How state governments have become addicted to tobacco.

How state governments have become addicted to tobacco.

How state governments have become addicted to tobacco.

Moneybox
Commentary about business and finance.
April 3 2003 5:50 PM

Cigarette Burns

State governments learn the cost of their addiction to tobacco revenues.

It's rare for officials of one state to attempt to intervene in the internal affairs of a non-contiguous state. It's even rarer for an attorney general who helped bludgeon a powerful defendant into an expensive settlement to act as friendly advocate for that same opponent. But that's exactly what happened last week when Altria Group, formerly known as Philip Morris, was required to post a $12 billion bond in order to appeal an adverse Illinois court ruling. Washington State Attorney General Christine Gregoire, who negotiated the landmark 1998 master settlement between the states and Big Tobacco, suggested she might spring into action to force Illinois to relieve the largest U.S. tobacco company of that onerous financial burden.

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Addiction forces people to do strange and sometimes desperate things.

Cigarettes, even more than being effective vehicles for nicotine delivery, are effective vehicles for revenue delivery to governments large and small. Income taxes, excise taxes, and funds paid under the 1998 settlement between Big Tobacco and the states add up to billions upon luscious billions every year. But now the Illinois lawsuit threatens the golden (or perhaps nicotine-stain-yellow) goose. This is separation of powers at work: State legislatures are spending so much tobacco cash that they now need the industry to stay profitable, even as state courts are issuing rulings to cripple it.

The current contention is a March ruling by Illinois State Judge Nicholas Byron. He ordered Altria to pay $7.1 billion in compensatory damages, and $3 billion in punitive damages for having misled consumers about low-tar cigarettes. The kicker: In order to appeal the massive award—as the company always does—Altria must post that enormous bond by April 20.

But shelling out that much cash could damage the company in two ways. First, Altria says it might not be able to make its $1 billion-plus share of a $2.5 billion payment to states—as dictated by the 1998 settlement—due on April 15. What's more, Standard & Poor's suggested that the company might have to consider bankruptcy if it had to meet this obligation. And that would jeopardize future payments.

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The 1998 settlement between tobacco firms and 46 states called for the industry to shell out $246 billion over 25 years to settle lawsuits and reimburse states for tobacco-related health-care costs. The companies are supposed to pay $10.9 billion this year, $8.4 billion yearly between 2004 and 2007, and $9.4 billion per year thereafter. Companies pay according to their market share, which means Altria shoulders about half the industry total.

The payments, which were supposed to fund state-level health-care and anti-tobacco initiatives, were quickly repurposed into a reliable revenue stream for strapped states. Many states have sold bonds against anticipated deliveries, thus spreading the rewards (and risks) of the grand settlement to investors. New York Gov. George Pataki is trying to close an $11 billion budget deficit without raising income taxes in part by borrowing against future payments. California is hoping to sell $2 billion in tobacco bonds this month to reduce its monster deficit. But with the uncertainty in Illinois—itself slated to receive $115 million on April 15—the market for such securities has effectively shut. Many of these tobacco bonds have been downgraded.

Of course, it's not as if the state governments weren't already relying on tobacco funds to balance their budgets. In recent years, cigarettes have emerged as an effective conduit for back-door taxation. In 2002 alone, 20 states—and some cities, including New York—raised cigarette taxes to close budget deficits.

There's a similar dynamic at the federal level. The federal government collects an excise tax of 39 cents per pack of cigarettes—$4.2 billion from Altria alone last year. Income taxes from tobacco companies are also enormous: Altria paid $6.4 billion last year.

Even so, the Ashcroft Justice Department is continuing to pursue a Clinton-era lawsuit against the tobacco industry. The action, initiated in 1999, asks courts to regard Altria and other tobacco firms not as a set of blue-chip businesses, but as a criminal racket that uses advertising, subterfuge, and the careful manipulation of nicotine levels to mislead and hook customers on their deadly products. In a January court filing, which came to public attention in March, the Justice Department said it would demand that the industry disgorge some $289 billion—all the industry's profits from selling cigarettes to underage smokers since 1954.

Through excise and income taxes, the federal government already claims a large chunk of the revenues spent on tobacco in the United States each year. But a $289 billion claim—far more than the market capitalization of large U.S. tobacco companies—would amount to an effective nationalization of the industry.

Altria is blowing smoke about the possible bankruptcy filing. If it needed to come up with $12 billion for an acquisition, or for some other discretionary purpose, it could do so quickly without a trip to Chapter 11. But in an odd sense, the 1998 settlement—which was regarded as a huge victory for the states—has helped Big Tobacco turn the tables on its legal tormenters. Now that they've tied their fiscal health to the demon weed, the states have an interest in ensuring that Altria and its confreres lead long and healthy lives.