Costlier Smokes, Cleaner Lungs?

Why the payoff from higher tobacco prices may be elusive

When President Clinton laid out his policy on tobacco on Sept. 17, the centerpiece was a $1.50-per-pack increase in the price of cigarettes. Although Clinton didn't spell out the details, such a price hike would probably be spread out over several years and adjusted for inflation. But no matter how the mechanics of the concept are resolved, it is clear that his plan would sting smokers: the cost of a pack of smokes could easily climb by 80%, to a nation-wide average of about $3.50.

What is much less clear is whether a $1.50-per-pack price hike would achieve the President's top policy goal: cutting youth smoking in half by 2005. And that's not the only question surrounding the potential cigarette sticker shock. Would it create a massive black market? That's what happened in Canada in the early 1990s after the country raised tobacco taxes by more than 250%. In fact, bootlegging became such a problem that taxes were rolled back in 1994.

What about the tobacco industry's profits? Will they be pummeled? Enormous state and federal tax dollars are also at stake. Will overall cigarette levies decline? Although in many cases the answers can only be preliminary, close investigation reveals that a $1.50-per-pack price increase would affect far more than just smokers and tobacco companies. It would be one of the most important public-health initiatives in history, with far-reaching effects on everyone from taxpayers to retailers to law enforcement authorities.

The most critical issue surrounding the price hike is whether it would cut consumption by teens. According to Frank Chaloupka, a University of Illinois associate professor and an expert on the economics of smoking, a 10% increase in the price of cigarettes leads to a 6.75% decrease in the number of teens who smoke. Because a $1.50 price hike would increase the average nationwide cost of a pack of smokes by close to 80%, his studies suggest that teen smoking should fall by well over the desired 50%.

BLACK MARKET. But, as Chaloupka points out, the size of the proposed cigarette price spike is unprecedented. His nationwide studies are based on the small price fluctuations that have occurred in the past. Those and other factors, then, skew the correlations to his studies; the rate of decrease in teen smoking may slow down as the price hike climbs.

For one thing, a black market could develop that would supply youths with cheaper cigarettes, says Gary Black, a tobacco analyst with Sanford C. Bernstein & Co. Additionally, teens could trade down from Marlboro and Camel to discount brands (though Black and many health authorities note that younger smokers are particularly label-conscious). Retailers also may hold down prices to build store traffic, Black says.

Many health advocates, meanwhile, say that while a $1.50 increase would have a large impact if it were imposed immediately, the impact will be diminished if it is phased in gradually. Bottom line: The hike would certainly take a big bite out of teen smoking--but don't bet on cutting it in half.

Another contentious issue is whether a black market in cigarettes will emerge in reaction to a price jump. Pointing to Canada's experience--as well as that of Michigan, which saw a dramatic increase in smuggling after it raised cigarette taxes--the industry and its defenders are convinced that Clinton's plan would lead to a burgeoning market in contraband tobacco. "A black market always comes in to fill the gap" between places with high cigarette prices and those with lower ones, says Gary Auxier, senior vice-president of the National Smokers Alliance in Alexandria, Va.

DIFFERENT SCENARIO. Law enforcement authorities worry that this might create a profitable new line of business for organized crime. In Michigan--where the cigarette excise tax jumped from 25 cents in 1994 to 95 cents in 1996--Middle Eastern gangs that also specialize in illegal gambling have entered the trade, says Detective Sergeant James Ward, supervisor of the state police's Tobacco Products Tax Team.

But health authorities say that neither Canada's nor Michigan's experiences shed much light on what would happen if the U.S. adopted a national $1.50 price hike. Unlike Canada, which saw an uncontrollable influx of cigarettes from the U.S., the U.S. wouldn't be adjacent to any enormous source of contraband tobacco, says David Sweanor, of the Non-Smokers' Rights Assn. in Ottawa.

For one thing, Canada's provinces would likely greet an American price hike with an almost immediate tax increase of their own, Sweanor says. And the Mexican border is much more heavily policed. Trucking in large quantities of tobacco would be an iffy economic proposition--especially if the U.S. raised tobacco taxes, marked cigarette packs with easily visible tax stamps, and kept an eye on industry sales to northern Mexico, Sweanor says. And while interstate smuggling would certainly still exist, the relative importance of the small differences in state excise taxes would be less important if a nationwide price hike were enacted.

PROFIT LOSS. Of course, tobacco companies will feel the impact quickly. Their worst-case scenario would occur if Congress insisted that the entire $1.50-per-pack increase apply immediately--as many health groups wish. If that happens, Philip Morris Cos.' 1998 estimated operating profits from domestic tobacco would drop from $4.7 billion to $2.7 billion, says Black. Estimated earnings per share would probably drop from $3.15 per share to $2.90. At RJR Nabisco Inc., estimated domestic tobacco revenues would drop from $1.5 billion to about $950 million, while estimated earnings per share would fall from $3 to $2.35.

But an immediate price hike is unlikely--and to the extent that it is spread out over time, the earnings hit will diminish. It is also likely that much of the cost increase will come in the form of a penalty if youth-smoking reduction targets are not met. The faster the industry hits the targets, the lesser the price hike--and the smaller the impact on profits. Given the new advertising restrictions that Congress would probably create, Black also estimates that the industry's $6 billion in annual marketing expenses could drop by 20%.

Finally, the original tobacco settlement deal gave companies a broad antitrust exemption: They may "act in concert" to achieve "the goals of the agreement." If the provision remains in a new deal, Federal Trade Commission Chairman Robert Pitofsky warns that manufacturers may be able to increase profits by raising prices far above the level needed to pay for the settlement.

Will government coffers start overflowing from a cigarette tax hike? Until Congress decides how much of the $1.50-per-pack increase will come in the form of increased levies and how much will be in the form of penalties, it is impossible to predict how Clinton's plan would affect government treasuries. But tax increases, if they are imposed, won't necessarily guarantee more revenue. If they actually push down smoking, government receipts could actually decline. But then again, maybe that's a price the country is willing to pay.