Source: Kentucky County Agricultural Agents
1/ Weights based on volume of quota sold per county
2/ Weights based on volume of quota leased per county

What is An Acceptable Quota Buyout Price?

A minimum acceptable quota buyout price will vary considerably among quota owners. The $8.00/lb quota buyout price offered in both Senator Richard Lugar’s proposal and in Senator Wendell Ford’s LEAF Act as part of Senator John McCain’s 1998 national tobacco settlement bill was deemed by most quota owners as an "acceptable" price. The $8.00/lb offered in these legislative proposals was equivalent to an average 40 cent/lb annual return on quota, calculated into perpetuity, assuming a 5% discount rate. The buyout quota level was to be based on the average 1995-1997 burley and flue-cured quota levels and was to be paid out over a maximum of 10 years. However since the defeat of the McCain tobacco bill, burley and flue-cured quotas have declined by over 50% relative to the 1995-1997 period. Recently, over 80% of Maryland tobacco farmers have reportedly accepted the state of Maryland’s $10/lb buyout offer over a 10 year period to exit tobacco farming. Kentucky’s Governor Paul Patton recently proposed a $20/lb buyout for burley and flue-cured quota owners over a 20 year period. The $20/lb buyout price was based on the 2000 burley and flue-cured quota level of nearly 800 million pounds resulting in a buyout package cost of approximately $16 billion --- roughly equivalent to the total cost to the LEAF Act compensation for tobacco farmers. The present value of $1/lb for 20 years is $12.48/lb. Interestingly, the average Kentucky rental rate for quota in 2000 of nearly 60 cents/lb calculated into perpetuity is $12.00/lb, assuming a 5% discount rate. However, rental rates for 2000 were inflated in response to federal disaster funds and tobacco settlement funds being bid into these prices. Also, basing the economic value of quota on a perpetual time horizon is subject to debate. Given recent quota sales, it appears that quota investors have been making their purchase decisions based on a very short time horizon (generally 3 to 5 years). However, tobacco farm leaders and policy makers argue that any buyout price calculation should be based on a perpetual time horizon since the tobacco program is permanent legislation.

In reality, a "reasonable" economic value of quota for tobacco quota would likely fall between the current market price of quota and the prices offered in recent buyout discussions. Nevertheless, recent buyout offers have certainly elevated quota owner expectations of an "acceptable" buyout price. Although no official survey has been conducted, it is likely that a $20/lb buyout would be almost universally accepted by tobacco quota owners today. Due to a variety of factors, such as differing expectations of future quota returns, degree of risk aversion, ag and non ag alternatives, acceptable buyout prices will vary among farmers and across tobacco-producing areas. Consequently, if a partial buyout evolves the most cost efficient means to structure a buyout would be to retire/redistribute quota on a sealed bid basis, where the lowest bids would be accepted to purchase a fixed quantity of quota. This would result in the initial volume of quota being bought out in areas with the lowest current demand for quota. For burley tobacco, this would be in eastern Kentucky, eastern Tennessee, western North Carolina and a few counties within and surrounding major urban areas.

Besides the per unit payment , the total cost of a buyout will also depend on whether it is a partial (i.e., voluntary) or a mandatory buyout. Table 4 presents the cost of buying out three different percentages of 2000 basic quotas (100%, 50%, and 33%) and three different buyout prices ($10/lb, $15/lb, and $20/lb). As an example, Table 4 illustrates that Kentucky’s Governor Paul Patton’s proposal of $20/lb would actually cost $15.8 billion or $790 million annually.

(Billion Dollars)

Table 5 below illustrates how the price per pound of quota would vary using the average 1998-2000 burley and flue-cured quota level of 1.12 billion pounds coupled with the same buyout costs calculated in Table 4.

