The Brookings Review
Winter 1998 Vol. 16 No. 1
Pages 14-19
C 1998 The Brookings Institution
Artwork by Glenn Pierce
All Rights Reserved.
Smoke and Mirrors:
Understanding the New Scheme for Cigarette Regulation
by W. Kip Viscusi
W. Kip Viscusi is John F. Cogan, Jr., Professor of Law and Economics and
Director of the Program on Empirical Legal Studies at the Harvard Law School.
Comments on the Article
Last June, U.S. cigarette companies, together with government officials,
chiefly state attorneys general, drafted proposed federal legislation that
would, if enacted, have a sweeping effect on the regulation of cigarettes, as
well as on prospective cigarette industry liability.
Cigarette regulation is nothing new. Cigarettes have long been subject to
heavy excise taxes at both the state and federal level, and Congress has
mandated on-product warnings and written the warning language for cigarettes
since 1964. Cigarettes have also been the target of decades of litigation, though here the
cigarette industry has enjoyed an almost unblemished record of success.
By 1997, however, the cigarette industry had been hit by a flurry of 40 state
lawsuits seeking reimbursement for the health insurance costs associated with
smoking. These suits, based on as yet untested legal theory, have led to
multibillion dollar out-of-court settlements in Mississippi and Florida. They
also prompted the legislative proposal, which would establish a reimbursement
formula for all states. This article explores the nature of this proposed
resolution, its implications for the cigarette industry, and its merits from
the standpoint of social efficiency.
The Price Tag
Public understanding of the settlement may extend little beyond a single
number - the widely publicized $368.5 billion face value of the first 25 years
of cigarette industry payments. The first payment, $10 billion up front, would
be followed by annual payments rising from $8.5 billion the first year to $15
billion in 5 years. The payments do not end after 25 years, but continue in
perpetuity so that focusing only on the first 25 years understates the long-
run implications of what is at stake.
The timing of the payments is not inconsequential. Although payment amounts
will be adjusted upward over time to reflect price increases (by 3 percent or
the percentage increase in the consumer price index, whichever is greater),
the settlement price tag of $368.5 billion is not discounted to reflect its
present value. If we were to discount the settlement payments using a 3
percent real rate of interest, the present value of the first 25 years of
payments would be $255.6 billion, with a present value in perpetuity of $494.4
billion. Because of possible disagreements about the rate of discount, the
focus has been on the total undiscounted package value.
The more important complication is that the value of the payments will vary
proportionately with the unit sales volume of tobacco products. If cigarette
consumption were to drop by one-fourth, the settlement payments would fall
similarly. Because of the sales volume linkage, the best way to think about
the settlement is in terms of the cost per pack: the payment is equivalent to
an additional 62 per pack tax. State and federal taxes already total 56 a
pack for an annual total of more than $13 billion. The new levy would bring
the total tax per pack to $1.18. Recently President Clinton voiced support for
raising the additional tax to $1.50 per pack, the same figure in Senator
Edward Kennedy's legislative proposal.
The Role of Taxes
Taxes have a variety of functions, from raising money for the government, to
penalizing behavior some may view as immoral, to helping align private and
social incentives. If, for example, smokers impose net costs on others, taxes
can discourage smoking, reducing it to the level that would be observed if
smokers took full account of the consequences of their actions. Similarly, if
smokers are making mistaken decisions that harm their future welfare, taxes
can discourage these decisions just as would, for example, a more accurate
understanding of the hazards of cigarettes.
Although the cost of the tax will be shared by consumers and firms (for firms
will lose profits as sales drop), most of the cost of the tax will be borne by
consumers. Tobacco industry payments could be structured differently - for
example, as a lump sum tax on companies rather than as a per unit tax - so
that costs would be borne solely by tobacco producers. But such a tax would do
nothing to discourage smoking or align private and social incentives.
Antismoking critics of the proposed settlement want to have it both ways. They
like per unit taxes because they discourage consumption and reduce societal
smoking rates. But they want companies to bear all the tax, and they want
payments to the government to remain the same even as sales decline. The form
the tax takes will affect whether it primarily decreases consumption or
profitability. From the standpoint of social efficiency, it makes the most
sense to link the tax to cigarette consumption if our intent is to make
product purchasers recognize the social costs of their smoking decision.
