Smokers Would Pay Bills for Previous Generations

Over the years, anti-smoking forces have tried to bury the tobacco industry under an avalanche of liability claims, ostracize it from respectable society and strangle it in a tangle of regulation.

But in a universal settlement hammered out with 40 state attorneys general and lawyers for diseased smokers, the tobacco industry would be allowed to continue earning generous profits for many years even as it is forced gradually to price and market itself out of business.

"The paradox here is that we have had to keep the industry financially healthy in order to finance its own demise," explained Iowa Attorney General Thomas Miller, a hard-liner among the attorneys general.

In effect, the proposed settlement would translate into a 75-cent per pack increase in the federal cigarette tax that would require each new generation of smokers to pay for the health consequences of smoking by previous generations. The gamble by government officials and public health advocates is that this sharp rise in the price of cigarettes -- along with advertising curbs, a massive anti-smoking campaign and tighter regulatory control over the content of cigarettes -- gradually will reduce smoking and its harmful effects on American health.

In deference to the political sensitivities of 50 million American smokers, however, no official tax increase would appear anywhere in the federal tax code. Instead, Congress will be asked to give a legislative blessing to a $368 billion settlement of liability claims, which the industry would pay over 25 years to a government-administered compensation and education fund.

Anti-tobacco negotiators fully expect the companies to finance most of the payments with an increase in the wholesale price of cigarettes. In fact, to encourage them to do so, they will press for special legislation that would protect the companies from price-fixing suits. And they will ask Congress to extend the terms of the settlement, including the annual payments, to any new tobacco company that tries to enter the U.S. market.

Longtime critics of the industry will take little moral satisfaction from an arrangement that puts the settlement's financial burden on smokers rather than an industry that, in their views, has engaged in 40 years of lies and deceit.

But in recent months, the state attorneys general who have spearheaded the latest legal assault on the industry came to realize that the economics of the tobacco industry made it impossible to simultaneously punish the companies, wean America off its cigarette habit, and generate billions of dollars for victims and state governments. Despite forceful declarations yesterday that the industry would suffer for its misdeeds, punishment in the end turned out to be the least important goal and the most difficult to achieve.

"Financially, I don't know if there is any way to really punish the tobacco companies short of legislating them out of business," said Arthur Schleifer, an economist at the Harvard Business School who advised some of the attorneys general.

By outlawing the sale of cigarettes, the government could have instantly vaporized the value of that portion of tobacco company stock tied to U.S. cigarette sales -- maybe $25 billion in valuation at the time the talks shifted into high gear earlier this spring. And in some sort of bankruptcy-like proceeding that would have likely followed prohibition, there might have been $50 billion left over to pay states and disabled smokers, once all the companies' assets were sold off and debts paid.

The attorneys general and plaintiffs' lawyers, however, viewed that as inadequate compensation for the estimated 400,000 smoking-related deaths each year and the $500 billion incurred annually in public and private medical costs as a result of smoking-related illnesses.

The alternative to shutting down the companies was to try to hobble them with a fine or tax large enough to reduce future profits. But that strategy, too, inevitably would run into the realities of free market economics.

Even if all the industry's after-tax profits from U.S. sales were expropriated, it would amount to less than $5 billion a year. And because no private company could be required to operate without a chance of earning any profit, the realistic figure that the government could recover each year from industry profits would have been significantly less than that.

Just as problematic, there is nothing to prevent tobacco companies from trying to recoup the cost of a settlement by raising wholesale cigarette prices. That tactic probably would not work in a typical industry with lots of competitors and price-sensitive customers. But neither condition applies to the cigarette market.

According to Jeffrey Harris, an economist at the Massachusetts Institute of Technology, the cigarette industry acts more like a cartel than a fully competitive market. Three companies -- Philip Morris Cos., R.J. Reynolds Tobacco Co. and Brown & Williamson Tobacco Corp./American Tobacco Co. (both owned by BAT Industries PLC) -- together account for 90 percent of the market. And like other cartels, Harris found the members generally have refrained from getting into price wars and gradually have raised the price of cigarettes more than the general inflation rate has risen.

