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Article Excerpt
Alberta has enjoyed unprecedented prosperity thanks to the recent run-up in oil and natural gas prices. Between 1999 and 2006, direct resource revenues accruing to the government increased 152 percent, program expenditures increased 80 percent and the government paid off all outstanding debt. (1)
Nonetheless, this state of affairs rests on a precarious foundation of volatile revenues from an exhaustible resource base. For this reason, many Albertans are asking whether the province has saved enough for the future. This question has taken on particular importance in light of recent media reports about the successful example of Norway, an oil-rich country that places more emphasis on saving its resource revenues than Alberta. (2) In order to address these concerns, we will focus in this Commentary on the following four questions:
* Has Alberta saved enough to date?
* What level of spending out of resource wealth is sustainable, moving forward?
* What are the implications of such a sustainable policy for provincial budget planning? * Should Alberta follow Norway's example?
To answer these questions, policymakers must first identify the principles that should guide fiscal policy over the long run. In recent years, the concept of sustainability has emerged as one such principle.
Economists define fiscal sustainability in terms of the Permanent Income Model, first proposed by Milton Friedman in the 1950s. In recent years, researchers working at the International
Monetary Fund have adapted this model for resource-rich jurisdictions in a version we call the Permanent Resource Income Model (PRIM). In simple terms, PRIM identifies the highest level of annual government spending that can be financed indefinitely from resource wealth, given what is known and expected about the resource endowment.
We argue that this level should be calculated in per capita terms in order to balance competing objectives of intergenerational equity, economic efficiency and fiscal prudence. The model deals with the eventual exhaustion of the resource base by building up sufficient financial wealth to provide an alternative stream of future income.
Applying the model to Alberta yields the following answers to our four questions:
* Alberta has, in fact, saved more than enough to date compared with a hypothetical sustainable policy implemented at the beginning of oil and gas exploitation in 1948.
* Notwithstanding this positive result, the province must now begin an aggressive savings policy if it wishes to sustain a constant level of per capita expenditure in the future. In particular, given our reference forecast of future revenues, the government must aim to save an amount equal to 139 percent of direct resource revenues over the next five years. Failure to meet this target will lead to a permanent decline in fiscal capacity this century, as the resource base and revenues diminish. (3)
* Alberta's Fiscal Responsibility Act provides for less than half the savings called for during the next five years, and its relative performance will deteriorate beyond that point. While further increases in resource royalties may help, our analysis suggests that the government will also have to undertake a combination of spending cuts and increases in non-resource tax levels. (4)
* The Permanent Resource Income Model is conceptually different from the approach followed by Norway. In particular, while PRIM seeks to equalize per capita spending over time, the Norwegian approach contains an explicit bias in favour of future generations. Nonetheless, under present circumstances, PRIM actually calls for Alberta to save more than the Norwegian approach, not less.
Beyond specific targets and values, PRIM provides the ground rules for a process of sustainable fiscal planning that any jurisdiction can follow. At its centre is the idea that government expenditure based on resource wealth should be smoothed out over time so that all citizens share equally in the resource bounty.
In contrast, current debates over resource-wealth spending usually revolve around the government's short-term record. In this vein, Alberta has in recent years legislated fiscal rules to eliminate deficits and constrain the budgeting process. (5) While these rules have proven useful as statements of the government's budgeting priorities, they are, in general, too ad hoc to provide long-lasting guidance on fiscal policy. Indeed, their history is one of constant revision as new developments render yesterday's rules obsolete. Unfortunately, repeated revisions have led to increased complexity, including a proliferation of savings funds. This complexity has reduced the transparency of the budgeting process and does not serve Albertans well.
The Permanent Resource Income Model, however, provides a comprehensive and clear framework for guiding long-term fiscal policy. The model supersedes all other fiscal rules. It also calls for the consolidation of Alberta's various savings funds, thus increasing the transparency of the budgeting process and the public accounts.
Fiscal Sustainability
The debate over managing resource revenues revolves around the following key questions: how much should be saved in any given year? and how much should be spent for the immediate benefit of citizens (i.e. program spending)? By saving, we mean payment of interest or principal, if the government is a net debtor, or accumulation of financial assets, if it is a net creditor. (6)
We interpret sustainability to mean that a given policy can be continued at the current level indefinitely. It follows that sustainability requires a shift of focus from the short term to the long term. Short-term thinking about fiscal policy revolves around the current budget balance. In contrast, long-term thinking focuses upon the government's total wealth--in particular whether this wealth is adequate to support a longterm fiscal plan of which the current budget balance is only one element. For this purpose, the government's total wealth consists of two components: its financial position (the difference between assets and liabilities); and the present value of future revenue streams.
Economists interpret fiscal sustainability in terms of the Permanent Income Model of budget planning, originally developed by Friedman (1957). Permanent income is defined as the annuity value of total wealth. In effect, it is as if the government could invest its total wealth (including the rights to future streams of revenue) in the bond market and receive an annual return on the investment. Permanent income indicates the amount that can be spent in a year consistent with maintaining total wealth constant. (7) Spend more than this amount and wealth will fall; spend less and wealth will grow. Thus permanent income corresponds with the maximum annual spending level that can be maintained indefinitely, assuming nothing changes.
