Fiscal Failings of the Government’s Tobacco Settlement

Eight years ago, 55 U.S. states and territories signed a landmark settlement with the nation’s four major tobacco companies. The Master Settlement Agreement forced the big tobacco companies to pay fees to the state on futures sales of cigarettes in return for an end to all state claims against the companies for fraud, anti-trust violations and smoking-related Medicaid expenses.

As a result, those governments have collected billions of dollars in extra revenue, and smoking has dropped an estimated 4 percent as a direct result of the 1998 agreement.

Sound like public policy at its best? Not even close, argues Jeremy Bulow, the Richard A. Stepp Professor of Economics at the Graduate School of Business. “In reality the settlement preserved tobacco companies’ profits while it gave the trial lawyers an incredibly large ongoing source of income gouged from the hides of smokers and handed state politicians bragging rights as Davids to Big Tobacco’s Goliaths,” he writes in the fourth quarter 2006 issue of the Milken Institute Review.

While it might be tempting to think the Master Settlement Agreement, or MSA, was a good thing that was somehow subverted over time, Bulow says it was never a good deal for most of the jurisdictions that signed. “Smokers in some states (including Georgia, Kentucky, North Carolina and Virginia) are paying over $100 million per year more for tobacco than the settlement returns to their states’ coffers.”

That disparity might be reasonable if it were based upon comparative health care costs, as some argue. But in fact, an examination of the data shows no link between payments and Medicaid costs, says Bulow.

Although the fees look like a tax to the consumer who pays $4 to $5 or more on each carton of cigarettes, they are somewhat different. And that’s a major problem with the agreement. “Straightforward taxes on cigarettes would be fairer and have a more neutral impact on competing manufacturers. But more conventional taxes would be much worse for the overall financial health of the trial lawyers and the tobacco companies, as well as for a handful of the states that were at the center of the negotiations on the master agreement,” says Bulow.

If the agreement wasn’t good for many of the states that signed, why come on board? In the first place, the states that weren’t party to the negotiations had just a week to evaluate the agreement and make a decision. “Given only a week from the time the settlement agreement became public to join in, many state attorneys general may simply not have had enough time to figure out what a bad deal they were accepting.” In a word, says Bulow, they were “bamboozled.”

Moreover, those states were essentially coerced into signing. If Oklahoma, for example, spurned the MSA, residents of that state would still have paid fees totaling about $4 a carton of cigarettes to every jurisdiction that did sign, but the state treasury would not have gotten a single penny in return.

“Big Tobacco,” as Bulow calls the companies, had a lengthy agenda in mind. They wanted:

Relief from state lawsuits stemming from damages suffered in the past and relief from possible future actions as well. Wholesalers and retailers to be exempt from future lawsuits. Big Tobacco needed to ensure that the largest outlets, such as Wal-Mart and the big supermarket chains, would continue to sell cigarettes. Without immunity from lawsuits, they might well have refused. The fees to be structured in such a way that there was an advantage to the sellers of more expensive, more heavily marketed brands like Marlboro, Camel and Virginia Slims. To deter entry by new manufacturers that chose not to join the settlement. Those companies, known as “non-participating manufacturers,” would be required to make hefty deposits to escrow accounts that would cover the potential costs of future liability suits.

Adding injury to the insults suffered by consumers, the MSA allowed Big Tobacco to raise prices by about $2 per carton over and beyond all cost increases linked to tax hikes and settlement payments. The increase, says Bulow, was about equal to the entire cost of producing the cigarettes.

Who else had a big stake in the MSA? Lawyers, of course. Had the lawsuits brought against tobacco manufacturers by the states simply been dropped and the state legislatures simply passed tax increases on cigarettes to cover smoking-related medical costs, the lawyers working for the states would have gotten, at most, hourly fees for their services. “But by framing the deal as the grand settlement of a legal claim, the lawyers got contingency fees totaling billions in the first five years of the agreement and continuing indefinitely at a rate of $500 million annually,” says Bulow.

State politicians made out as well. “It sounds better to say you negotiated a large settlement from the death dealers of tobacco than to say you imposed an equally large tax increase on long-suffering smokers.” What’s more, argues Bulow, “by claiming that the revenues were attributable to a one-time settlement paid out over decades, rather than a tax increase, states were able to borrow against future revenues and spend the cash immediately without violating constitutional requirements to balance their budgets.”

At bottom, though, the argument about smoking in general and the MSA in particular really comes down to public health. Here, too, says Bulow, the public good was not served well by the agreement.

“Without the settlement’s legal protections, smokers might no longer be able to find cigarettes at the major stores where they do most of their shopping. Thus by helping ensure that cigarettes continue to be sold ubiquitously, the agreement makes it that much harder for addicts to avoid impulse purchases.”

If the public is ever to rid itself of the MSA, relief may come because of Big Tobacco’s greed. Despite their enormous gains, the major manufacturers are now suing to have $1.3 billion in fees returned to them by the states. They are invoking a provision of the agreement that requires states to compensate them if they lost market share as a result of ineffective enforcement of a part of the agreement designed to undermine the competitive edge of the non-participating manufacturers.

Should Big Tobacco win, the states may finally come to realize that the cigarette makers are not docile allies and decide they would be better off with legally bulletproof excise taxes than with the settlement. And that, says Bulow, would be a significant gain for the public.