OPINION
Smoke and Mirrors

Illustration by Jordin Isip

Three states stand to collect on every cigarette sold in the United States. Is this taxation without representation?

By Jeremy Bulow and Daniel P. Kessler

Talk about smoke-filled rooms! The back-room deals between Mississippi, Florida, Texas, and the tobacco industry collusively raise tobacco prices around the country, effectively by imposing a national cigarette tax for the exclusive benefit of those states and some plaintiffs' lawyers. While these deals are modeled on the proposed national settlement, there are two important differences--they have been enacted without any legislative approval and they are almost surely illegal.
       Of the $368 billion national tobacco deal proposed in June 1997, $358 billion was to be paid by consumers through a 62 cents-a-pack surcharge on each cigarette company's future national sales, assiduously referred to as "damage payments" by all interested parties. But whatever you want to call it, a per-unit charge on national sales is a national excise tax. If anyone started a new cigarette company tomorrow, without any blame for past events, they would be forced to pay the surcharge just like Philip Morris.
       The bill that came out of the Senate Commerce Committee is modeled along the same lines as the original deal, though it is much less favorable to tobacco companies. It would raise cigarette taxes by $1.10 over five years (without using the T-word) and would continue to allow the class action and punitive damages legal claims that would be barred under the original deal. Furthermore, while under the original deal the penalty for the companies' not meeting youth-smoking-reduction goals was about two cents a pack, the Commerce Committee proposal would impose penalties that would amount to about 25 cents a pack if there were no decline in smoking. The only benefit for the tobacco companies under the Senate plan is that, as under the original plan, 80 percent of all damages paid as a result of lawsuits will be paid from the tax revenue collected under the plan--meaning that the government will have four times the stake in defending tobacco suits as will the companies! (There is also a cap of $6.5 billion in total annual payments.)
       The consequence of these changes is that the tobacco companies will fight the proposed legislation and the passage of a national deal may be postponed. It seems hard to imagine that the politicians will be unable to find a way to take advantage of this rare opportunity to raise taxes in a way that will appeal to most voters, but as of this writing the issue is in doubt.
       If a national deal is not passed, then there will be nothing to supersede the state deals, and they will remain in effect indefinitely. We regard these deals as atrocious. It is certainly within the power of the U.S. Congress to impose a national excise tax on cigarettes. However, it is not within the power of states' attorneys general to do so. The problem is, each of the individual state's deals mimics the national in that each imposes a per-unit surcharge on national sales. Although none of these settlements resolves the federal government's claims against the cigarette industry, and not one was adopted as a result of legislative action, each nonetheless imposes a national cigarette tax, with the revenue payable to one state. Florida collects about a penny tax on every pack of cigarettes sold in the United States; Texas gets more.
       Three features of these deals make them likely to be illegal.
       First and foremost, taxes are a matter for a legislature to decide, not a matter to be settled between the executive branch and industry in a smoke-filled room.
       Second, the Due Process Clause prohibits a state from imposing taxes on another state's citizens who never had any contact with the state. What right does Florida have to impose a tax on cigarettes that were made in Virginia and sold in Tennessee? The three settling states are currently receiving about $10 million a week from smokers in the other 47. This is taxation without representation.
       Third, even if you don't want to call these "damages" a tax, the settlements probably violate federal antitrust law. Why? The agreements finance "damage" payments with what amounts to a collusive industry-wide agreement to raise national prices by a per-pack amount on all future sales. Specifically, the agreement increases each firm's costs per pack by the same amount, assuring that the costs will be passed on to consumers. Consistent with this, national prices were raised by all of Big Tobacco after the Florida and Mississippi deals, and again the day after the Texas deal. The fact that the revenues from the collusion go to three states and a bevy of trial lawyers, and the companies only benefit through the dismissal of some lawsuits, is irrelevant.
       Even the support of state attorneys general and the public's distaste for the tobacco industry may not be enough to rescue the deals from this final legal pitfall. If the Federal Trade Commission sought to block the deals, all it would have to do is convince a federal judge that a preliminary injunction against a series of huge price-fixing agreements would be in the public interest--a pretty minimal standard given the serious questions about the agreements' legality.
       The deals might be legal and a lot less objectionable if, for example, Texas were only raising taxes on sales in Texas. This would serve much more effectively to achieve the attorney general's supposed goal of reducing sales within the state. And while an agreement that raised prices throughout the state would still be collusive, it might be allowed under the principle of "state action," which is what allows cities and taxi owners to fix fares without running afoul of the federal antitrust laws. There would still be the issue, now hot in Texas, of whether state Attorney General Dan Morales could not only negotiate a tax increase but also decide how to spend the money without consulting the state legislature. But at least no one would deny the state's right to increase taxes on its own citizens.
       So why were the deals structured as national taxes? Three reasons. First, Florida would like nothing better than to get its tax revenue from the residents of other states if it could. Second, and probably more important, is that to collect the damages strictly from Floridians, the settling parties would have had to admit that the damages are really a tax. Cigarettes are sold to jobbers, who then resell to retailers. Arbitrage prevents the wholesale price from being different in different parts of the country, so the only way to charge Floridians more is to raise their state stamp tax.
       Third, tiny Liggett, with less than 2 percent of the national market, is exempt from the state deals because of a prior settlement, but it is not exempt from the national deal. If the state deals were financed exclusively by in-state damage payments, they would create a price differential of 30 cents or more a pack between Liggett and the other companies in Florida, Mississippi, and Texas. The market disruption in those states would be significant. By basing damages on national sales, the deals give Liggett a small, nondisruptive national advantage of a few cents a pack.
       Why doesn't anyone want to 'fess up to the damages being a tax, which would solve all these problems? For the politicians, eager to claim credit for a victory over Big Tobacco rather than a tax increase on consumers, the incentives are obvious. The companies also want to say that they are paying enormous damages, instead of saying that they have sold out their customers by agreeing to cigarette tax increases in return for protection from lawsuits.
       Of course, the lawyers, particularly those in line for contingency fees, would like nothing better than to collect a percentage of a tax increase. In Texas, Judge David Folsom has already ruled the lawyers' 15 percent contingency fee, projected to be about $90 million a year forever, adjusted for inflation, to be "reasonable." According to the Texas agreement, these fees will be added on proportionately to the damage bill. This means that as long as the state settlement holds, every carton of cigarettes sold everywhere in the United States will include a 2-cent tax for select members of the Texas plaintiffs' bar. We find the prospect of a group of private citizens getting paid a percentage of a tax increase they helped negotiate troubling, to say the least.
       The large sums involved make a political settlement on tobacco almost inevitable. And if Congress wants to raise national cigarette taxes, that's its prerogative. But these state deals set dangerous precedents if allowed to stand. The question is, who will challenge them? One possibility is the FTC, which has carefully studied the possible anticompetitive effects of the national deal and is undoubtedly keeping a close eye on the state deals as well. Another possibility is that some enterprising plaintiff's lawyer in one of the other 47 states will file a class action on behalf of the smokers in his own state. As with the lawyers supposedly representing smokers in the national settlement, the odds that he would end up helping his clients would be minimal. But the fees for settling should be terrific.

About the Authors: Jeremy Bulow is the Richard Stepp Professor of Economics. Daniel Kessler is assistant professor of economics, law, and policy.