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On July 16, 1997, we released a detailed analysis of the analysis of the proposed resolution to the tobacco litigation without citations or bibliography and requested comments and criticisms. Several people provided technical comments, and many people asked that we "repackage" our analysis in to a series of 2-3 page "briefing papers" on different issues related to the tobacco deal. We are now releasing these draft "briefing papers" to again solicit comments. We anticipate finalizing both these briefing papers and the detailed analysis in early September and would appreciate any comments you have to offer. (We will publish the final report in two volumes.) If you would like to provide us with comments, please send them to Stanton A. Glantz, PhD, Box 0124, University of California, San Francisco, CA 94143 or email glantz@cardio.ucsf.edu, with copies to Brion Fox (email fox@cardio.ucsf.edu) and Jim Lightwood (email lightwo@itsa.ucsf.edu).

LIST OF BRIEFING PAPERS

EXECUTIVE SUMMARY

On June 20, 1997 a group of attorneys general presented to the public a proposed resolution, which would resolve their lawsuits against the tobacco industry and establish a national tobacco policy for the United States. This deal, which had been negotiated with the tobacco industry, was widely anticipated. It became possible as a result of the intense pressures the tobacco industry has faced in the past few years from regulatory authorities and from the threat posed by civil litigation against it.

Because of these pressures, the tobacco industry was willing to come to the negotiating table and develop a deal acceptable to it and to a group of attorneys general who had sued it. As conditions for settlement the tobacco industry wanted protection from the threat of lawsuits and restrictions on regulatory control. In return the attorneys general wanted concessions which would provide the states reimbursement for the excess medical expenditures and would improve the public's health.

In the months leading up to the publication of the deal, many commentators discussed the relative merits of entering into a negotiated resolution. The advocates of the deal pointed to the ability to obtain specific relief, the advantages of having a national tobacco policy, and the elimination of the risks to continuing the litigation. Critics of the deal making process were concerned about making a deal which would guarantee tobacco industry profitability, would require Congressional action because of the influence the tobacco lobby in national politics, would preempt stronger state, local and regulatory efforts to control tobacco and would preclude broad based public health efforts to control tobacco in the future.

With the publication of the deal it is possible to analyze its merits directly. Within the Preamble to the document are many strongly worded claims that the deal will strengthen the federal and state government's regulatory arsenal, reaffirm individual's right of access to the courts, ensure FDA and state regulatory flexibility to affect youth access, hazardous components of tobacco products, and other tobacco related issues, and fund various programs to compensate those who have suffered loss due to tobacco products. When the terms of the deal are analyzed directly, it is clear that the deal does not measure up to the promises made.

An analysis of the individual terms of the deal discloses three facts.

First, the deal is far from complete. In many parts terms are left undefined, there are ambiguities and inconsistencies. The legislation that is drafted with this as a basis will need to make assumptions which may or may not be consistent with the drafters' intent. In most cases the ambiguities are in areas emphasizing the public health implications of the deal, whereas the portions of the deal which provide protection to the tobacco industry are more well-defined.

Second, the deal fails to live up to its billing. Close scrutiny of the likely policy implications of the individual terms of the deal disclose that the disadvantages outweigh the advantages.

The advantages purported in the deal could be obtained without the necessity of incurring the disadvantages attendant with giving the tobacco industry special treatment.

As a result, we conclude that the deal fails as a public health tool.

The Funding Provisions Are Inadequate

The money in the deal is large in absolute terms but small when compared against the damage done by tobacco products. Therefore, with a careful analysis it becomes clear that there will be insufficient funds to satisfy all claims. The amount of medical damages against the industry for the settled claims are out of proportion to the actual money that will be available resulting in a great under-funding. Moreover, the financial portions of the deal are structured in such a manner that they will guarantee industry profits and will be insufficient to cause a dramatic drop in demand or create incentives for industry reform.

The Taxpayers will Absorb a Substantial Fraction of the Nominal Costs to the Industry

All payments by the tobacco industry, including those made "in lieu of" punitive damages, are tax deductible which results in a decrease in incentives to the industry and a cost shifting to American taxpayers. Taxpayers will absorb 30-40% of the cost of the deal.

The Industry Will be Protected From Most Threats of Litigation

The civil liability protections will strongly protect the tobacco industry. They will increase the barriers to litigation and provide perfect security to the industry in the way of capping exposure. The limitations on litigation may deprive injured smokers from receiving just compensation. The caps will eliminate the incentives civil justice system by reducing any threat for failing to act in a responsible manner.

