Feb. 19 (Bloomberg) -- Higher federal and state taxes on cigarettes this year may bring the biggest drop in smoking ever, reducing the tobacco industry’s annual payments to states by as much as $500 million and threatening the repayment of $37 billion in municipal bonds backed by that money.

An expansion of the State Children’s Health Insurance Program this month will raise the federal tax by 62 cents to $1.01 a pack, bringing the average price of a pack of cigarettes nationally to around $5. The tax increase alone will save 900,000 lives, according to the American Cancer Society’s Cancer Action Network.

Combined with new levies under consideration in about a dozen states, the higher prices could cut U.S. cigarette consumption by as much as 10 percent, said Richard Larkin, research director at Herbert J. Sims & Co., a municipal-bond firm in Iselin, New Jersey.

A reduction of that size, which is about 2.5 times the yearly average over the past decade, would decrease payments to states under the 1998 Master Settlement Agreement, or MSA, to $6.5 billion in 2010 from an estimated $7 billion this year, Larkin said.

“While settlement revenues may be shrinking, most tobacco bond structures have debt service requirements with built-in increases for future years,” he said.

A $500 million decline -- coming amid the industry’s attempts to recoup parts of some previous payments -- could force some issuers to dip into reserves for debt service, said Larkin.

Virginia’s Debt Service

States including California, Florida, Kentucky, Utah and Washington are considering tax increases on cigarettes to help close budget gaps, pay for education and health programs or discourage smoking. The push comes as state governments confront a combined $47.4 billion in budget shortfalls this year.

In Virginia, where lawmakers this month rejected Governor Timothy Kaine’s proposal to double the 30-cent per pack tax, the Tobacco Settlement Financing Corp. receives 50 percent of the annual MSA payment -- about $66.4 million in 2008. The amount equaled 106 percent of debt service coverage, said Evelyn Whitley, director of debt management for the state. The final maturity for the tobacco bonds sold by Virginia in 2007 is 2047. Most tobacco bond issuers planned on using surplus funds to pay off such long maturities early.

“This isn’t an immediate cash crisis, but if we see a double-digit decline in 2009, that could mean a significant reduction in MSA payments in April 2010,” said analyst Larkin, 57, who spent 21 years at Standard & Poor’s LLC. “And then it’s not hard to see 1 times coverage, and after that, issuers having to dip into reserve funds to pay debt service.”

Forced to Tax

Larkin estimated that Virginia’s financing corporation would receive $61.8 million in 2010. With reserve fund earnings, debt service coverage in 2010 would be about 1.026 times. Without those earnings, coverage would be about 0.95 percent, he said.

The higher federal excise tax may force states to raise their own cigarette taxes in most cases, according to a Jan. 30 report from Fitch Ratings titled “Higher Taxes to Further Pressure Cigarette Volumes.”

“States that earmarked revenues from cigarette excise taxes for specific programs may be forced to make cuts to those programs or increase the cigarette excise taxes, to make up for the revenue shortfall caused by the volume decline resulting from the federal excise tax increase,” the report said.

States collected $14.5 billion in cigarette taxes in 2007, the latest date for which information is available, said Fitch. Taxes range from 7 cents per pack in South Carolina, up to $2.75 per pack in New York.

‘Striking Irony’

“The striking irony of the MSA was that it made states dependent on the sale of a deadly product that dramatically increases their health-care costs,” said Allan M. Brandt, dean of the Graduate School of Arts and Sciences at Harvard University in Cambridge, Massachusetts, and author of “The Cigarette Century: The Rise, Fall, and Deadly Persistence of the Product That Defined America” (Basic Books, 2007).

Lessened demand will save public health-care costs associated with smoking, “now estimated to be about $2.2 billion a year,” Brandt said.

In Washington, state Senator Rodney Tom said his proposal to raise the $2.02 cigarette tax by $1 a pack is “not about revenue, it’s about health savings.”

Tom noted that the federal Centers for Disease Control and Prevention in 2006 pegged the societal costs of smoking -- that is, expenses associated with medical care and lost productivity - - at $16.01 per pack in Washington.

“So we’re subsidizing smoking,” Tom said. “We just can’t go that direction.”

‘Discouraging Smoking’

For Kentucky, where Governor Steve Beshear proposed raising the state’s 30-cent per pack tax by 70 cents, “it’s about both the budget and discouraging smoking,” said spokesman Jay Blanton. The state has a $456 million shortfall this year, he said.

Consumption declines as much as 5 percent for every 10 percent increase in cigarette prices, Larkin said in an e-mail.

“That means that domestic cigarette shipments could fall an additional 4.5 percent to 7 percent just because of the federal tax hike, on top of the 10-year average decline of 4 percent per year since 1998,” he said.

He noted that most state tobacco bonds were sold based on the assumption that cigarette use would drop by around 2 percent a year.

States first began selling bonds backed by the annual payments in 1999, the year after the national settlement between big tobacco companies and 46 states over public health costs. Fewer than half the states have done so.

Trying to Recoup

As the credit crunch extended to the municipal market in September 2008 and investors shunned all except the safest securities, tobacco bonds backed solely by settlement payments plummeted to trade for as little as 53 cents on the dollar.

Cigarette makers are trying to recoup portions of payments they’ve already made. Under the settlement agreement, participating manufacturers can ask for such adjustments to compensate for market-share losses to smaller, non-participating manufacturers. So far, the companies are asking for reductions of $1.2 billion for 2003, $1.1 billion in 2004 and $775 million in 2005. 2006 is expected to be challenged this year.

To contact the reporter on this story: Joe Mysak in New York at jmysakjr@bloomberg.net.

Last Updated: February 19, 2009 00:01 EST