Report to the Presidential Commission on Tobacco
The declining national marketing quotas for United States tobacco reflect a number of factors that have negatively affected demand for U.S. tobacco and reduced the world market share of U.S. tobacco producers. One way to understand these declines is to think of the problem in terms of eroding market power. Market power can be thought of as the ability to set the price of U.S. tobacco by restricting the supply of U.S. tobacco available on the world market via the tobacco program. The historical success of the U.S. tobacco program in garnering higher prices for U.S. tobacco than would have been obtained with unregulated tobacco production is critically dependent on the market power of U.S. tobacco in the world market.
Market power has eroded as a result of declines in demand for U.S. tobacco resulting from: 1) declines in U.S. consumer demand due to health concerns surrounding smoking, higher cigarette excise taxes, and higher cigarette prices due to the tobacco settlement and litigation costs, 2) declines in cigarette exports by U.S. cigarette manufacturers, 3) substitution for both quality and quantity of tobacco in cigarettes (lower tobacco use per cigarette) as a result of technological changes in cigarette production such as filters and flavorings, and 4) substitution away from U.S. tobacco as a result of the development of cheaper tobaccos of similar quality in foreign countries, such as Brazil. As market power erodes, the national marketing quotas must be set at lower levels in order to maintain price. Ironically, smaller quotas decrease the world market share of U.S. tobacco which further decreases market power. Decreasing market power makes maintenance of a tobacco program increasingly dependent on political intervention.
As market power has eroded over the last 20 years, numerous options have been discussed. The program modifications of the early and mid-1980=s that included price reduction were options actually implemented and were in part responsible for the recovery of quota in the late 1980=s and early 1990=s. Several policy options for the current program situation are presented below. In evaluating these options, it is important to understand the potential effect of changes in farm level tobacco prices on the quantity of tobacco demanded by domestic and foreign cigarette manufacturers.
Potential effects of price changes on quantity demanded (sold)
Data from the 1950=s through the 1970=s indicated that for a 1 percent decline in U.S. flue-cured price, unmanufactured exports would expand by 2 to 2.5 percent. The results of the price support reduction in 1985 seem to bear this out since exports rebounded from around 350 million pounds to over 400 million pounds over a 5 year period. Demand by U.S. cigarette manufacturers is much less responsive to changes in price than is the export market. Research indicates for a 1 percent decline in U.S. flue-cured price, the quantity demanded has historically increased around 0.9 percent and for a 1 percent decline in burley price, quantity demanded has increased only about 0.1 percent. These relationships change over time and undoubtedly are substantially different today than 15 years ago. As closer substitutes for U.S. tobacco have been developed, purchasers are more sensitive to changes in U.S. tobacco prices since they can more easily switch to tobacco produced elsewhere. One possible exception to this generalization is unmanufactured flue-cured tobacco exports. U.S. flue-cured exports may be very price sensitive at much lower prices, for example prices near those of Zimbabwe or Brazil. But at the higher prices under the U.S. program many Aprice sensitive@ foreign buyers may have already abandoned the U.S. market, leaving less price sensitive foreign buyers. These Aprice sensitive@ buyers may be hard to lure back without large price declines. Sufficient data (enough years of data) to conduct analyses that could confirm or refute these suspicions are difficult to obtain at present.
When price is lowered, a lower return to quota is experienced. The rental rate for quota is the market=s value for the return to the right to sell tobacco. Quota owners that rent their quota to growers earn this return. It is also appropriate to think of growers (most of whom own quota as well as rent quota from non-growing quota owners) as earning the rental rate as a return to their own quota. When price is reduced the return (rental rate) on quota falls reducing income from quota ownership to both growing and non-growing quota owners.
At the same time, if reducing price results in more tobacco being sold, then growers earn larger returns on their management, labor, and fixed assets. Low quotas, especially unexpected quota declines (as has been the case in recent years), dramatically reduce grower earnings. Earnings on specialized assets for tobacco production (greenhouses, curing barns, etc.) may be eliminated completely by declining quotas.
In light of these price/quantity relationships and their effects, the following options are presented.
