Compensating Farmers for the Tobacco Settlement

Compensating Farmers for the Tobacco Settlement

98-133 ENR
Updated July 6, 1998
CRS Report for Congress
Received through the CRS Web
Compensating Farmers for the Tobacco
Settlement
Jasper Womach
Specialist in Agriculture Policy
Environment and Natural Resources Policy Division
Summary
Legislative proposals designed to reduce smoking, primarily by teenagers, are likely
to have negative economic consequences for tobacco growers and tobacco-dependent
communities. This is because reduced cigarette consumption by Americans, particularly
young Americans, and thereby decrease domestic demand for U.S.-grown leaf tobacco.
This, in turn, likely will affect the value of tobacco marketing quotas held by farmers,
and thereby the value of their land and holdings and their ability to obtain credit or
contribute to local economies. For these reasons, there appears to be growing support
for some kind of compensation to farmers as part of the settlement package legislation.
On the other hand, a consistent downward trend in domestic cigarette consumption,
which some contend is likely to continue even without the tobacco settlement, argues
against compensation.
Compensation is not just an economic issue. Bill sponsors undoubtedly would like
the support of Members of Congress from tobacco states and communities. Therefore,
how much, if any, funds should go for compensation to growers is a political issue, as
well. One obvious approach would be to estimate the likely losses to farmers under the
various provisions and provide compensation on that basis. But, it is difficult to
precisely estimate the potential economic consequences of the tobacco settlement for
growers.
Higher Prices, Consumption, and Farm Impact
The tobacco bills contain several measures designed to decrease consumption of
tobacco products in the United States. Among the most prominent of these are proposals
for substantial increases in the price of tobacco products (either through manufacturer
payments or higher excise taxes), which are designed to finance other anti-smoking efforts
and health care provisions in the proposal. Price increases have a direct impact on
consumption, and consequently, can be used to estimate changes in the domestic demand
for U.S.-grown tobacco, its production, and farm income. Other provisions in the
Congressional Research Service ˜ The Library of Congress

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settlement designed to reduce and prevent consumption (e.g., age and advertising
restrictions) are less easy to quantify.
Analysis of consumer price behavior has been done to determine a price-elasticity
of demand for cigarettes in order to predict likely consumption declines over the short
term. For a pack of cigarettes, analysts estimate each 1% increase in price causes a
decline of four-tenths of 1 percent in purchases (or, an elasticity of demand of minus
0.4).1 This consumption decrease must be adjusted to determine the effect on farmers
because U.S. cigarette manufacturers use both domestic and imported tobacco, and
because a sizable quantity (33%) of U.S.-manufactured cigarettes is exported, and the
export market is a large outlet for unmanufactured leaf tobacco (35%). Foreign sales for
cigarettes and leaf tobacco may not be affected at all by the settlement, except that export
marketing efforts could intensify.
According to numerous observers, the original tobacco settlement proposal of June
20, 1997, specifying manufacturer payments amounting to $368.5 billion over the next
25 years, could cause cigarette prices to rise by about $0.60 per pack. Using $2.00 per
pack as the average retail price, a $0.60 price hike amounts to a 30% increase. Some
policy officials advocate a price hike of $1.50 in order to achieve a greater consumption
decline among teenagers and children. If the price of cigarettes goes up by $1.50 per
pack, because of higher excise taxes or some other mechanism, this would amount to a
75% price increase. Using the demand elasticity value of -0.4, a 30% price increase could
reduce overall consumption by 12% (0.4*30%=12%), and a 75% price increase could
reduce consumption by 30% (0.4*75%=30%).
If cigarette consumption declines by 12% or even 30%, what would be the impact
on domestic tobacco production? In 1996, about 58% of the tobacco in U.S.-
manufactured cigarettes was domestic leaf and 42% was foreign leaf. Furthermore, nearly
65% of the U.S.-manufactured cigarettes were consumed in the United States and the
remainder exported. Since, there are no provisions in the settlement that directly impact
on cigarette or leaf exports, and excise taxes are not applied to exports, the export market
is held constant for purposes of this analysis. Therefore, a 1% reduction in U.S. cigarette
2
consumption translates into a 0.38% reduction in the use of domestic leaf
(1%*58%*65%=0.38%). So, if consumption declined 12%, other things being equal, the
use of domestic leaf tobacco could be expected to decline by about 4.5% (12%*0.38%).
Likewise, if consumption declined 30%, the use of domestic tobacco could decline by
about 11.4% (30%*0.38%).
According to data from the U.S. Department of Agriculture (USDA), tobacco
production has averaged about 1.526 billion pounds over the five-year period between
1993 and 1997. A 4.5% decline in output from the 5-year average, due to a $0.60 price
1 For a more thorough examination of how the settlement might affect cigarette prices and how
a price increase could impact consumption, see CRS Report 97-995 E, The Proposed Tobacco
Settlement: Effects on Prices, Smoking Behavior, and Income Distribution.
2According to USDA data, cigarette exports have shown a strong upward trend, increasing from
100 billion pieces in 1988 to an estimated 240 billion pieces in 1997. Tobacco leaf exports have
averaged 582 million pounds over the past 10 years, ranging 10% above and below this average,
but showing a relatively flat trend.

