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The Proposed Tobacco Settlement: Issues from a Federal Perspective April 1998

On June 20, 1997, the tobacco industry reached a settlement with a number of state attorneys general who had brought suit against it. Under the agreement, tobacco companies would make substantial annual payments to state governments and others and would abide by many additional regulations, including restrictions on advertising, labeling, and access.

The settlement specifies payments of $368.5 billion (in 1998 dollars) over the next 25 years, assuming no change in tobacco consumption. If consumption fell, however, the industry's payments would be reduced proportionately.

In return, the agreement would place limits on future litigation against the industry and alter the Food and Drug Administration's (FDA's) authority to regulate tobacco products and smoking. Under the settlement's restrictions on litigation, no class action suits or suits by any government entity could be brought against the tobacco companies, and those companies would be immune from all punitive damage liability for past conduct. The settlement would allow only individuals to bring suits to recover compensatory damages (such as medical costs and lost wages) for past industry conduct and compensatory and punitive damages for future conduct.

Implementing the agreement would require federal legislation, at a minimum, to grant the promised legal immunity to the tobacco industry and, perhaps, to modify FDA policies.

The settlement targets the use of cigarettes and smokeless tobacco for reduction efforts.⁽¹⁾ Cigarettes account for most of the spending on tobacco products in the United States (see Box 1). This paper focuses on how the settlement might reduce cigarette consumption and estimates the amount of payments that the tobacco industry would make.
 

BOX 1. THE TOBACCO INDUSTRY Tobacco is the basis for a multibillion-dollar industry that is dominated by a few large firms. Cigarettes account for over 90 percent of spending on tobacco products in the United States, and last year American consumers smoked about 24 billion packs. Smokeless tobacco, cigars, and pipe tobacco are also produced by the tobacco industry. In 1995, U.S. spending for all tobacco products totaled about $49 billion. Five American companies--Philip Morris, R.J. Reynolds (a subsidiary of RJR Nabisco), Brown and Williamson (a subsidiary of B.A.T. Industries), Lorillard (a subsidiary of Loews), and Liggett--produce almost all of the cigarettes sold in the United States. Two companies, Philip Morris and R.J. Reynolds, account for more than 70 percent of industry sales. About 36 billion packs of cigarettes were produced by U.S. firms in 1997, with about 12 billion packs exported to other countries and about 280 million packs shipped to U.S. territories and to U.S. armed forces stationed overseas. The rest were consumed by domestic smokers. Cigarette revenues totaled about $46 billion in 1996. Smokeless tobacco products are also produced by only five domestic manufacturers: U.S. Tobacco, Conwood, Pinkerton, National, and Swisher. Over 120 million pounds of chewing tobacco and snuff were produced in the United States in 1996; in 1995, smokeless tobacco companies posted revenues of $1.7 billion. Cigars and pipe tobacco are produced in a market that is less concentrated in a few companies. About 2.5 billion large cigars and cigarillos and 14.2 million pounds of pipe and roll-your-own tobacco were produced by U.S. companies in 1995. The United States is the second largest tobacco producer in the world, falling well below China in total production. In 1996, tobacco was grown on over 124,000 U.S. farms, producing a crop valued at $2.9 billion. The Department of Agriculture administers a system of marketing quotas that supports the price of tobacco, as well as a loan program for tobacco producers. The quota system has no significant costs other than those of administration. Over time, the loan program is intended to pay for itself. The tobacco industry supports over 600,000 jobs for people who produce and deliver tobacco products. In addition, 625,000 retail outlets distributed cigarettes and tobacco products in 1992. Convenience stores and gas stations sold about $12.7 billion in tobacco products that year, with vending machines adding $2 billion in sales.

 

Initiatives to Reduce Smoking

The settlement would reduce cigarette consumption in two ways. It would set in place an array of regulatory and public health initiatives designed to limit the marketing and use of cigarettes. The settlement would limit or ban many forms of advertising and promotion; restrict smoking in workplaces and public areas; ban sales to people under age 18; and fund a variety of smoking prevention and cessation programs, among other actions.

Those regulatory and public health interventions would lead to reductions in cigarette consumption if they were funded at the levels envisioned in the settlement. Most of the decline would result from the infusion of new funds into smoking cessation programs aimed at adults. A larger decline in teenage smoking might result from the restrictions on advertising by the industry and from smoking prevention programs funded under the settlement. However, because teenagers account for a very small fraction of total cigarette consumption, the impact of most regulatory and public health provisions on total consumption would be small, at least over the next several years.

The settlement would probably generate more significant reductions in cigarette consumption through its effect on the price of cigarettes. By requiring the tobacco industry to make substantial payments to state governments and others, the settlement would result in higher prices for cigarettes. Those payments would be unlikely to reach the $368.5 billion figure, however, since they would be reduced as the total consumption of cigarettes fell. Nonetheless, the industry would make substantial payments under the settlement and cigarette prices would be likely to increase significantly.