Regulatory Controls are Unnecessary and Insufficient

Specifically, the claims of that the deal results in new regulatory authority are exaggerated. The FDA already has jurisdiction over tobacco products and is executing its regulatory authority pursuant to its jurisdiction. The few provisions in the deal which are not currently a part of FDA regulations could become so, or like the advertising restrictions, be regulated by another agency. Furthermore, the claims regarding the benefits attendant with many of the regulatory changes are exaggerated. Even with the advertising restrictions in place, the tobacco industry will still find successful ways to market their products, and tobacco imagery will be ubiquitous. Similarly, the proposed regulations regarding tobacco warnings, and restrictions on youth access add little new authority.

The deal also adds intensive rollbacks to the FDA authority that currently exists. The Agency will face additional regulatory hurdles before it can regulate tobacco constituents and will have specific restriction on how and when it can regulate nicotine. These hurdles will preclude much of the potential for reform towards safer products.

Similarly, the environmental tobacco smoke provisions represent a rollback of the current ability to regulate broadly. The ETS provisions within the deal would exclude a large number workplaces such as in the hospitality industry. These restrictions are not a part of the proposed OSHA regulations currently under review.

The Lookback Provision Is Inadequate

There are provisions in the deal designed to hold the industry accountable for not implementing programs to decrease youth smoking, by exacting penalties for not meeting specific targeted reductions. These targets, however, are based upon faulty analysis of youth prevalence rates, and the penalties imposed are not sufficient to create industry incentives to eliminate youth smoking.

The Deal Preserves the Oligopoly Structure of the Industry

Throughout the deal there are a number of provisions which increase barriers to market entry and preserve the current profit structure. These provisions will encourage anti-competitive behavior and eliminate any incentive to innovate towards safer products. Furthermore, by closing the market new companies will find it more difficult to compete. This situation will further guarantee excess profits for the industry.

There are no Barriers Other than a Lack of Political Will to Adopting the Beneficial Provisions of the Deal

If one assumes that there are beneficial aspects to this deal, but one is nevertheless concerned with the negative aspects of the deal, much of the same legislation could be, and arguably should be passed independently. For example, the public health measures could be funded by an increase in the tobacco excise tax. The Congress could give the FDA and OSHA more direct authority over tobacco products, and could ensure full funding for the programs. The States could enter into individual legal settlements with the tobacco industry in the same way that Mississippi did. The absence of such political will may be indicative of how the Congress is still a pro-tobacco institution and also how the deal will fare in Congress.

Conclusion

When weighing the advantages with the disadvantages of the deal it becomes clear that the costs far outweigh the benefits, and that it is unnecessary to view the deal as a whole. The deal removes all incentive for the tobacco industry to change its behavior by limiting regulatory, civil liability and market controls. As a result, we conclude that the public health would be better served if the deal is rejected on its merits.

The Tobacco Deal: Political Issues

The original premise for the deal was that, while public health advocates had rarely been able to overcome opposition from the tobacco industry in Congress for tobacco control legislation, the unprecedented pressure that the state and private lawsuits were placing on the tobacco industry created a unique opportunity for a negotiated settlement in which the tobacco industry was willing to accept (and support in Congress) legislation that it had previously opposed. Under this scenario, the public health community, together with the attorneys general, would go to Congress as partners,1 to secure passage of a legislative package that would include tobacco control measures and protection of the industry from legal liability.

When questioned by skeptics, the deal¹s primary architects, Mississippi Attorney General Mike Moore and Dick Scruggs (one of the leading private attorneys involved in the negotiations) assured people that they had private assurances from President Clinton and Senate Majority Leader Trent Lott (Scruggs¹ brother-in-law) that if the attorneys general, public health groups, and tobacco companies could come to an agreement, that they would see that the deal went through Congress unchanged. As a result, the deal was presented as a take it or leave it proposition, with various proponents arguing that it is both necessary to do everything in the deal, and that it is impossible to separate out the individual provisions of the deal.

The Boards of Directors of Philip Morris and Lorillard tobacco have endorsed the deal as it is written.

In contrast, no public health organization has embraced the deal as written.2 Therefore, the public health groups have abandoned the original premise of the deal, namely that they will go to Congress in partnership with the tobacco industry so as to avoid the likelihood that the tobacco industry will dominate the Congressional decision making process. In order to implement the changes that these organizations have said are necessary, they will need to go to Congress as opponents of the tobacco industry, the very situation that the deal was supposed to avoid. Moreover, President Clinton and many members of Congress have already called for revisions to the deal as written.

While there is a wide belief within the public health community that there is strong public opposition to the tobacco industry, there is no evidence that public health groups can translate this public opinion into a defeat for the tobacco industry in Congress. The tobacco industry remains among the largest sources of campaign contributions to Congress, particularly to the Republican Party, which controls Congress. The industry¹s power was manifest recently when Congress gave (and President Clinton signed) a tax provision granting the industry a $50 billion credit against the costs of the deal based on the fact that the tobacco excise tax (paid by smokers) was increased by 15¢.