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increase, would amount to nearly 70 million pounds. A 11.4% decline, due to a $1.50
price increase, would amount to nearly 175 million pounds.
Production cutbacks of this magnitude, while sizable, are not outside the range of
recent experiences. From 1981, a recent peak production year, to 1997, farm output of
tobacco declined about 20%. For 1998, the basic marketing quotas stipulated under the
federal tobacco support program have been reduced by 16.5% for flue-cured tobacco and
9% for burley tobacco. A tobacco marketing quota is the quantity of tobacco a farm is
allowed to market each year. Through marketing quotas, U.S. production is constrained
and prices are thereby held higher than would be the case if farmers were free to harvest
and sell as much as they wanted.
Calculating Farmer Compensation
Tobacco prices have been supported and stabilized by the federal government’s
commodity support program since the 1930s. The tobacco program operates through a
combination of marketing quotas, which limit supplies, and no-net-cost tobacco loans,
which help to balance marketings with demand. The high stable prices created by th
3
e
tobacco program raise farm incomes above what they would be otherwise. As it might
be expected, the economic benefits of the tobacco price support program have been
capitalized into land values and marketing quota rents. The holders of the 336,000 quotas
likely will realize a loss in net worth under a tobacco settlement. A rough estimate is that
63% of the quotas are held by absentee landlords whose rental income could decline.
Likewise, under the assumptions made here, all of the roughly 124,000 tobacco farm
operators (owners and lessees) would be expected to suffer a decline in sales revenues.
How much of a decrease in net worth or rent would likely result from a $0.60 or
$1.50 per pack cigarette price increase? In Kentucky, a sizable proportion of the tobacco
quotas are leased and transferred to another farm for a production season. Survey data
indicate an average lease-and-transfer price of $.42 per pound for burley marketing quota
over the past 5 years. One way t
4
o estimate the loss to farm owners from declining quota
A
3
more complete explanation of the federal tobacco support program is available in CRS Report
95-129 ENR, Tobacco Price Support: An Overview of the Program. Tobacco marketing quotas
are assigned to farms that have a history of tobacco production. The owners of these farms are
characterized as holders of quota in this report.
4This average is calculated from survey data collected and published annually by William Snell,
Department of Agricultural Economics, University of Kentucky. Data are not available on quota
sales prices in North Carolina, but experts in North Carolina and the U.S. Department of
Agriculture agree that $1.87 may not be far off. The holders of burley tobacco marketing quota
are allowed to lease the quota to other tobacco growers, who then transfer the quota and produce
on their own land. Consequently, there is an active lease-and-transfer market for burley quotas.
Unlike burley, flue-cured marketing quotas cannot be leased and transferred. Rather, farms with
flue-cured quota are leased and the program participation records reconstituted so that production
can be located anywhere on the combined properties. While there is an active tobacco farm-lease
market in North Carolina, lease rate data are not collected. However, experts believe that the
$0.42 per pound average for burley in Kentucky is a reasonable estimate for average flue-cured
lease rates in North Carolina. Two simultaneous but opposing circumstances are pushing sale
prices down and lease prices up. First, there is substantial uncertainty about the long-term
(continued...)

