Politics and Trust

Abstract

Trust funds are a particular way of governing resource flows. Governments use trust funds to bind policy decisions of future actors and remove resource flows from budget competition. The State of Alaska removed a portion of their oil revenues from political competition through the creation of the Alaska Permanent Fund. A unique feature of the fund is that it pays annual dividends to Alaskan citizens, thus creating a citizen stake in the management of the Fund. Through this framework Alaskans have successfully protected a significant stream of revenue (21 billion dollars) from political demands.

Introduction

Public Purpose Trust Funds are created by laws that govern allocation of designated public resources. These Funds capture and channel resources for particular policy purposes. The state of Alaska maintains one such public trust fund, different from most others. It captures a portion of state oil revenues, invests them in a broad portfolio and pays cash dividends to all resident Alaskan citizens. This "Permanent Fund" limits short-term political choices in favor of long-term policy goals.

This paper presents a case study of the Alaska Permanent Fund. It explores the historical background and political pressures that have shaped the development of this financial tool. It then examines how this fund has isolated a particular revenue stream from legislative appropriation.

The Alaskan Permanent Fund: Historical Background

State finances in Alaska are a complex melange of no state personal income, sales or property taxes, declining state revenues and budget cuts, along with individual payouts to citizens from the public trust fund known as the Alaska Permanent Fund, something unique in U.S. governance. The roots of the Alaska Permanent Fund lie in oil, the black gold that replaced the yellow kind as the central source of wealth for the state. Since the Russians first occupied Alaska in the mid-18th century, its economy has been based predominantly on natural resource extraction. In the 18^th and 19^th centuries Russians, British and Americans pursued an enormously profitable trade in sea otters furs. U.S. purchase of the territory from Russia in 1867 for $7.2 million did not change dependence on natural resources. In the 19^th and 20^th centuries, gold, fish, lumber and oil have dominated the economy and initiated the boom and bust cycles typical of natural resource dependent economies.

With the signing of the Alaska Statehood Act on January 3, 1959, by President Dwight D. Eisenhower, Alaska became the nation's 49th state. The state constitution evolved from considerable study of other states' experiences and consultations with administrative experts. The resulting "model constitution" sought to avoid the "mistakes" of the lower 48 by establishing a single elected executive, a judiciary staffed under the Missouri Plan (executive appointment followed by periodic retention votes), and a constitutional prohibition on dedicated funds, all to avoid the influence of partisan politics on public policy. The Constitution was designed for administrative efficiency, although Alaska's libertarian tendencies did result in including citizen initiatives and referendums.

Black Gold!

Spending pressures increase with the influx of money, and for Alaska, oil pumped from the vast resources of Alaska’s North Slope provided that influx. Under the Alaska Constitution (Alaska, 2001) the natural resources of Alaska belong to its citizens. In 1968, nine years after statehood, Atlantic Richfield pumped the first oil from Prudhoe Bay, beginning a new boom cycle. The following year the state held an auction for oil leases, and in a single day collected 900 million dollars, at a time when the state budget itself was barely over 100 million dollars. This shower of riches sent Alaska into a frenzy of public spending, particularly on capital projects. From 1961 to 1981 state general fund expenditures grew at an average annual rate of 22%, from $45 million to over $3 billion. Oil revenues as a percentage of state revenues peaked at 90% in 1980, and only in 1999 did they drop to barely below 70%, due to a sudden downturn in oil prices. Alaska's dependence on oil revenues is overwhelming. The influx of oil dollars into state coffers reduced the need for other sources of funding, and consequently, in 1980 Alaska abolished the personal (but not corporate) income tax, institutionalizing the state's preponderant dependence on oil revenues.