The differential effects of the tax are of particular interest. Younger
smokers tend to be more responsive to cigarette prices than older smokers are.
Whereas a 10 percent jump in cigarette prices would cause a 4-7 percent drop
in smoking overall, it would cause smoking by teenagers to fall 12-14 percent.
Thus the tax is particularly effective in discouraging youth smoking.
Another noteworthy distributional aspect of the taxes is that cigarette
smokers tend to be poorer and more likely to be blue-collar workers than the
average American. Indeed, cigarette taxes are regressive not only in terms of
the percentage of income going toward the tax, but also in absolute terms.
Those in lower income groups pay more in terms of the total dollars of
cigarettes taxes than the very affluent. If Congress passes this proposed
resolution, the maintenance workers at the Capitol will pay more of the tax
than the members of Congress who voted for the legislation. Such concerns may
have led to the failure to enact a cigarette tax as part of the mid-1990s
health insurance proposals.
The Role of the States
The 40 lawsuits filed against the cigarette industry represented an
unprecedented attempt by state governments to recoup the insurance-related
costs of a product. As the issue was framed by the states, the focus was a
narrow one - the total increase in medical costs arising from cigarette
smoking. Other human health effects and other welfare consequences of smoking
were excluded. Framed thus, what has been the cost to the states? The answer
depends in large part on what one chooses to count. Table 1 summarizes my cost
calculations for the two states that have settled out of court as well as for
the two states for which litigation is most imminent. The medical care costs
range from 1.70 per pack in Mississippi to 3.10 in Minnesota. Because smokers
tend to be sicker than nonsmokers, their medical costs to the state, chiefly
Medicaid, are higher. Focusing only on this cost indeed increases costs to the
states, though far less than claimed in the lawsuits.
More comprehensive cost tallies, however, give a different view. Consider the
estimates for the state of Florida. Because of smokers' shorter life spans,
they pay 1.60 per pack less in earnings taxes to the state than nonsmokers, but
they also save the states 7.50 per pack in nursing home care costs and 5.20 per
pack in pension costs. The total net savings is 7.90 per pack, so that Florida
gains overall. What would happen if in fact one concluded that cigarettes did
impose a net insurance cost on the states? One could presumably recoup these
costs through litigation, though at substantial additional cost. Another
approach is simply to impose the tax at the time of purchase through an excise
tax. Such excise taxes already exist, and they range from 18c per pack to 48c
per pack for the four states in table 1. Thus, taking into account excise
taxes, the states gain from 21.20 per pack to 56.60 per pack.
Even if one considers only the medical effects of smoking, however, nursing
home expenditures should logically be included in these net calculations. And
when they are, cigarettes on balance pay for themselves in terms of their
medical insurance consequences for state governments.
Why the Cost Counting Differs
A dizzying array of figures has appeared in the press and in public debates
over the costs of cigarette smoking. The primary reason for the wide range of
numbers, of course, is the scope of what is included in the cost calculations.
The states, as noted, use only the top row in table 1 in assessing their
medical care expenditures. But there are other reasons why such a seemingly
straightforward economic exercise as calculating the costs associated with
cigarettes could lead to so many different results. One springs from flaws in
the way states calculate medical expenditures. First, states often estimate
the medical care expenditures assuming that smokers live as long as nonsmokers
- in effect charging smokers for their medical expenses after they are dead
based on their relative medical costs while alive. Second, state calculations
often take no account of the fact that smokers have other demographic
characteristics that lead to higher medical costs. Smokers, for example, are
more likely to work in risky jobs and to be injured on them. Third, the
estimates for the state medical costs generally exclude the share of costs
that will be reimbursed by the federal government. Thus, the states are
attempting to collect twice for this portion of the costs - once from the
cigarette companies and a second time from Washington.
The states argue that this reimbursement is a collateral source and should not
be considered. The calculations reported above isolated only the portion of
the costs borne by the states.