1. Maintain the current tobacco program without changes in support prices. Unmanufactured exports would continue their downward trend. Eventually, the quota could decline to a level that reflected mostly domestic purchases. Domestic purchases may recover from their current very low levels as manufacturers lower inventories to desired levels. For flue-cured tobacco this could eventually imply a quota of between 400 and 500 million pounds. Political intervention likely would be required if periods of high stabilization stocks occur. Interruptions in foreign supplies, such as caused by weather, unexpected change in exchange rates, or political unrest could slow or interrupt the trend to lower quota levels. Quota return per pound (rental rates) will increase resulting in total quota returns falling less than in the case of a price reduction. Grower earnings on management and fixed assets continue to decline with most specialized tobacco assets having a near zero value.
2. Lower price supports while keeping the current tobacco program, as was done in the 1980=s. If historical relationships between price and quantity sold are still valid then quotas would be expected to rebound over 3 to 5 years after the price support reduction. Return per pound (rental rates) and total returns to quota would decline. Grower earnings on management and fixed assets would increase as the quota increased. However, this scenario is dependent on whether or not historical price/quantity relationships still hold. Some degree of market power is still required for this option to have the desired effect of increasing quotas. Market power would continue to erode with the likely results being additional program modification after a number of years. Such an option could include changes in regulations or compensation designed to move quota from non-growers to growers. This could alleviate policy dilemmas where non-grower quota owner and grower interests conflict.
3. Lower price support to close to the free market price of tobacco with significant modification of the tobacco program. Lowering price supports to below the price that U.S. tobacco would sell for with unregulated production likely would cause exports to rebound and domestic cigarette manufacturers to increase use of U.S. tobacco even if U.S. tobacco has little remaining market power in the world tobacco market. Price would decline to the free market price for tobacco, probably in the range of $1.10 to $1.30 per pound for U.S. flue-cured tobacco. U.S. tobacco production and sales would increase significantly. Expanded U.S. tobacco production would take world market share away from foreign tobacco producers, such as Zimbabwe with little effect on total tobacco consumption.Maintaining price supports at some level below expected market price would provide a safety net for farmers when world tobacco prices fell unexpectedly. This would be an important feature of this option, since world tobacco prices can be very volatile. Figure 1 illustrates the volatility of Zimbabwean versus U.S. tobacco prices. Payments equaling support price minus market price could be made to tobacco farmers during periods when market price dropped below support prices. Tobacco would be allowed to clear the market at world prices. No cooperative would be needed to purchase tobacco not bringing support price. This option is similar to the loan deficiency payment feature of government programs for cotton, soybeans, and grains where a payment can be made to farmers when market prices fall below preset loan rates. This option is also similar to the European Union=s program for tobacco farmers.Some level of production controls might be desirable under such an option. If support price is set too high or production costs fall due to rapid technological change then production and consequently farmer payments could become large. Production controls would prevent production from expanding more than is desirable by policy makers concerned about program costs and by health advocates concerned about expanding U.S. tobacco production. Under such a program the right to produce tobacco only would be held by active tobacco growers.Such a program could not operate effectively with the only funding source being assessments on sales of tobacco. A continuing external funding source for farmer payments, as is the case with other farm programs, would be required. Quota and the associated economic returns as are known under the current program would be eliminated under this option. Total grower earnings on management and fixed assets would increase as production increased. Depending on how much price declined and how production rights were allocated under this option, considerable structural change could occur at the farm level, including significant consolidation of farms and changes in location of production.
4. Segment tobacco sales into export and domestic markets with different prices. Theoretically, returns to quota owners could be maximized by enforcing a quota on domestic sales of tobacco to force a higher price in the less price sensitive market for U.S. consumption and allowing greater sales and lower price in the more price sensitive export market. The U.S. peanut program has operated in such a manner for over 20 years. The problems associated with such an option are that strict import controls on tobacco must be enforced to prevent lower priced export tobacco or products made from export tobacco from reentering the U.S. Strict import controls are difficult to enforce and may be impossible to implement under the current rules of the World Trade Organization. These problems currently threaten the effectiveness and continuation of the U.S. peanut program.
5. Elimination of the tobacco program would result in substantial structural change in tobacco farming. Tobacco prices would fall toward the world price making U.S. tobacco more competitive in world markets. While tobacco production would increase, many smaller tobacco farmers, particularly those in geographical regions with the highest production costs, would leave tobacco farming. The end result would be fewer but larger tobacco farms producing more tobacco at lower and more volatile prices. Because of the growth in tobacco sales, cash farm sales from tobacco might grow, despite lower prices and lower net returns per acre. Kentucky and Virginia likely would produce less tobacco, while North Carolina, South Carolina, and Georgia likely would produce more tobacco.