By 1976 the state had spent most of the initial lease money, and Alaskans were aghast that they had frittered away so much in so short a time. Fears of uncontrolled legislative spending had been confirmed, and Alaskans sought ways to protect their natural resource revenues for future generations. One solution was to establish a public trust fund. As early as 1970 the first bill to establish a trust fund to set aside a portion of oil monies was introduced by then Governor Keith Miller. However, Miller's suggestion received little serious attention at the time (Brown and Thomas, 1994). Additionally, the state Constitution prohibited dedicated funds, viewing them as political techniques inhibiting efficient management.

Unrestrained spending continued, and in 1975 "Legislators watching the balance of the 900 million dollar Prudhoe Bay sale evaporate into the fiscal 1976 budget" passed legislation to establish a so-called permanent fund "in part to stem the tide of state spending." Detractors noted "it was naive to assume future legislators would refrain from raiding the fund for day-to-day operations." (Juneau Empire, June 2, 1975).

The following year Governor Jay Hammond proposed a constitutional amendment to create a fund to preserve oil revenues. [Note: this was required because the state Constitution prohibited dedicated funds.] The Legislature passed the amendment which was approved by voters the following year by a nearly 2-1 margin (75,588-38,518).⁸

The amendment reads:

At least twenty-five percent of all mineral lease rentals, royalties, royalty sale proceeds, federal mineral revenue sharing payments and bonuses received by the State shall be placed in a permanent fund the principal of which shall be used only for those income-producing investments specifically designated by law as eligible for permanent fund investments. All income from the permanent fund shall be deposited in the general fund unless otherwise provided by law.

The Fund provides an example of a public purpose trust fund established with dedicated revenues but no specified policy purpose for expenditures. Its primary purpose was to protect a portion of oil income from any legislative spending. It did allow the Legislature to govern the investment strategy of the fund and further indicated that earnings from the fund were available for legislative allocation. Since the law governing investment and earnings is statutory, not constitutional, it is controlled by the Legislature.

How exactly to invest the savings remained unsettled. The Legislature set up a study commission to address the questions of fund management and use of fund revenue. For the next three years the state engaged in an intense debate over the ultimate purpose of the Fund: economic development or intergenerational trust.

Ultimately, advocates of the trust fund concept prevailed. The 1980 Alaska Permanent Fund Corporation legislation stated that:

1. the fund should provide a means of conserving a portion of the state's revenue from mineral resources to benefit all generations of Alaskans (emphasis added)

2. the fund's goal should be to maintain safety of principal while maximizing total return;

3. the fund should be used as a savings device managed to allow the maximum use of disposable income from the fund for purposes designated by law.

[Article 01 Section 37.13.020]

Investment Rules, Asset Distribution and Fund Management

The amendment did not specify how the assets of the fund were to be invested, except that investments were to be "income producing." After a long, acrimonious debate the Legislature adopted a conservative "prudent investor" approach in the Permanent Fund Management Act of 1980 (Alaska Permanent Fund, 2001). The Permanent Fund Corporation's emphasis in all investment decisions is preservation of principal, with return on investment secondary. However, Fund legislation also mandates that “assets shall only be used for income producing investments,” which acts to avoid pressure to direct funds toward speculative or personal ventures. While initially mandating fixed income investments, the approved investment list was later expanded to include stocks and real estate. Today, equities comprise the majority of Fund investments. While Alaska-based investments form a part of the portfolio, they are undertaken only when the investment is comparable to what can be obtained elsewhere.

The creation of a separate trust corporation and mandating a "prudent investor" rule emphasizing preservation of principal insulated the Fund from demands to invest money in Alaska-based projects unless they proved competitive with other investments. Political pressures to invest in pet programs that have plagued other public trust funds were, thus, limited.

While the fund was established as an investment account and public trust, the legislation following the example of the constitutional amendment, left open the disposition of the Permanent Fund earnings, saying only that the Legislature could appropriate those funds as it saw fit.