Finally, many of the widely varying cost estimates refer not to the states,
but rather to the nation, including the federal government. The scale of these
costs is much greater, but the general story line is the same. Smokers have
higher medical care costs of 58 per pack, with nursing home care savings of
23 per pack and pension savings of $1.25 per pack. The total net insurance
cost of smoking is a cost savings of 32 per pack - in addition to the excise
taxes paid on cigarettes. The general spirit of this conclusion is consistent
with other studies in the literature.
Nonprice Components of the Proposal
Although the primary focus of the settlement has been on its impressive price
tag, the agreement would also lead to sweeping nonprice regulatory measures.
The Food and Drug Administration would take on broad authority to regulate
cigarettes, and the marketing and advertising of cigarettes would change
dramatically. Cigarette packages would have a new series of nine rotating
warnings, all bolder and stronger than those used now. Outdoor advertising of
cigarettes would be banned, as would the use of cartoon characters, such as
Joe Camel, and human figures, such as the Marlboro man, in advertising. Except
in adults-only facilities and publications, cigarette companies would be
restricted to black text advertising. The federal government would launch a
$500 million annual antismoking ad campaign, as well as a variety of other
antismoking efforts, such as federal public smoking standards. Both the
nonprice regulatory provisions and the financial costs associated with the
proposal will lower cigarette consumption. As sales decline, so too will the
amounts paid by the tobacco industry as part of the settlement. Some have
criticized the decrease in revenues without understanding that the lower
revenues necessarily will accompany reduced consumption achieved through
higher cigarette prices.
Underage Smokers
The proposed legislation includes a wide variety of measures targeted at
reducing underage smoking. In addition to setting a minimum age of 18 to
purchase tobacco products, it would require photo identification of anyone
under age 27, ban the sale of tobacco products through vending machines, ban
self-service displays of tobacco products except in adults-only facilities,
license retail tobacco product sellers and require conformance with the terms
of the license as a condition for holding it, impose penalties for violations,
and decrease payments to states that do not meet the "no sales to minors"
performance targets. Such stringent, carefully structured efforts are well
suited to addressing a problem restricted to a segment of the smoking
population.
The higher prices that will be charged for cigarettes will also, as noted,
discourage consumption. Because the responsiveness of the demand for
cigarettes by teenagers is roughly three times that of adults, the higher
prices will probably lower their consumption much more than that of adults.
The actual price increase may be twice the 62 per pack penalty levy because
of the mark-up of cigarette prices at the wholesaler level - a mark-up, it
should be noted, that harms cigarette producers, since it further depresses
cigarette purchases.
The proposed legislation establishes a series of targets for reducing youth
smoking: a 30 percent decline in underage use of cigarette products within 5
years, a 50 percent decline within 7 years, and a 60 percent decline within 10
years. If these targets are not met, additional "look-back" provisions would
increase the penalties by up to $2 billion per year.
Much of the impetus for the proposed $1.50 per pack cigarette tax is that a
62 tax alone will not discourage consumption sufficiently to meet the stated
targets. The estimates of the effect of the 62 tax, however, neglect the role
of the nonprice measures as well as the mark-up that will occur on the taxes
before they reach the retail level. A more basic concern about using price as
the principal policy lever for discouraging youth smoking is that most
cigarettes are not purchased by underage smokers. Depending on the particular
study, it appears that roughly 95-97 percent of all cigarettes are purchased
by those over 18 years of age. Increasing prices for all consumers is thus a
blunt policy instrument for discouraging youth smoking. It will impose
substantial costs on people who are of legal smoking age and too often are
relatively poor. Policies specifically targeted at reducing underage smoking
can foster this policy objective more equitably.
What Tobacco Firms Get
Not all the provisions in the proposed legislation favor the states. Others,
pertaining primarily to civil liability, are favorable to the financial health
of the cigarette industry.
Most important, the legislation would end all present and future actions by
state attorneys general. Cigarette companies would escape the potential
liability they could face because of an unfavorable ruling about which costs
count or because of an unpredictable jury.