When assessing fiscal sustainability for resource-based economies, economists typically narrow the focus of the model to resource-based wealth only; i.e., financial assets plus the present value of future resource revenues. (8) For this purpose, we denote spending from resource wealth (9) as [G.sup.R]. We take the view that all Albertans, including those yet to be born, are entitled to an equal share of resource-based spending. Therefore, we define fiscal sustainability in terms of the maximum constant value of [G.sup.R] per capita. By definition, this value is equivalent to permanent resource income per capita, which is the annual return on per capita resource wealth.
In a given year, resource revenue may be less than or greater than [G.sup.R]. If less, then the difference is covered by either investment income or borrowing. If greater, the surplus is savings. The role of borrowing springs from the fact that resource revenues do not, in general, flow at a constant rate. In particular, if revenues start out low at the beginning of extraction and increase over time, the Permanent Resource Income Model entails borrowing against future revenues at the outset, then paying off the debt and building positive wealth later when revenues are greater. This way, all generations can enjoy the same level of spending per capita from the resource base, despite variations in the revenue flow. In the long run, it is important to build significant financial wealth to provide a base for continued spending once the resource base is exhausted. Thus, over time, the flow of resource revenue is replaced by a flow of investment income, as in-ground wealth is converted into financial wealth.
This blending of borrowing and saving is analogous to household financial planning. When income is temporarily low, the household may borrow against future earnings; when income is unexpectedly high, the household may save the surplus. And, ultimately, the household will probably wish to accumulate adequate financial wealth to provide for spending during retirement. In this context, debt is not a bad thing, because it is manageable within a long-term plan.
There are, however, other perspectives on fiscal sustainability. Tersman (1991), for one, defines sustainability in terms of a constant ratio of [G.sup.R] to non-resource GDP. Assuming non-resource GDP grows over time, this rule entails that [G.sup.R] grows at the same rate. Further, if non-resource GDP grows faster than the population, it follows that [G.sup.R] must also grow faster than the population. While such growth may seem attractive, it comes with a price. In particular, compared with the constant path we propose, [G.sup.R] per capita in Tersman's framework must start out lower, with more of the resource revenue saved in every period. Consequently, this growth in [G.sup.R] per capita benefits future generations at the expense of early generations. In light of the fact that future generations will also benefit from higher non-resource GDP per capita in this scenario, we see no ethical basis for skewing resource-based spending in their favour as well.
Engel and Valdes (2000) point out that even constant [G.sup.R] per capita may be too generous for future generations since, as mentioned, they will likely benefit from higher non-resource GDP per capita. With this in mind, they propose that resource wealth be used to compensate earlier generations for lower non-resource incomes. This approach entails a declining path of [G.sup.R] per capita. (10)
Fiscal policy must also take into account the impacts of taxation and uncertainty. A constant or declining path of [G.sup.R] per capita must be accompanied by an increasing path of non resource tax rates if, as expected, the per capita demand for public goods grows in step with per capita GDP. Such increases in tax rates have a cost in terms of greater economic distortion. Economists argue that stabilizing tax rates over time--a condition known as "tax smoothing"--can minimize the distortionary cost of taxation. (11) But stabilizing tax rates would require a constant [G.sup.R]/GDP ratio, rather than constant or declining [G.sup.R] per capita.
Uncertainty complicates fiscal planning further. The Permanent Resource Income Model generates a prescription for a constant level of resource expenditure, provided nothing changes. In reality, however, most of the relevant factors, including resource prices, extraction rates, costs and reserve size have proven to be quite volatile over time. Applied research uses a "certainty equivalent" approach, in which expected values of variables are treated as certain values in the solution of the model, and no other adjustments for uncertainty are made. (12) This approach is followed here. However, theoretical research indicates that risk-averse agents respond to uncertainty by saving more than the certainty equivalent level, a phenomenon referred to as "precautionary saving."
To summarize, we have identified three arguments for deviating from our rule of constant [G.sup.R] per capita. First, the equity argument: since early generations will likely be poorer than future generations, we should skew [G.sup.R] in the the former's favour. Second, following the theory of tax smoothing, we should maintain a constant GR/GDP ratio to keep tax rates constant and minimize related distortions. In contrast to the equity argument, this approach calls for skewing [G.sup.R] in favour of future generations. Third, precautionary savings requires more saving and less spending than certainty equivalence, thus skewing [G.sup.R] in favour of future generations compared with our rule.
Accounting formally for these three arguments is beyond the scope of this Commentary. However, we note that our model's deviation on the first item is opposite to its deviations on the second and third items. Thus, the deviations may be at least partially offsetting. Further, we note that Alberta's tax system is among the least distorted in Canada, with flat tax rates of 10 percent on both personal and corporate income and no provincial consumption tax. (13) Thus, the argument for tax smoothing may be weaker for Alberta than elsewhere. Since equity and efficiency are pulling policy in opposite directions here, a rigorous approach would require finding an optimal balance, which of course would lie somewhere in the middle. It is possible that our constant [G.sup.R] per capita rule may not be far off.
Finally, we note that, as a practical matter, uncertainty of future variables means that regular revisions of the fiscal plan will be necessary as new information becomes available. At a given planning date, the permanent income approach yields a prescription for a constant level of resource-based spending based on expected values of variables and assuming nothing changes. But of course conditions do change. In every planning period (e.g. next fiscal year), the exercise will need to be repeated, using realized values for the elapsed period and updated forecasts of future variables. In light of these changes, the prescribed level of resource spending would change as well. Thus, in retrospect the amount of per capita resource spending would be variable, while in any given year the plan would call for a...
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