Nov 5, 2018

Natural Resources Can Be a Blessing or a Curse for State Fiscal Conditions

Oil Tax Revenue Volatility and Windfalls
Olivia Gonzalez Research Associate

The national economy is thriving, and many states are experiencing an economic expansion; unemployment is low, opportunities abound, and some states’ energy industries are booming. According to the Bureau of Economic Analysis, second quarter growth reached a four-year high of 4.2 percent. Times like these can help policymakers breathe a little easier. Increased economic activity can bolster tax revenues and make it easier to balance budgets. These revenue windfalls may seem like an unequivocally good thing, but the reality is that, in a poor institutional environment, they can actually become a nuisance.

If you suddenly get a bonus at work, it’s definitely worth celebrating, but what you do with that money matters. We all have our own preferences (some more or less responsible), but most would agree that the worst thing you can do is to take out a lease on a new car—or some other new recurring payment—in response to a one-time increase in income. Sure, you might get another bonus next year, but is it guaranteed?

This same logic applies to state budgeting. When a state gets a windfall of revenue, policymakers can get excited about the opportunity to spend it on something new or increase appropriations to a pre-existing program, but this is risky if the revenue source is somewhat unpredictable. It’s especially a problem if a large portion of your budget relies on this revenue source.

When your revenues rely on a commodity like oil, your budget is vulnerable to ebbs and flows in the market. As oil prices rise, your revenues increase and times are good, but when oil prices fall, things can quickly go awry. Things can get especially hairy if each time you get a windfall from increased oil prices, you spend that money or direct it into a restricted fund that is not easily accessible instead of setting it aside for worse economic times.

Wyoming, Alaska, and North Dakota often do this. They ranked 6th, 11th, and 19th, respectively, in this year’s Ranking the States by Fiscal Condition report. In any given year, their finances may not look too bad, but if you look at their finances over time, the picture gets a lot worse. Because of these states’ heavy reliance on oil tax revenues to finance government spending, their budgets are marked by big swings in short-term solvency. In contrast with my last post on the most consistent states, you could argue that these three states are the least consistent states.

Inconsistent Performance

All states experienced weakened operating ratios as a result of the recession in 2008 and 2009, but the key difference is that most states have since recovered and stabilized. Alaska, North Dakota, and Wyoming, by contrast, are still marked by volatility in their budget solvency metrics. When it comes to their ability to match revenues with expenses, they’ve had the most difficulty stabilizing. For example, in most years, Alaska’s revenues have exceeded its expenses by 50 percent or more. A decline in oil prices, however, resulted in revenues falling short of expenses by 50 percent in FY 2016. North Dakota and Wyoming follow similar paths.

In FY 2015, North Dakota’s revenues exceeded expenses by 27 percent, but in FY 2016, they fell short and covered only 98 percent of spending. Wyoming’s FY 2014 revenues exceeded expenses by 48 percent, but then in FY 2016 revenues fell to cover only 93 percent of expenses.

The Pew Research Center warns against the highly volatile nature of severance taxes and ranks Alaska, North Dakota, and Wyoming as having the first-, second, and third-most-volatile revenue streams of the 50 states, respectively, between 1997 and 2016.

These three states aren’t the only ones with severance taxes on oil, however. According to the National Conference of State Legislatures (NCSL), 34 states have enacted taxes or fees on the extraction, production, and sale of oil and natural gas. Why don’t these states experience as much volatility as Wyoming, Alaska, and North Dakota?

It’s because they do not rely as heavily on oil and gas production for their revenues. Revenue from severance taxes made up 41 percent and 19 percent of general revenues for North Dakota and Wyoming, respectively, in fiscal year 2016. Alaska typically relies on severance taxes more so than any other state. In fiscal year 2016, however, it was unable to generate enough severance tax revenue to pay for the tax credits it had already committed to giving to oil producers, with the result that it reported a negative amount of severance taxes brought in.

New Mexico, Oklahoma, Montana, Texas, and West Virginia implement similar severance taxes on oil production, but they amount to 10 percent or less of general revenues. Since these states do not rely as heavily on these taxes as do Alaska, North Dakota, and Wyoming, they do not experience as much revenue volatility. The Pew Research Center’s study ranks New Mexico, Oklahoma, Montana, Texas, and West Virginia as having the 8th, 14th, 25th, 26th, and 47th most volatile revenue streams, respectively.

States interested in maintaining stable budgets should be wary of implementing severance taxes. Recently, policymakers in Pennsylvania have been considering a severance tax on natural gas. 2018-2019 budget estimates bring potential revenues resulting from a hypothetical severance tax to $248.7 million. Although this only amounts to about one percent of general revenues, they should be wary of introducing more revenue volatility into their budget.