The tables above reveal that either a partial or a total quota buyout will be costly. While program participants would like a relatively short compensation period, the availability of funds will dictate the time horizon of a buyout. The two most apparent sources to finance a tobacco quota buyout at these levels would either be the federal government or tobacco companies (or a combination of funds from both of these sources). While the federal government has recently provided disaster funds and forgiveness on existing loans for tobacco farmers, it is unlikely that general taxpayer funds will be made available to fund a buyout. However, the possibility exists that the U.S. Congress could ear-mark tobacco excise taxes to finance a quota buyout. The federal excise tax is scheduled to be increased by 5 cents/pack on January 1, 2002. If these funds are already appropriated, additional tax increases could be assessed to finance a quota buyout. Table 6 illustrates the potential revenues from increasing the excise tax on cigarettes by 2 to 5 cents/pack over a 10 to 20 year time horizon. The tax revenues are based on an assumed 2% annual decline in domestic cigarette consumption. As an example, a 4 cent/pack increase in the federal excise tax on cigarettes is projected to increase tax revenue by approximately $13.45 billion over a 20 year period (or $673 million annually). If consumption falls by an average of 3% annually, a 4 cent/pack increase would net around $12.39 billion over 20 years (or $620 million annually).

(Billion Dollars)

Although tax increases of this magnitude would have minimal effects on consumption, tobacco companies, while generally supporting a buyout, would likely oppose this finance option in fear of additional taxes being "added-on"as was the case with the 1998 McCain settlement legislation. In addition, it is important to note that the tobacco grower settlement clearly stated that all future tobacco excise tax increases directly appropriated to tobacco quota owners or tobacco growers would reduce future Phase II payments dollar per dollar. It is unclear whether the scheduled 5 cent/pack tax increase for January 2001 is also subject to this provision.

A second source of funds could evolve from the tobacco companies. The major U.S. cigarette manufacturers are currently contributing both Phase I (MSA) and Phase II (tobacco farmer) payments to tobacco-producing states. Given the political environment surrounding Phase I monies, it is very unlikely that tobacco states could coordinate these funds becoming available as part of a buyout package. Even if some coordinating mechanism among the tobacco states for Phase II monies could be agreed upon, the remaining $4.5 billion of funds would only provide for approximately $5.70/lb for buying out burley and flue-cured quotas based on 2000 quota levels. This would not likely be enough to satisfy all quota owners and would deplete funds set aside for tobacco growers. However, the amount left in the fund could potentially support a partial buyout of quota and still retain some funds for growers. Again, perhaps the biggest obstacle in this option would be coordinating an acceptable plan among all the tobacco-producing states.

Besides using settlement money or an excise tax increase, another option would center around the tobacco companies ear-marking a relatively small cigarette price increase to fund a buyout over time. This would salvage the Phase II monies for growers, but would likely have to include other changes in the federal tobacco program to become attractive to the tobacco companies. Table 6 provides an estimate of the potential funds that could become available to finance a buyout assuming the price increase was initiated from the companies instead of the government.

Another possible means for tobacco companies to finance a buyout would be in terms of cost savings evolving over time in response to lowering the price of U.S. tobacco. Table 7 presents estimated total leaf savings over a 20 year period attributed to a 10 to 40 cent/lb reduction in leaf prices, assuming total demand levels varying from 900 to 1,250 million pounds. For example, Table 7 illustrates that a 20 cent per pound reduction in the price of U.S. tobacco could generate around $4 billion in cost savings over a 20 year period (or $200 million annually) based on one billion pounds of U.S. leaf demand. But, this table assumes that demand would increase, despite the total cost of U.S. tobacco (as measured by both the cost of the leaf and funding the cost of a buyout) remaining roughly the same. A more attractive package to the tobacco companies would likely have to include greater price reductions to boost demand, and thus yield an overall net cost savings to the companies in exchange for funding a buyout. Also, it remains very questionable if all tobacco buyers would contribute to the fund. Obviously, if only the domestic tobacco companies contribute to the fund based on their purchases, the total funds available will be much smaller than the levels indicated below which accounts for both domestic and export demand.