The settlement would also preclude all future "addiction" or dependence
claims, all class actions, and all claims for punitive damages. Individuals,
however, could still sue for past conduct, so that in the long run the
industry would not be free of the current set of liability concerns.
The value of these restrictions on liability is hard to assess. Certainly the
tobacco company payments stipulated by the legislation greatly exceed any
liability sum that would be estimated based on past success rates in
litigation.
But the stakes involved are enormous, with the outcomes being highly
correlated. Losing one state suit, for example, greatly increases the
likelihood of losing others. Addiction claims likewise could snowball if the
cigarette industry developed a losing track record. The global settlement
gives the industry a safe harbor from the vagaries of the tort system and the
randomness of jury awards.
Legal Fees
The proposed settlement would not provide for compensation of the plaintiffs'
lawyers, but parallel agreements would lead to such payouts. Total fees to
lawyers will be in the billions. Indeed, the private lawyers retained by
Florida are seeking contingency fee payments of $2.8 billion, or 25 percent of
the total settlement, an amount that dwarfs their actual legal expenses, much
of which were incurred after the national settlement was proposed, making
compensation likely. In its initial review, the court rejected this legal fee
claim, noting that "$2.8 billion simply shocks the conscience of the court."
The role of the private attorneys in cigarette lawsuits has generally come
under increased scrutiny. When, for example, a recent class-action lawsuit by
flight attendants was settled out of court, the flight attendants received no
financial compensation, but the trial lawyers received $49 million - again, a
sum far in excess of their legal expenses. Genuine concern is developing that
the plaintiffs' lawyers in various tobacco suits should receive compensation
for their legitimate expenses, but not windfall gains.
Toward a Rational Smoking Policy
If a global settlement is ultimately approved by Congress, it will presumably
be somewhere between the initial proposal and the $1.50 per pack levy endorsed
by the president and Senator Kennedy. Once these financial and liability
issues are settled, the more important concern will be how society addresses
smoking behavior.
Much of the disagreement to date stems from a confusion on the part of the
antismoking forces over whether their goal is to harm the cigarette industry
or to help consumers. The most sensible basis for policy is to foster rational
and informed smoking decisions. As a practical matter, such an approach should
lead policymakers to embrace rather than condemn technological improvements
that enhance the safety of cigarettes. The smokeless cigarettes introduced by
R.J. Reynolds - the Eclipse and the Premier - would have greatly diminished
the cancer risk associated with smoking, yet leading public health officials
attacked the new cigarettes as nicotine delivery devices rather than urging
consumers to experiment with this clearly safer product. In much the same way,
the recent development by Philip Morris of a smoking box that would trap side
stream smoke and reduce environmental tobacco risks and exposures has been the
object of ridicule.
In almost every other area of health and safety regulation, Washington has
promoted and often required technological improvements to enhance safety. It
can play a similarly supportive role for cigarettes by encouraging innovations
to reduce health risks and expand consumer choice.
Critics contend that we may not know what innovations are safer or how much
safety they provide. Often, indeed, there is real uncertainty: will filtered
cigarettes raise or reduce the risk? More drastic innovations, however, such as
the de-nicotined cigarette and the smokeless cigarette, should raise far less
doubt as to their efficacy. And the existence of some uncertainty provides all
the more reason for the government to take the lead in identifying the
comparative product risks.
The government should establish a standardized rating system to assess the
relative risks of cigarettes so that consumers can make informed choices.
Providing information about tar and nicotine levels alone is not enough: it
may not, for example, capture carbon monoxide risks of smokeless cigarettes.
The cigarette companies are in a difficult position with respect to all such
matters since they are not permitted to make health claims on behalf of their
products. They can make only oblique claims, such as saying a cigarette is
"smoother" or "light." fostering safety innovations and providing the
information that enables consumers to choose safer cigarettes remains a
neglected component of the government's smoking policies.
A primary reason for such neglect is a governmental mind-set that is
anti-industry. State and federal governments alike should abandon their
combative stance, take a more open-minded approach to the safety of tobacco
products, and make advancement of consumer welfare their paramount concern.
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