On Oct. 26, Alaska Attorney General, Craig Richards, released a report titled, "A Sound Fiscal Future." In Standard & Poor's Ratings Services' view, publication of the report itself is a favorable development because it illustrates to state lawmakers how a pathway to a more sustainable fiscal structure for Alaska's general fund is possible.
Its recent outlooks have noted Alaska will need to find some way to address its fiscal imbalance if it is to prevent its credit quality from slipping. The Financial Opportunities Working Group, which was formulated by Governor Bill Walker and produced the report, has outlined an approach with several policy options for lawmakers to consider.
From a credit perspective, more important than any particular policy detail it contains is that the report's main proposals would help bring the state closer to structural fiscal alignment.
Currently, the state's fiscal 2016 budget is operating with a structural deficit of approximately $3.1 billion, equal to roughly 55% of general fund expenditures.
The state is financing the gap with transfers from its budget reserves. Given that its various budget reserves total more than $16 billion, it can do this for several years, but the situation is not sustainable.
That's why on Aug. 18, 2015 — and following enactment of the state's fiscal 2016 budget —S&P said it revised its outlook to negative from stable on the AAA credit rating on the state.
Although lawmakers had made significant spending cuts in the budget, there was little progress on the state's underlying fiscal imbalance.
In August the agency said that if lawmakers failed to enact significant fiscal reforms to reduce the imbalance within the next year, the state's rating could begin transitioning downward. It added that, as the state's budget reserves approached depletion, the migration to a lower rating would likely persist and accelerate if lawmakers continued to defer taking action.
A move such as the one the attorney general's report proposes constitutes the type of significant fiscal reform that will be necessary to avert a downgrade, according to the agency.
The report's main proposal entails fundamentally redefining the source of revenue for the state's general fund. Most significantly, the state would transition away from relying on oil-related royalty and severance taxes to finance its general fund expenditures.
Instead, the state would manage all of its assets, including those in the $46 billion permanent fund, as a sovereign wealth fund. Under this model, Alaska would deposit all or most oil-related revenue to the permanent fund and then make a consistent draw from the permanent fund to pay for general fund expenses.
This approach has the benefit of shifting the effects of oil price volatility to the permanent fund, away from the general fund.
Notwithstanding that the state has previously succeeded in building up large budget reserves, the effects of oil price volatility is evident when reviewing a history of the state's general fund expenditure pattern.
State policymakers have tended to allow general fund spending on operations and capital projects, in particular, to swell when oil prices are high, only to be forced to drastically cut expenditures when oil prices fall. By providing a steady stream of revenue to the general fund, the sovereign wealth fund model would likely discourage this kind of boom-and-bust approach to budgeting.
However, adopting the sovereign wealth model—despite being nothing short of a complete overhaul of the state's finances—would not immediately solve the state's fiscal problem.
The report estimates that it would require total assets of $100 billion to sustainably fund state expenditures and to pay dividends to state residents at their current levels. Presently, however, total state assets sum to roughly $56 billion (includes the permanent fund, permanent fund earnings reserve, and a portion of the state's constitutional budget reserve).
Therefore, the current level of assets can support an annual draw of $3.4 billion while maintaining its value in real terms. And once accounting for the $1.4 billion estimated cost of funding dividend payments to state residents, revenues available for the general fund would only be $2.0 billion.
Based on fiscal 2016 general fund expenditures of $5.2 billion, this leaves a large, $3.2 billion structural deficit, similar to the existing deficit in the enacted budget.
That's why, in addition to adopting the sovereign wealth fund model, the report also puts forward a proposal for revising the basis on which dividend payments to Alaska residents are calculated.
Currently, the amount available for dividend payments is the result of a formula based on five years of investment returns on the state's permanent fund. The working group illustrates how if, instead, the pool of funds available for dividend payments were limited to half of annual oil royalties (approximately $700 million), the sovereign wealth fund could sustainably support a higher transfer to the general fund.
According to the state's model, in fiscal 2017 the fund could transfer $3.3 billion to the general fund. When combined with some smaller sources of revenue, the state estimates total general fund revenue would be $4.1 billion in fiscal 2017.
The proposed reform is significant. It could reduce the structural deficit by 65%. However, when it comes to the state's credit rating, it may still be insufficient because it would leave the state with a $1.06 billion fiscal gap (based on fiscal 2016 expenditures).
Closing the remaining deficit would require some combination of additional spending cuts, reduced tax credits (intended to incentivize oil exploration and production), or other new revenue (including possibly introducing a new broad-based statewide tax). Furthermore, the sovereign wealth fund model is not risk free over the longer term; it assumes a 6.73% rate of return on the state's assets. The value of Alaska's assets in real terms could erode if investments underperform the state's assumptions.
Nevertheless, S&P said, the proposal marks an important step forward for Alaska's fiscal future and arrives not a moment too soon. Previously, the agency indicated that the upcoming legislative session, beginning in January, is likely to be crucial for the state's fiscal and credit prospects.
Release of the proposal in October may provide lawmakers with sufficient time to give it—or something similar in scale to the effects it would have on the state's fiscal condition—full consideration. As it said in August, whatever path the state embarks on won't be easy politically because almost any proposal that makes meaningful progress on improving the state's fiscal structure likely requires not just limiting the dividend payments, but also increased tax revenue and expenditure cuts.
The attorney general's report shows how cutting dividend payments roughly by half still falls short of closing the fiscal gap. Therefore, without some combination of some or all of these measures, S&P continues to see a material likelihood that it would lower the rating on the state, although no rating actions are currently warranted.
