action earlier this year to use some of the $65 billion Permanent Fund’s earnings to help fund the state budget has solved only part of the state’s structural finance problem.

There is still a deficit in the budget, although not as large as before. Also, the final form of Senate Bill 26, which passed the Legislature May 8, did not allocate funds specifically for the Permanent Fund Dividend, or PFD, leaving this issue dangling for political candidates to debate in the 2018 elections.

There are already calls by politicians to “fully fund” the dividend and some urge putting the PFD into the state constitution.

SB 26, which was signed into law June 13 by Gov. Bill Walker, authorizes a percent-of-market value, or POMV draw on the Fund’s earnings. The bill leaves unresolved how much of this is to help fund the budget and how much goes to the Permanent Fund dividend.

Earlier versions of SB 26 specified percentages to go to the budget and to the PFD but legislators were unable to agree on those amounts in the end, so the final bill had no specific allocations.

This means that each year the Legislature will have to determine how much of the money will go to the dividend and how much to public services like schools, state troopers, prisons and road maintenance.

While there is a state law that sets a formula as to how the dividend is to be calculated, that amount is subject to appropriation by the Legislature. Lawmakers must balance how much of the funds available under the POMV draw will go to public services and how much will go to the dividend.

This year will see a $2.7 billion draw on the Fund’s earnings based on the POMV. In its budget the Legislature decided appropriated $1 billion of that for the dividend, which was set at $1,600 this year, leaving $1.8 billion of the draw on earnings available for the budget.

When combined with about $2.2 billion expected in normal state revenues, mostly oil and gas, the total available reaches $4 billion, which is about $700 million short of what’s needed to fund the state operating and capital budget.

The deficit will be covered by funds drawn from the Constitutional Budget Reserve, a state savings account that holds about $2.2 billion.

In comparison, if the formula for the PFD set in statute were to be followed, the dividend for 2018 would be $2,900, according to an analysis by Juneau economist Ed King. That would require $1.86 billion of the $2.8 billion POMV draw,

King said his calculations are estimates based on the best information at hand. The Department of Revenue did not do a PFD calculation based on the statute this year because the $1,600 amount had been set by the Legislature.

“Fully-funded” POMV would balloon the deficit

Fully-funding the PFD to the statutory amount, however, would have left only $1 billion of the $2.8 billion POMV draw available for the budget.

When combined with the $2.2 billion in expected normal revenues, the resulting $3.2 billion total would have pushed the deficit to $1.5 billion, draining about half the money remaining in the Constitutional Budget Reserve. If the same pattern were to be following next year, in 2020, the reserve fund would be fully depleted.

This is unwise, state budget officials have said, because the state uses the Constitutional Budget Reserve to meet its monthly expenses like payroll and vendor payments, through the year. If the CBR were not available the state would have to resort to short-term borrowing by issuing revenue-anticipation notes to meet expenses like payroll. Borrowing would add costs.

Aside from the annual fight over money for the budget and the PFD, the structural change in state finances, the first-ever use of Permanent Fund earnings puts the Fund and its management into a central place in the state’s fiscal structure, equal in importance to oil and gas revenues.

While this is considered good as a diversification of the state’s revenue sources, the new dependence on financial markets and performance of the Permanent Fund carries risks, too. There will be volatility in financial markets similar to that in oil markets.

The state now has two legs to its financial stool, but both are also unsteady. The Legislature has still rejected the most traditional of state revenue sources, broad-based taxes on citizens like an income or state sales tax, which are also the most stable.

Nevertheless, now that the decision has been taken to use the Fund earnings, what dangers are there?

The most obvious is that it could affect the Fund’s management of its portfolio, driving some decisions toward short-term liquidity and cash income from asset sales to meet cash calls. Currently the entire Fund is managed for long-term gain across a broadly diversified set of investments, and the only cash call had been to fund the annual citizen dividend, which was easily managed without changes in the overall portfolio strategy.