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is to calculate the present value of foregone future quota rent. Because a dollar today is
worth more than a dollar next year, future earnings must be discounted. The discount rate
chosen for the analysis should adjust for inflation, account for risk, and consider whether
the returns are pre- or post-tax. If it is assumed that interest rates will continue at current
levels and tobacco quotas will earn annual rental income long into the future of $0.42 per
pound, but because of a risk that tobacco support might be eliminated or quota levels
might decline these expected earnings could be discounted by 10% or higher. Assuming
a 10% discount rate over 25 years, the present value is $3.81 per pound. In contrast, if the
future earning potential of tobacco quota is viewed as highly secure, comparable to a U.S.
Treasury note or a bank certificate of deposit yielding 5%, then the present value is $5.92
per pound. However, it is not likely that any farm product would approach the T-bill rate
— if only due to risks of weather and disease.
If tobacco quota is valued at $3.81 per pound, a decline of 70 million pounds due to
a $0.60 per pack price increase means lost quota value of $266.7 million. Likewise if
cigarette prices go up $1.50 per pack, the 175 million pound decline in demand means lost
quota value of $666.75 million. If tobacco quota is valued at $5.92 per pound, then the
losses could amount to $414.4 million or $1.036 billion for cigarette price increases of
$0.60 or $1.50 respectively.
Another way to judge the value of tobacco quota is to examine the price at which
quota is sold. Again, data from Kentucky indicate the average sale price for burley quota
over the past 5 years was $1.87 per pound. It is arguable whether the sale price average
of $1.87 per pound represents an accurate measure of quota values, since only about 1%
of the burley tobacco quota is sold annually. Certainly, if a pound of burley quota brings
in $0.42 in annual rent, it might be expected to sell for a higher price. A financial analyst
could conclude that the combination of a sales price of $1.87 with a rental rate of $0.42
per year implies an expected 7-year life for the investment at a discount rate of 10%. In
other words, the data imply that there are large short-term rewards from growing tobacco,
but a high risk is perceived about the longevity of the income.
If all quota losses from the tobacco settlement are valued at $1.87 per pound, then
a 4.5% reduction (70 million pounds) could eliminate about $130 million from the net
worth of tobacco quota holders. If tobacco quota is reduced 11.4%, then the net worth of
quota holders could be reduced by about $327 million.
The preceding calculations demonstrate a wide range in estimated tobacco quota
values and the losses that might be incurred from a tobacco settlement. The result
depends upon the discount rate used to determine the present value of future rental income
and the anticipated life of the income stream. Furthermore, consumption decreases are
based only upon a price elasticity of demand estimate, and do not include other factors
that could affect the consumption of tobacco products.
4(...continued)
survival of the tobacco price support program in the face of growing public pressures and
regulations against smoking. As such, buyers of tobacco quota are discounting the expected life
of this asset. Second, the quota itself has been declining, so farmers with investments in tobacco
equipment and facilities have bid-up annual lease prices in an effort to maintain their economies
of size.

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Community Impacts
Certainly, tobacco farming is an important part of the agricultural economy of the
regions where production is concentrated, as the following USDA data show. Flue-cured
tobacco production is centered in North Carolina. Burley production is centered in
Kentucky. These two states account for 65% of total tobacco production. The
surrounding states of Tennessee, Virginia, South Carolina, and Georgia produce 26%. In
1997, some 124,000 tobacco farms harvested 795,000 acres, with a yield averaging 2,069
pounds per acre. This total crop of 1.65 billion pounds could have a farm value of about
$3 billion once the seasons marketing receipts are tabulated. In North Carolina, tobacco
cash receipts account for nearly 32% of total crop receipts and nearly 14% of total crop
and livestock receipts. In Kentucky, tobacco receipts account for nearly 42% of crop
receipts and nearly 22% of total crop and livestock receipts.
The significance of tobacco to local economies is summarized in two USDA
reports.
5 Most tobacco farms are located in areas that have a low dependence on farming
and less so on tobacco farming for economic activity. The areas most adversely impacted
by reduced tobacco production would be the isolated rural communities throughout
Kentucky, the Virginia-Tennessee, and Virginia-North Carolina borders, the coastal plain
of the Carolinas, Georgia, and northern Florida. In 1992, 311 counties had tobacco sales
of more than $1 million. In 43 of these counties, tobacco receipts exceeded 10% of local
earnings (with 8 counties in the 20-30% range, and 1 county reaching 55%). The most
tobacco dependent counties also have the fewest nonfarm opportunities for the
workforces.
Tobacco quota holders and farm lessees are obviously identifiable as economic losers
if their rental incomes and sales revenues decline. But the impact may spread to the entire
community if farm and personal consumption expenditures decline. Local property tax
revenues might decline due to declining property values. This could then impact on
community services. It is beyond the scope of this report to quantify the magnitude of
potential community impacts because the outcome depends largely upon how dependent
the local economy is on tobacco and what substitute economic activities are possible.
Additionally, tobacco leaf and cigarette exports could increase in the future and offset
some of the decline in domestic consumption.
Legislative Proposals for Farmer Compensation and
Community Assistance
Several bills have been introduced in the 105 Congress that propose to compensate
th
tobacco quota holders, to make transition payments to farm operators who do not own,
5 Fred Gale, Tobacco Dollars and Jobs, Tobacco Situation and Outlook Report, Economic
Research Service, U.S. Department of Agriculture, September 1997, pp 37-43; Economic
Structure of Tobacco-Growing Regions, Tobacco Situation and Outlook Report, Economic
Research Service, U.S. Department of Agriculture, September 1997, pp 40-47.