As a result, selling cigarettes in America has been among the world's most profitable activities, with pretax operating margins last year of 38 percent, according to industry analysts. That works out to about 31 cents on the 83 cents wholesale price of a pack of cigarettes.

In addition, the companies also are blessed with customers who are literally addicted to their products.

Dozens of economic studies have been done to gauge how sensitive -- or insensitive -- smokers are to changes in the price of cigarettes. On average, the studies have found that for every 10 percent increase in the retail price, there has been a 4 percent short-run reduction in sales.

So tobacco companies, according to economists, are probably better off trying to recoup the settlement cost by raising prices rather than by paying it out of the company profits. The calculations go something like this:

A 75-cent per pack price hike would generate enough extra revenue to cover the expected $15 billion a year settlement cost. But the 40 percent increase in retail price would reduce cigarette consumption by 16 percent, which would translate into a $1.4 billion reduction in operating profits.

That sounds like a big number. But according to calculations done by Gary Black, an industry analyst at Sanford Bernstein & Co., most of that drop in pretax operating profit could be comfortably offset by a corresponding 25 percent decline in the industry's enormous marketing and advertising budget ($5.5 billion) and a 50 percent reduction in its legal budget ($600 million).

In other words, the deal could wind up costing the tobacco companies very little.

"The companies may take a small, brief hit from a settlement, but over the long run consumers of cigarettes will be paying for most of it," said MIT's Harris, who has studied the tobacco industry for a decade and advised the attorneys general.

Other students of the industry, such as economists Sam Peltzman at the University of Chicago Business School and Robert Tollison of George Mason University, disagree that the industry could and would simply pass the price of a settlement on to consumers in the form of higher prices. If the industry is such a powerful cartel that can raise prices at will, these economists ask, why haven't they already raised them 50 cents and increased their profits even further?

"If this is a $12 billion-a-year fine on the companies, stockholders will get hit hard," Peltzman said.

But stockholders don't seem worried. In recent years, the price of tobacco stocks had declined sharply because of uncertainty over litigation claims. But in recent weeks, Wall Street analysts are nearly unanimous in predicting that any settlement that significantly reduces or eliminates those litigation risks would cause tobacco stocks to rise from their recently depressed levels. Indeed, as prospects for a settlement increased over the past two months, the Standard & Poor's index of tobacco stocks has risen more than 20 percent.

There is, however, one big hitch in the otherwise favorable scenario for the tobacco industry -- one that was paramount in the thinking of public health advocates represented at the negotiations.

For while it is true that most smokers are relatively insensitive to price increases, studies also find that young smokers, who make up 20 percent of the market, are quite price conscious. According to a report by the Surgeon General, a 75 cent increase in the price of a cigarette pack could cause smoking by persons under the age of 25 to drop by as much as 40 percent. And because most adult smokers say they began when they were young, any such decrease in new customers could lead to a gradual reduction in overall cigarette smoking.

To ensure this result, in fact, the settlement requires tobacco companies to pay additional penalties if teenage smoking in the United States is not cut by 30 percent in five years and 60 percent in 10 years. And if those goals are met, and other long-term trends hold, cigarette sales could be cut in half over the next 50 years -- a result that Harris predicts could eventually have a dramatic impact on industry profits.

The international angle remains one of the wild cards in the settlement talks. Industry foes have argued that tobacco companies should be forced to dip into profits from foreign sales to pay claims here.

But foreign governments have begun to look to the settlement here to see if they might win similar concessions from the industry. Just this week, the Canadian province of British Columbia filed a suit virtually identical to the ones filed by the state attorneys general.

Because of this and other uncertainties, it is likely to be years before consumers, taxpayers and shareholders will know the final impact of this week's settlement on their financial health. But economists warn that any settlement is likely to prove something of a double-edged financial sword for nonsmokers.

To the extent that a settlement cuts down on smoking, the economists note, it surely will cut down on medical costs associated with smoking-related illness and boost economic output due to reduced sick days and premature death.

But economists also note that a reduction in smoking that allows smokers to live longer will put extra financial burdens on the the Social Security, Medicare and Medicaid programs, as well as most private pension plans.

W. Kip Viscusi, an economist at Harvard University, said, "From a purely economic sense, smokers are already paying the costs they impose on society, just by dying early."