Now that there will be cash calls to help fund the budget, and large ones, it may force a rethinking of the portfolio management.

There are “inflation-proofing” payments from the earnings but these are deposits back to the principal, so they do not affect the overall value of the Fund. Taking money for dividends and the budget will reduce the fund.

The potential loss of revenue causing by having to shift funds into short-term assets from long-term can be substantial. Last year, for example, the Permanent Fund, invested long-term, earned 10 percent. In contrast, the Constitutional Budget Reserve, which is all short-term so as to meet state cash calls, earned 1.8 percent.

If even a small part of the Permanent Fund were shifted to short-term the loss of income could reach hundreds of millions of dollars.

How does the POMV work?

SB 26 provides that the POMV draw, for the next three years, will 5.25 percent of the Fund’s value averaged over the previous five years. Because the Fund’s total value is growing this has the effect of lowering the actual draw this year to about 4.9 per-cent.

In three years, under SB 26, the authorized draw drops to 5 percent. Again, because of the five-year averaging, the actual draw will be lower.

As an example, if a 5 percent draw were made this year against the Fund’s value averaged over the last five years the effective draw would be about 4.6 percent.

The Legislature planned for the POMV draws to be less than the Fund’s expected annual average return of about 7.5 percent (typically the Fund does better, earning 10 percent last year).

The difference between the actual draw and the Fund’s annual return, slightly more than 2 percent, is to allow for inflation. Thus the POMV has a built-in mechanism for inflation-proofing.

However, SB 26 also allows the Legislature to make an additional inflation-proofing appropriation from earnings outside of the POMV but it is not required. If that appropriation were made, however, it would in effect double the inflation-proofing, which happens automatically in the POMV and again through a specific appropriation.

In their approval of this year’s budget legislators did make the additional inflation-proofing appropriation but whether it happens in future years will depend on the fund available.

Tim Bradner is editor of the Alaska Legislative Digest and is 2018 Visiting Atwood Professor of Journalism at University of Alaska Anchorage.

Sidebar

State’s financial dilemma – the background

From 1977, when North Slope oil production started, and 1981, when Alaska repealed its personal income tax, most of the state’s budget has been funded with oil revenues. Alaskans pay little in the way of state taxes.

As oil prices rose over the years Alaska’s revenues were ample and the state operating and capital budgets rose. In 2015 oil prices and revenues plunged, creating huge, multi-billion-dollar budget deficits. Fortunately, there were $18 billion in two liquid asset savings accounts, the Constitutional Budget Reserve (CBR) and Statutory Budget Reserve (SBR). Over three years $15 billion was withdrawn from these funds to pay the annual deficits, which leaves about $2 billion in the CBR and a minor amount in the SBR.

For several years there had been discussion of using some of the Permanent Fund’s income. By 2018, the CBR and SBR had been drawn down to below $3 billion, leaving insufficient funds to fully-fund a FY 2019 deficit comparable to previous years.

The Legislature was forced to act. Senate Bill 26 was the result. The bill authorized a draw from the Fund’s earnings of about $2.8 billion for the state general fund and the 2018 Permanent Fund Dividend.

What makes up the Permanent Fund?

• Corpus, or principal (cannot be spent):

As of June 30, $40.2 billion corpus; $5.9 billion unrealized earnings

• Earnings Reserve Account (can be spent)

$18.8 billion* as of June 30

Source: Alaska Permanent Fund Corp.

Where did the money come from?

Of the $40 billion corpus, or principal, approximately $16 billion is from oil royalties paid since 1977, another $17 billion is in “inflation-proofing” payments from earnings. Another $7 billion is through one-time appropriations by Legislature. Unrealized earnings in the principal and funds in the Earnings Reserve are from investments earnings of the Fund.

Source: Presetation by Craig Richards, Alaska Permanent Fund Trustee, at a meeting of Commonwealth North

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