Different Approaches to Windfalls

States have several options when deciding what to do with their revenue windfalls. On one extreme, they could spend the unexpected money, or on the other, they could restrict their cash in what are called permanent funds. I would argue that a happy medium would make deposits into a well-structured rainy day fund, an account explicitly designed to smooth out revenue fluctuations during worse economic times.

Both Alaska and Wyoming have extremely high levels of cash, which is usually a good thing, but not all of their money is easily accessible. As I’ve discussed previously, Alaska has consistently had high levels of cash, but this hasn’t always translated to sound fiscal health. In fiscal year 2016, Alaska and Wyoming ranked 50th and 37th, respectively, when it came to trust fund solvency. This means that despite having high levels of cash, these states haven’t successfully funded their pension liabilities and other post-employment benefits. Similarly, Alaska and Wyoming ranked 50th and 47th, respectively, when it came to their budget solvency in 2016. It should be noted, however, that Alaska’s trust fund solvency may be improving in the future. The state’s two major defined benefit pension plans have been closed to new entrants since 2005, so those liabilities aren’t going to be growing anymore.

The mismatch between high levels of cash and less than ideal fiscal solvencies comes down to each of these states’ unconventional institutional environments.

Permanent Funds

Alaska, Wyoming, and North Dakota each direct much of their windfalls into restricted permanent funds. In fiscal year 2016, Alaska had $69.15 billion in cash, cash equivalents, and receivables, but $44.79 billion of this was restricted for the state’s permanent funds, meaning it could not readily be accessed for meeting short-term bills. Similarly, Wyoming and North Dakota’s high cash solvency indicators reflect the state’s reported cash on hand, of which some is restricted as non-spendable or restricted by their mineral and coal development trust funds.

A permanent fund is one of five governmental fund types established by Generally Accepted Accounting Principles (GAAP). They are legally restricted to the extent that only earnings, not principal, may be used for purposes that support the reporting government’s programs. Alaska, for example, uses its permanent fund to provide annual dividends to their residents. One of the motivations for creating it was to save money for future generations that might not have access to oil as a resource by investing the principal in the stock market. This was decently forward-thinking, but the fund’s creators did not foresee the restrictions this would impose on their budget. The state has consistently issued dividend checks to residents, even in years with steep budget gaps, severely limiting policymakers’ ability to address their fiscal distress.

Rainy Day Funds

A rainy day fund is an account used to save money for when regular income sources are disrupted. Most states use these to help deal with budget shortfalls in years where revenues do not match expenses as a result of poor economic times. The key to rainy day funds, however, is that they are designed well and aren’t abused. Having well-defined deposit and withdrawal conditions that are tied to revenue volatility can help ensure that a state has a robust savings fund for emergencies.

Thankfully, these states do have rainy day funds. According to Pew, Alaska and Wyoming ended fiscal year 2017 with the first and second largest, respectively, rainy day reserves as a share of operating costs. North Dakota, however, has less than a week’s worth of operating costs in reserves.

This was the second year in a row that Alaska withdrew from its rainy day reserve, which shrank to their lowest level as a share of operating costs since 2008. What’s more, the state used the funds to finance regular operating costs. If Alaska is already drawing from their rainy day fund during good economic times, it is worrisome to think about what they will have available when worse economic times hit.

The differences between permanent restricted funds and rainy day funds may seem narrow, but the key lessons for maintaining fiscal health are still apparent. Regular payments into a rainy day fund can help combat revenue volatility, especially for states that rely heavily on taxes on commodities like oil. But when large portions of your cash go into restricted funds, you might be tempted to make regular withdrawals from your rainy day fund. Permanent restricted funds can tie the hands of policymakers so that they can’t readily access their cash for operating purposes. Alaska, Wyoming, and North Dakota have both types of accounts. This complicates their institutional environments. When windfalls hit, large portions are directed into permanent restricted funds so that when they experience shortfalls, they either can’t access it or experience pressure to withdraw from their rainy day fund.

States can avoid this complexity by not relying too heavily on volatile revenue sources and by being careful how they design their rainy day and restricted funds.

States should be careful about what revenue sources they rely on and about what they do with unexpected windfalls. Relying so heavily on oil taxes can lead to more volatility in your budget. With oil prices currently on the rise, it may be tempting to spend the resulting revenues, but policymakers should fight this impulse. Having a robust rainy day fund can be a helpful way to combat this urge and smooth out fluctuations in revenue. States should be careful not to overly restrict themselves with permanent funds, but also to have enough foresight to not immediately spend any revenue infusions, regardless of the cause.

Photo credit: imageBROKER/Shutterstock

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