If funding becomes available (which remains a very questionable assumption), the structure of a quota buyout and the distribution of the funds associated with a buyout will lead to many difficult and controversial issues that will have to be resolved and analyzed by various farm groups and policy makers. A partial identification of these issues include:

Will the quota buyout be voluntary or mandatory?

Will the federal tobacco program be maintained, modified, or eliminated in conjunction with a buyout?

Assuming the program is maintained, a buyout could be structured to simply transfer the quota from the non-producing quota owner to the individual who grew the base the previous year. If the quota was not leased the previous year this base could be redistributed to active growers. If tobacco was produced under a tenant/landlord relationship, does the quota transfer to the landlord or to the tenant?

Another possible method to structure a voluntary buyout program would consist of a pool of funds becoming available to active growers to assist them in the purchase of quota. This would have the tendency to bid up quota sale prices in the short-term. However, this result could potentially be offset by requiring non-producing quota owners to either grow their base or forfeit their base, thereby increasing the quota sales volume and potentially lower the overall net sales price.

A voluntary buyout could also be structured so that either quota would be permanently retired following a quota cut (resulting in a zero or reduced quota cut for remaining quota owners) or redistributed among all remaining program participants once a predetermined amount of quota was purchased following the announcement of the national quota level. If existing quota is redistributed would it occur within the original county or throughout the belt? If quota remains in the county of origin, would an individual or a county be required to provide evidence of a utilizing (i.e. planting or leasing) a certain percentage of the transferred quota to maintain this base or be subject to redistribution across the belt?

If a buyout occurs within the program, how will buyout funds be distributed among program participants? Should quota owners be the sole recipient of funds or should they be shared among all parties associated with the quota, including tenants? If so, what allocation method is the most equitable? Potential options could include utilizing the current Phase II payment distribution formulas among quota owners, growing farms, and growers or dividing the funds based on the current crop share arrangement.

Would quota be transferred to an individual or to a farm? Assigning quota to an individual may constrain the implicit cost of quota, but problems arise with the transfer of this production right to future generations.

If quota is transferred to active growers, a critical issue becomes what happens to those growers who have been awarded quota, but have limited/no land, barns and access to capital. To remain active, these individuals will likely have to rent or purchase land/barns. Will they have the option to transfer or sell their quota/production rights? Will they have to assign the quota to a parcel of land? Will they have access to future Phase II funds to assist in capital needs?

Other issues that need to be assessed include the impact of a buyout on:

farm structure

rural economies

agricultural and non-agricultural investment opportunities

income and property taxes

future political support for tobacco farming, including disaster funding, loan forgiveness, and the ability to modify/protect the federal tobacco program (if it remains in existence).

land prices

future profitability in growing tobacco

transfer of quota to future generations

Even if a buyout evolves, a buyout does not, by itself, improve the competitiveness of U.S. tobacco. What the buyout does affect is the cost structure of the remaining growers. With lease prices historically averaging 40 cents/lb in Kentucky and given only around 25 to 30% of the crop is typically leased, the effect of leasing on the overall marginal cost of production has been relatively low. The transfer of quota could also provide some benefits associated with economies of scale, but these benefits for burley tobacco are also arguably relatively low. Nevertheless, additional production opportunities would provide existing growers with a lower cost structure, and thus the incentive to examine various policy options to improve the competitiveness of U.S. tobacco in world markets.

The relatively high cost of quota is a critical problem facing tobacco growers who are attempting to expand their production amidst a time of declining demand for U.S. tobacco. The structure of distributing grower settlement payments and federal disaster funds are contributing to this problem. A buyout of quota from non-producing quota owners to active growers could provide some short-term benefits to reduce this cost. However, the availability of funds to finance a quota buyout remains very questionable at this time. Furthermore, additional program modifications, in conjunction with a buyout, would likely have to be adopted to enhance tobacco production opportunities that would allow a partial rebounding of tobacco farm economies.