The Dividend

Governor Hammond, however, was not satisfied that the money deposited in the Permanent Fund was suitably protected from the legislative propensity to spend. He urged the establishment of a dividend, similar to any investment fund, payable to all Alaskans. His argument was that this dividend would establish a citizen interest in the Fund. Hammond believed, and his logic has been proved accurate, that establishment of the dividend would make it more difficult for the Legislature to spend Fund earnings, because any spending would lessen the dividend paid out to citizens.

Even prior to the passage of the Constitutional amendment, Governor Hammond had suggested that the proceeds of the Fund might be used for direct payments to Alaskan residents. (Juneau Empire, October 18, 1976). In 1977 he proposed tax increases be coupled with "direct public sharing in state oil and gas revenues" (Juneau Empire, January 11, 1977) in what he called his "Alaska Inc." plan. He stated the proposal was

"aimed at limiting the growth of state government from non-renewable resources….Rather than permitting government to spend all public monies earned through exploitation of the public's resources for what government thinks best, let's grant shares to Alaskans and let them determine what services they want enough to permit government to recoup those shares in taxes. Nothing could do more to curb excessive growth of government….What Alaska Inc. does is it ties the string from the public pocket book to the bureaucratic balloon. Every time we float it up and twitch the string through increased taxes or reduced dividends the people are going to react." (Harmon, 1977).

By tying distributions to length of residence and voter registration, Hammond hoped the plan would encourage a stable and voting population.

Hammond believed oil revenues exemplified the "tragedy of the commons," to which every politician has a right, but not a responsibility. He predicted the dividend would serve as a check on excessive government spending by mitigating what economists call "fiscal illusion" (O'Brien and Olson, 1990). With oil revenues accounting for 85% of state spending (and no state sales or income taxes) voters tend to underestimate the true cost of government spending. The result is that they support too much spending and too many public goods. The dividend establishes a link between citizens and expenditures. Higher state expenditures means less money available for dividends (Brown and Thomas, 1994).

The idea of a citizen dividend from a public trust fund is a unique concept. While a number of states have created public trust funds for various designated purposes, none have established a dividend, payable to all resident citizens of the state. Other states earmark revenue for support of specific state purposes, such as education. But the establishment of a universal dividend created a vested interest for all Alaskans in the health and continuity of the trust, thus strengthening political protection from appropriation. It is unlikely, for instance, that the state government would find it politically possible to borrow from the Permanent Fund in the same way that the federal government borrows from the Social Security trust fund because of the public interest established by the dividend program (as well as statutory limitations).

Hammond’s original plan allocated dividends on the basis of years of residency in Alaska. After the U.S. Supreme Court invalidated that distinction (Zobel vs. Williams, U.S., 102 S.Ct. 2309.72 L.Ed.2d 672, 1982) dividends have been distributed to all qualifying Alaska citizens. Over the years the Permanent Fund Dividend, or PFD as it is commonly referred to by Alaskans, has increased with the value of the Fund, growing (after an initial $1,000 payment) from $386.15 in 1983 to $1,850.28 for 2001. (See Chart 1) At the same time, the principal of the fund, which is constitutionally protected, has also continually increased through 1) dedicated oil revenues 2) inflation-proofing allocations and 3) legislative allocations.

[Chart 1 about here]

In 1982, the first year of the dividend, the legislature adopted so-called "inflation-proofing" which specified that 50% of the (five year averaged) Permanent Fund earnings be distributed as dividends, while from the other 50%, an amount equal to the annual increase in the U.S. Consumer Price Index times the total principal of the fund, would be added to the Permanent Fund principal. The remainder of the earnings, if any, are held in an Earnings Reserve Fund, which may be appropriated by the Legislature, used for future inflation protection or reallocated to the Fund principal.

The Alaska's state Legislature has taken steps over the years to make additional appropriations to the Fund principal. In 1980, the year the Permanent Fund Corporation was established, the Legislature contributed an additional $900 million to the Fund, symbolic of the $900 million from the original lease auction. Since then, six more special appropriations have been legislatively added to the Fund principal including $250 million appropriated in June of 2000. Since 1987 these appropriations have come from the Earning Reserve Fund.