Considerable research supports the proposition that increasing the price of cigarettes would be the most effective way to reduce their use. Even so, there is considerable uncertainty about how the industry would change the price of cigarettes in response to the cost increases in the settlement. Some analysts believe that tobacco firms would attempt to "pass along" the cost increase--about 63 cents per pack--to consumers by raising cigarette prices commensurately. Other analysts believe that the pricing dynamics in the tobacco industry plus the settlement's lifting of some antitrust provisions would allow tobacco companies to raise prices by more than the cost increase, perhaps by as much as $1.50 per pack. A 63-cent increase in price would lead to significant reductions in smoking; a larger price increase would be even more effective.
 

The Likely Outcome

The widely cited $368.5 billion industry payment is based on the assumption that tobacco consumption will remain at its current level for the next 25 years. That outcome is highly unlikely, however. One obvious reason is that if the settlement is enacted, its provisions will lead to lower consumption of tobacco and lower payments by the industry.

Even without the settlement, tobacco consumption would be likely to follow its downward trend of the past two decades. That trend reflects both changes in consumer preferences about smoking (perhaps because of a greater awareness on the part of the public of the link between smoking and health) and steadily rising retail prices. As a result, enactment of the settlement, along with anticipated declines in tobacco consumption that would occur in any event, could lead to large total reductions in cigarette consumption and industry payments well below $368.5 billion.

Considerable uncertainty exists about the extent of the decline in smoking that would occur in the absence of a settlement. This analysis considers an illustrative benchmark under which total consumption declines by about 16 percent over the 25-year period. That figure is consistent with a number of plausible scenarios about future declines in the popularity of smoking as well as hikes in state excise taxes and other factors that would increase the price of cigarettes. The benchmark assumes that roughly half of the payments the industry would make under the settlement would be paid to resolve outstanding lawsuits, even in the absence of federal legislation.

Measuring against that benchmark, CBO estimates that tobacco consumption would have declined by a total of 23 percent to 26 percent at the end of 25 years provided that the settlement was enacted with all of its regulatory and public health components and that it led to a 63-cent-per-pack increase in cigarette prices (in 1998 dollars). That drop in consumption includes a reduction of 16 percent that is assumed to occur in the absence of the settlement; thus, the incremental effect of the settlement would be to lower consumption by between 7 and 10 percentage points. Under a price increase of $1.50 per pack (in 1998 dollars), total consumption at the end of 25 years would have fallen by 32 percent to 45 percent--with an incremental impact of 16 to 29 percentage points attributable to the settlement.
 

Lower total consumption of cigarettes would also imply lower industry payments; payments would total between $288 billion and $298 billion under the scenario of a 63-cent price increase.⁽²⁾ The industry is assumed to have made a substantial payment even without a national settlement; thus, the incremental payment resulting from the settlement would be from $128 billion to $138 billion. Total payments under a $1.50 price-increase scenario would be between $216 billion and $263 billion, and incremental payments would be correspondingly lower.

Overall, on the basis of analyses of several potential price increases that could result from enactment of the settlement, it appears highly unlikely that industry payments would ever approach the $368.5 billion figure that is commonly cited. The shortfall in payments would occur because the fundamental goal of the legislation--to reduce cigarette consumption--would at least to some extent be met.
 

Reducing Teen Smoking and Other Considerations

Many public health officials believe that people who do not start smoking as teens are much less likely to pick up the habit as adults. As a result, even though teens account for only a small fraction of all cigarettes consumed in the United States, one of the major objectives of the settlement is to reduce the number of teens who smoke. The settlement establishes targets for reducing the percentage of teenagers who smoke on a daily basis and imposes additional payments on the industry if those goals are not met. Such reductions in smoking, however, are unlikely to occur. If prices were raised by 63 cents a pack, the goal of reducing the prevalence of daily smoking by 30 percent over the first five years could be achieved--but only under the most optimistic of assumptions. Even then, the more ambitious goals that the settlement specifies for later years would not be met.

Many other issues could also arise in drafting legislation to enact the settlement.

• The settlement would increase cigarette prices significantly, providing a strong financial incentive to engage in illicit black-market activities. Diligent enforcement efforts would be necessary to ensure the integrity of the tobacco market under those circumstances.
  
  
• Most analysts agree that higher prices are the single most effective way to discourage consumption of cigarettes. However, because the settlement would levy the scheduled payments on tobacco firms and allow any price increases to be determined in the market, the size of those price increases is uncertain. The price of cigarettes could be increased with somewhat greater certainty by imposing an additional federal excise tax that could yield tax receipts equivalent to the payments under the settlement. Under that approach, cigarette prices could rise by at least as much as the additional excise tax.
  
  
• Since the settlement would reduce the demand for cigarettes, people who depended on the tobacco industry for their livelihood could be adversely affected. The economic impact would be concentrated geographically in a few southeastern states, which account for the bulk of tobacco growing and manufacturing in the United States.
  
  
• The costs of Medicare, Medicaid, and other public health programs would be unlikely to change perceptibly in the near term as a result of the settlement, given that cost savings would be likely to accrue only over decades. If the settlement effectively curbed teen smoking and if that translated into permanently lower cigarette consumption as those people grew older, the long-run impact on tobacco-related health care costs could be significant.

1. Cigars, pipe tobacco, and other tobacco products are not included in the settlement.

2. Those amounts represent payments that would be made by the industry and not the impact of those payments on federal or state budgets.

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