1. One wonders if this was ever a realistic expectation. It is hard to imagine the image of John Seffrin (CEO of the American Cancer Society), Dudley Hafner (CEO of the American Heart Association), Geoffrey Bible (CEO of Philip Morris), and Steven Goldstone (CEO of RJ Reynolds) appearing at a witness table together, stating under oath that they all supported any piece of legislation.

2. The American Cancer Society, American Heart Association, and American Medical Association, the three highest profile public health groups that have been supporting the principle of a negotiated settlement with the tobacco industry, have all published extensive critiques of the deal that would require fundamental changes in its structure. The American Lung Association and many tobacco control groups have opposed the deal.

The continued support of some public health groups for the process of a negotiated settlement with the tobacco industry has been based on the assumption that some sort of Congressional action is necessary to advance the public health agenda. This is untrue. Many of the terms of the deal would be better left to percolate through the current system at the state or local level or under existing Federal law without involvement of the Congress. Moreover, if the public health community is to go to Congress as opponents of the tobacco industry, it should be to implement the positive aspects of the deal legislatively independent of the concessions that had been made to the tobacco industry regarding liability and regulatory relief.

The FDA currently has the authority to regulate tobacco products. It is not necessary to pass a law to give them authority. Alternatively, if it is deemed good public policy to do so, this law can be passed independently of the comprehensive deal. It is not a bargaining chip for the tobacco industry to agree to abide by the terms of the law as written. Without the terms of the deal, most of the FDA regulatory provisions can be implemented by the FDA. Should the FDA lose the authority through court challenges this could be remedied through be a minor repair of the enabling act.

OSHA is developing a rule which would restrict secondhand smoke throughout workplaces across the country. The deal is not required for OSHA action.

Mississippi entered into a separate settlement of its litigation against the tobacco companies. Under the terms of this settlement it recovered more of its damages than it would recover under the terms of the deal. It is believed that many of the other states and private litigants could achieve more favorable terms by settling independently with the tobacco companies than by supporting the deal.

Several states (California, Massachusetts, Arizona and Oregon) have large tobacco control efforts. Massachusetts and Minnesota have laws requiring ingredient disclosure.

Even if it were a valid policy gesture to settle the Medicaid lawsuits, there is no reason that other private litigants should have their rights restricted.

The primary effect of the deal on tobacco consumption has been assumed to be through the price increase associated with the passthrough provision. As constructed, this situation essentially taxes smokers to pay for the tobacco industry's legal liability (just as Congress' recent action to give the industry a $50 billion credit against the cost of the deal did). It would be simpler and more just to simply increase the tobacco tax.

Prepared by:
Brion Fox, James Lightwood, Stanton Glantz
University of California Institute for Health Policy Studies
August 20, 1997 DRAFT

The Tobacco Deal: Funding the Settlement

There are three parts to the settlement funding: an initial lump sum Up Front Payment, an annual Base Payment which extends into perpetuity, and an eight year Public Health Trust Fund. The annual payments will be adjusted for inflation using the consumer price index or 3%, whichever is greater. The Up Front Payment is equal to $10 billion with no allocation provided for in the deal is not incorporated into the analysis. This payment is presumably to compensate for past damages. There are also adjustments to annual payments which depend on industry tobacco sales volume. The primary disadvantages with the payment allocation is that it fails to provide enough money to adequately compensate those injured.

The Base Payments are to be divided in the following manner (Table 1): First, is the Civil Liability Fund. This Fund is one third of the Annual Base Payments to be reserved for any individual civil judgments against the tobacco industry. If judgments against the industry exceed the annual fund allotment, then the remainder is paid out of the next annual fund allotment. If the fund is not exhausted each year, a Presidential Commission will determine the use of the funds, which can include public health expenditures, compensation to claimants not otherwise entitled to compensation, or other purposes. Second, other moneys from Base Payment are to be used for public health programs (called the Public Health Funds), which consist of smoking education, smoking cessation programs, community anti-tobacco programs, and replacement funds for lost tobacco company arts and sports sponsorships. Third, is the disposition of the Base Payments. The deal does not specify any use for these funds. Presumably they will be used to offset societal costs of smoking to governmental health programs such as Medicaid and Medicare, and to compensate individuals and entities precluded from suing the industry. Most believe that because the states who sued the industry were among the main negotiators of the deal, that Medicaid programs will have high priority in recovering costs from these unallocated funds.