Due to dedicated oil revenues, inflation-proofing and special appropriations, the constitutionally protected Fund principal (and consequently earnings) has continually increased, from 54 million dollars in 1978 to 21 billion dollars on June 30, 2001 (See Chart 2).

[Chart 2 about here]

By 2001, the total Permanent Fund had increased to over 25 billion dollars with annual earnings of approximately 2 billion dollars. Over the 25 years of the Fund's existence, approximately a third of the additions to principal have come from dedicated oil revenues, a third from inflation-proofing, and a third from special appropriations.

The State Budget

Under the Permanent Fund Legislation, the Legislature may spend that part of Permanent Fund earnings remaining after the PFD distribution and inflation-proofing, which is known as the Earnings Reserve. However, political pressures have kept the Legislature from spending the Reserve, and they have instead reallocated these leftover earnings to the Fund principal, even when state budgets were being cut.

In recent years oil production has declined and various other reserve accounts have been drained. During a time of economic expansion for the rest of the United States, Alaska has cut state budgets. Despite declining oil revenues, Alaska has refused to re-introduce the state income tax, or institute state wide sales or property taxes. Legislators have been caught between the typical pressures of providing services to constituents and cutting (or in this case not creating) taxes. While this situation is similar to that of other states, the difference in Alaska is the existence of a huge unallocated public trust fund. While the state Constitution prevents legislators from tapping into the principal, only public opinion prevents it from using Fund income. In 1998 Fund earnings for the first time exceeded state oil revenues. Increased Fund earnings juxtaposed to declining oil revenues have directed more attention toward possible use of Permanent Fund earnings to fill the gap in state income available for expenditures.

In 1999, despite the pinch of service cuts and talk of reinstitution of an income tax, 84% of Alaskans in a non-binding referendum rejected the concept of using Permanent Fund earnings for state government funding. While some measure of the defeat can be attributed to ambiguous and complex wording, it is likely the referendum would have been defeated even if it were clearly written. Alaskans were not convinced that the Legislature would wisely spend "their" PFDs, supporting cuts in government services and refunds to citizens. Thus, former Governor Hammond's belief that the dividend program would control state spending by giving Alaskan citizens a stake in the use of oil revenues proved correct.

The Alaska Legislature has the power to access the Earnings Reserve Account through simple appropriation. It can tap into additional Fund income by amending the dividend legislation. However, strong public opposition, developed almost certainly because of the dividend link, inhibits Legislative appropriation of Fund income. In the 2000 Legislative session there were several proposals to spend Permanent Fund earnings. One proposed piece of legislation would have paid $25,000 to every Alaskan in exchange for abandoning the dividend program forever. None of these proposals gained much support in the wake of the 1999 referendum, and rising oil prices lessened the fiscal crisis for the state. In the end, instead of spending it, on June 9, 2000 an additional 250 million dollars was appropriated from the Earnings Reserve into the constitutionally protected principal of the Permanent Fund. In the 2001 legislative sessions, in progress at the time of this writing, there are several more proposals to allocate some income to state budgets. None of them propose to eliminate either the dividend or continued inflation-proofing of the Fund principal.

Trust Funds

A trust fund is essentially a contract governing future use of specified resources. Resources are transferred by the owner, or trustor, to an agent, or trustee, who manages them for a specified beneficiary or beneficiaries. The trustee may control the fund for a few years, or indefinitely, depending on the terms of the trust. Trust provisions may specify how the trustee manages the fund, and may limit how beneficiaries use distributed trust resources. A trust can be either revocable or irrevocable. In a revocable trust, the trustor may change or cancel the trust fund at any time, so maintaining ultimate control over the resources. In an irrevocable trust, the rules of the trust may not be changed after the trust is created. Thus, a trust is a tool of resource control allowing the trustor to transfer resources, but retain future control over how those resources are used. Governments use the trust fund concept similarly, to control future use of resources.