Compensation for Changes in the Tobacco Program
There are many arguments for and against compensation to stake holders in the tobacco program if program changes are made. If the current program is maintained, grower earnings on management and fixed assets suffer. If price is reduced or the program is eliminated then the value of quota is reduced or eliminated. Cigarette manufacturers and their customers are the beneficiaries of price reductions.
If government officials or others decide to compensate growers and quota owners in the event of a change in the tobacco program then what compensation levels should be used? First and foremost, this level is a function of what policy makers consider Afair.@ If the value of quota disappears some farm groups and legislators argue that since the tobacco is permanent legislation, quota owners should be compensated for all potential future lost income from quota where quota is assumed to generate income into perpetuity. This is how the $8 per pound of quota figure was arrived at during the tobacco settlement debate of 1998. Others argue that compensation should only be for a set time horizon of lost quota income or that market values of quota should be used. Finally, some groups may argue that market prices paid for quota reflect the risk of program elimination and consequently no compensation for quota is warranted.
Market values of quota are determined by buyers and sellers based on several criteria. The first factor is the expected annual income from owning one pound of quota. In the past this annual income has been the difference between the expected market price for one pound of tobacco and the cost of producing and selling one pound of tobacco (less the cost of the quota). This difference or expected income is represented by the rental rate. Expectations concerning future Phase II payments or potential government payments associated with quota ownership have caused much uncertainty in the quota market and have inflated quota values. Currently, expectations of annual income from quota seem to include future rental value plus some expectation of Phase II or other payments.
The second factor is how much, if any (and when), the quota is expected to decline or increase in quantity in the future. When the national quota is set each year, the quantity of quota owned by an individual will increase or decrease by the same percentage as does the national quota. Thus, in a situation of expected decreased demand for tobacco (for example, due to a tobacco settlement or increase in cigarette taxes) future quantities of quota would be expected to decline having a negative effect on current quota values.
The third factor influencing the value of quota is how long the tobacco program is expected to last (i.e. how long farmers can expect an income stream from the quota). This factor is influenced heavily by the content and tone of any policy debate about the tobacco program at the time the market values are observed. Finally, the uncertainty surrounding the forecasts for the first three factors affects the discount rate used to calculate the current value of the expected stream of income from a pound of quota. (A discount rate is similar to an interest rate and accounts for the effects of inflation on the purchasing power of future earnings and the risk or uncertainty of achieving the expected outcomes for the first three factors.)
Since current market values of quota likely are distorted by expectations of payments associated with quota ownership, calculation of quota values may be useful. This can be done by determining some annual income level for the quota and some discount rate that reflects the risk associated with the future of the tobacco program. Current rental rates likely are also distorted in most states by expectations that growers will receive Phase II payments based on the quantity of quota grown. Thus, it may be reasonable to use a range of rental rates. Determination of the appropriate discount rate is also very speculative, so a range of discount rates should be used. A higher discount rate indicates greater risk of a reduction or loss of future income from quota (e.g. due to program elimination). Table 1 gives quota compensation values using rental rates of $0.40, $0.50 and $0.60 and discount rates ranging from 5 to 20 percent.
Table 1. Present value of annual quota income
If tobacco price is reduced to a level greater than the free market price, then quota income would not fall to zero. In other words rental rates would still be positive. If compensation were paid under such a scenario smaller payments could be justified since quota would still have value, albeit lower.
If the tobacco program were eliminated, then many tobacco growers would exit tobacco farming. Those that remained would probably have to make substantial changes in their operations. Farm groups and some legislators argue that tobacco farmers should not only be compensated for lost value of quota, but also for the costs and losses incurred with the transition out of tobacco or to production in a deregulated market. This was the justification given for the $4 per pound of quota grown compensation level discussed during the tobacco settlement debate of 1998.
Once a particular program option is chosen and policy makers determine what conditions for compensation are Afair,@ then economists can assist policy makers in determining compensation levels that meet the parameters and conditions set for Afairness.@