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but are quota lessees, and to provide economic development assistance to tobacco
dependent communities. When compared to the rental and sale prices agreed to in the
marketplace, the proposed compensation rates appear to be on the generous side.
S. 1310 (Ford) would compensate quota holders at the rate of $4 per pound per year
for reductions in quota, up to a lifetime limit of $8 per pound based on the 1994-96
average quota. Quota lessees would be paid $2 per pound per year up to a lifetime limit
of $8 on half the average quota. The sponsor estimates these compensation provisions
will cost no more than $16.5 billion. Annual economic development grants of $300-350
million would cost $8.3 billion. Additional assistance for displaced industry workers and
higher education grants for farm families would put the estimated total cost at $28.5
billion for the 25-year life of the bill.
S. 1313 (Lugar) would eliminate the quota program and phase out price support
loans, but compensate quota holders at $8 per pound and lessees at $1.20. This is
estimated by the sponsor to cost $14.7 billion. Another $300 million would be distributed
as community economic development block grants. Total cost is set at $15 billion. In the
absence of a tobacco support program, economists believe prices could decline by at least
the level of rents created by the program, and then production could increase as U.S.
tobacco becomes more price competitive in world markets. There would be adjustment
costs associated with such a transition.
S. 1415 (McCain) (as brought to the Senate floor on May 18, 1998, but recommitted
to the Commerce Committee on June 17, 1998). Going into debate, the bill contained two
competing farmer alternatives with a majority vote, which did not happen, intended to
determine the outcome. One alternative would be similar to a combined S.1310 & S
1582. It would provide assistance for 25 years to tobacco farmers, displaced industry
workers, and tobacco-dependent communities. For relinquishing all quota or for future
reductions in quota from the 1995-97 average (the base quota), quota owners would be
paid $4/lb per year, subject to a lifetime limit of $8/lb on the total base quota. Quota
lessees also would be paid up to $4/lb. The burley program would continue largely
unchanged. Flue-cured marketing permits (nontransferable) would replace quotas.
Economic development block grants would be made to tobacco states, displaced tobacco
industry workers would be eligible for special assistance, and higher education assistance
would be targeted toward tobacco farm families. Total cost is estimated by the sponsor
to be $28.5 billion. The other alternative (incorporating a modified version on S. 1313)
would eliminate the quota program and phase out price support loans, but compensate
quota holders at $8 per pound and lessees at $4.00. Another $1 billion would be
distributed as community economic development block grants. Total cost is estimated by
the sponsor to be $18 billion.
S. 1582 (Robb) would transfer the administration of the current marketing quota and
loan programs from the USDA to a private corporation. Marketing quotas would become
annually renewable licenses to market tobacco without any rights of ownership or
transferability (thereby eliminating rental costs). Current quota holders would be
compensated at the rate of $8 per pound for lost equity and lessees would be given
transition payments of $2 per pound. The proposal includes annual community economic
development block grants of $250 million. The sponsor estimates the entire proposal will
cost $22.8 billion.