Public Purpose Trust Funds

Governments at every level administer hundreds of trust funds. In most cases they are special revenue funds or dedicated funds, set up to channel designated revenues into particular policy areas. Examples at the federal level are Social Security, Highway and Airport Trust Fund, Unemployment Trust Fund, Foreign Military Sales Trust Fund, Inland Waterway, Mass Transit, Boat Safety, Harbor Maintenance, Superfund, Oil Spill Liability, and the Leaking Underground Storage Tank Trust Fund (quaintly known as LUST). The U.S. government also administers thousands of Indian Tribal and individual trust (fiduciary) funds (Gonzales, 1997) which are similar to private sector trust funds. States and municipalities also administer a great variety of trust funds for many purposes.

Trust funds in government accounting, however, differ significantly from private sector usage. Governments own the assets of most government trust funds, and can raise or lower future trust fund collections and payments, or change the purposes for which the collections are used, by changing existing laws. Most Public Purpose Trust Funds, unlike the Alaska Permanent Fund, do not separate principal and income. All income is expendable. There is no substantive difference between trust funds and special funds or between revolving funds and trust revolving funds. Whether a particular fund is designated in law as a trust fund is, in many cases, arbitrary (United States, 2001).

Binding Future Action

Dedicated revenues are often established in tandem with public trusts. A dedicated, or special revenue, fund (recipient of dedicated revenue) stipulates the sources and uses of revenue. Future legislators cannot change the allocation decisions through the appropriations process, which is more amenable to individual power and political maneuvering. Trust beneficiaries (and the agency administering those funds) are protected from the competition of the appropriations process. Revenue streams removed from the general fund are thus protected from some forms of political tradeoffs (Rubin, 2000).

Public purpose trusts control future actions. They enforce a past legislative consensus on future citizens and legislators. Public trusts often combine the roles of trustor and trustee because the legislature both establishes the fund and governs its administration. Because public trusts may be terminated by law, they are revocable. When trusts are established by state constitutions, a degree of space is created between trustor and trustee, because citizens, who must approve constitutional changes, share the role of trustor.

The Alaska Permanent Fund as Self Binding Trust

The Alaska Permanent Fund was created as a tool to restrict government spending actions after the 900 million dollars from the first oil lease auction was spent so quickly. It removed a portion of revenue from the usual political budget competition and bound future legislators from allocating those resources for other purposes. The Alaska Permanent Fund is further isolated from budget competition because its existence is Constitutional, rather than just statutory. By expanding the identity of Permanent Fund trustor to include 2/3 of legislature and a majority of the voters (necessary to amend the Constitution) Alaska established a fund revocable only by the entire electorate. The Legislature may not take unilateral action, and ultimate protection of the Fund is directly in the hands of citizens.

Alaskans helped ensure the permanency of their Fund by designating certain income as "principal," not accessible for spending. The inclusion of this endowment element mandates that only income may be spent. Alaskans ensured permanency and growth through the establishment of a dedicated funding stream (percentage of oil revenues).

A further level of protection was established by creating a separate trustee organization for the Fund. While most public trust funds are managed by government departments or ministries, the Alaska Permanent Fund established a separate government corporation with its own board of directors and portfolio managers. Day-to-day decisions about Fund management are governed by concepts of prudent investments, rather than budget and political pressures. If a trust fund is established to promote economic development, as was the original plan for the Alberta Heritage Savings Trust Fund, strong political pressures will be exerted concerning where such money should be invested. In Alberta, the initial policy was to invest in provincial development rather than for income, as a "prudent investor." This, along with the lack of isolating principal, resulted in the declining value of that Fund in the 1980s (Smith, 1991).

The Alaska Constitution specifies that the principal of the Permanent Fund is restricted to "income-producing investments" (Alaska, 2001). The statute establishing the fund specifies that "the prudent investor rule shall be applied by the board in the management and investment of fund assets." It further specifies "reasonable diversification," and that in-state investments must be "comparable to alternate investment opportunities” (Alaska Permanent Fund, 2001). Through these investment rules, the Fund is insulated from political pressures to direct investments toward pet projects. Investment choices require economic justifications.

The Fund is further protected by political reality. Any government policy has stakeholders, and stakeholders strive to influence policy. The larger the number of stakeholders, the more influence they have on that policy and the less likely legislators are to alter the policy contrary to the preferences of those stakeholders. The Alaska Permanent Fund dividend program effectively creates active stakeholders of all Alaskans through its dividend program. All qualified applicants receive a cash payment on an annual basis. Any move to alter the rules affects every Alaskan. Because of this personal stake in the Fund, Alaskans are extremely chary about use of Fund income.

Primacy of Politics

How do trust funds affect the ability of the legislature to "plan," and how do they impact democratic governance? Critics of public trust funds assert they inhibit democracy by limiting the future choices of democratically elected representatives. Patashnik (1997, 2000) discusses the tension between credibility and flexibility. "In a democratic polity, how much should we commit policy to a particular direction, and how might we craft credible public commitments if we want to do so? Can a political system "undo" inherited commitments when they become incompatible with an assessment of current needs?" (Patashnik, 1997, p.431).

In order to make credible commitments for the indefinite future, political actors create institutional arrangements that prevent opportunistic actors from reneging on their, or their predecessors', bargains. The ability to lock in future commitments expands the set of deals political actors can strike in the present. This "self binding" argument is limited, because what a political system can do, it can undo. Legislation can be repealed, in most cases by a simple majority. However, Patashnik argues the real significance of trust funds is their political impact. He argues that trust funds contribute to policy credibility less by prescribing or proscribing particular budgetary outcomes than by shaping actors' beliefs and expectations of what constitutes political fidelity and defection.

Patashnik asserts that trust fund proposals are more likely to succeed when many actors have incentives to support them. The more people who benefit from a program, the more political support it has. Programs that benefit most or all citizens will have few opponents. What controls or limits the actions of political actors is less the trust fund's institutional rules, and more the political mandate. The more people benefit from the policy, the more difficult it is for political actors to change it. This logic is supported by the experience of the Permanent Fund Dividend program.

A 1981 study prepared for the fledgling Alaska Permanent Fund by the Harvard Institute for International Development (Gillis, 1981) addressed international experiences with oil income. It emphasized the problems surrounding the influx of dollars into an economy and the tendency in oil-producing countries to initiate large infrastructure projects and subsidize economic development, both of which have serious, long term, negative consequences. "Virtually all countries…have sought to use oil money to create a viable modern economy outside the oil sector, so as to be able to sustain a relatively high income after the oil is depleted. In my judgement, none of the political jurisdictions.… have had even moderate success in coping with the often bittersweet shock of enormous inflows of natural resource income" (p.13).

The report encouraged the Permanent Fund to follow a strategy of maximizing returns, which tends to avoid "pet projects and boondogles" (Gillis, 1981). The state of Alaska took this advice to heart as it attempted to isolate a portion of their oil revenues from political spending pressures through the creation of the Alaska Permanent Fund.

Future Choices for Alaskans

Trust funds attempt to ensure long-term commitment of resources through institutional rules and dedicated revenues. The State of Alaska has insulated a significant revenue stream from political competition and appropriation through a number of statutory and constitutional barriers. Because of the citizen-wide dividend program it is politically difficult to alter the Alaska Permanent Fund, or appropriate its earnings, even in the face of significant budget pressures and declining state revenue. Alaskans may have to decide between a reduction in their cherished dividend or the establishment of new taxes. It will be interesting to observe which of these two "evils" is more palatable.
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