The civil liability fund is inadequate. According to some estimates as much as $70 billion dollars worth of recoverable damages are incurred by potential private plaintiffs every year. At its maximum the civil liability fund will only provide $5 billion, or 7%, of the total amount recoverable. This figure does not include punitive or other consequential damages nor does it include civil fines. These additions will make the civil liability fund even more inadequate.

The unallocated funds will be inadequate to compensate those plaintiffs whose cases are legislatively settled, including all suits brought on behalf of governmental entities, all class actions, all parens patriae actions, and all nicotine addiction actions. (It is not clear whether class actions will be settled or decertified as classes. Reading the deal literally, the cases would be settled and the plaintiff classes would be entitled to reimbursement from the settled cases fund.) This creates a logjam of plaintiffs seeking reimbursement from an inadequate fund. For example, if we assume that the state governments are the only ones being reimbursed and that all other parties are shut out of the process, including the federal government, territories, cities and counties as well as the private class actions there is insufficient money to reimburse the states for current Medicaid losses. When it is recognized that the amount of money expended by the Federal government on tobacco-related health costs in the Medicare program alone is roughly double that which is expended under the Medicaid program, and that other governmental programs are likely to double that figure again, it is apparent that the money to reimburse plaintiffs is woefully insufficient even before the class actions are considered.

This under-funding is magnified further when it is realized that the wrong inflation adjustment is used to account for the increases in medical expenditures over time. Medical inflation rises at a rate faster than the rate of inflation and is usually measured by a rate known as the medical CPI. If the medical cost inflation continues to grow at the annual rate of the last ten years, less than 80 per cent of the Medicaid can be financed out of the annual payments over the first 25 years of the settlement. Similarly, the amount of damages incurred by the other plaintiffs will be reduced.

A volume adjustment clause changes the payments in proportion with changes in tobacco product sales volume. If the volume adjustment results in decreased payments while industry profits increase, a profit penalty will be triggered. The profit penalty offsets the decrease in payments (that is, makes the decrease in payments smaller) by 25 per cent of the increase in profits. The compensation numbers get worse with future decrease in consumption because the adjustment to damage payments related to volume decreases in cigarette sales is too generous. The damages incurred by the states and individuals, however, are unlikely to drop in a similar fashion. For example, there is a 20-30 year lag in the development of smoking related diseases after smoking initiation. Thus, the tobacco companies would be able to reduce its payments immediately even though health care costs won't drop for twenty years.

Looking specifically at the test case where only Medicaid is reimbursed from the unallocated funds it is clear that the amount of money is insufficient. We do not assume that medical costs increase at the rate of general inflation. We consider two cases. The first is a low cost case in which real Medicaid costs grow only because of increases in enrollment. We assume enrollment growth continues at the average rate of the most recent ten years (omitting 1990-1995 when legislation greatly expanded eligibility. Enrollment growth is assumed to incease by 1.7 per cent per year. The second is a high cost cases which assumes that expenditures also increase at the rate of medical care inflation. This is assumed to continue at the rate of the most recent ten years. During this time medical inflation was 3 per cent per year greater than general inflation. The high cost case results in an annual increase in Medicaid expenditures of a little over 4% above general inflation, for a total nominal increase of about 7% per year. Excluding 1990-1995, nominal Medicaid expenditures have increased at an average rate of about 8% per year over the last ten years.

The problem of fully funding Medicaid costs increases after the first ten years if the medical inflation rate exceeds general inflation significantly because Medicaid costs will increase faster than the inflation adjustment. Assuming that the level of smoking and the fraction of costs due to tobacco does not change, funds will be adequate if medical inflation matches the CPI. For the low cost case, the undiscounted sum of the budgets for years 11 to 25 is $223 billion, for the high cost it is $306 billion. With annual real settlement payments of $15 billion, this totals $225 billion over the same period. So 100% of the budgets can be funded in the low cost case but only 74 per cent in the high cost case. Medicaid costs are by far the largest budgeted items after year ten, and these costs alone exhaust the Base Payments less the Civil Liability Fund starting around year 14 of the settlement in the high cost case, and Medicaid alone will exhaust the total $15 billion annual payment in year 22.

All told, about one third of the Medicaid claims are paid in the first year. This rises gradually to over 100 per cent of the claims in the low cost case, and around 80 per cent in the high cost case by year ten. However, even in the low cost case, excess funding in the later years does not compensate for the initial shortfall (Table 2). The adequacy of the funding of the settlement, assuming current levels of cigarette sales is questionable. The effects of the sales volume adjustment would reduce payments as much 10 to 15 per cent within 10 years and make any shortfalls more severe.

Similarly, if there is a significant market shift to a reduced risk or nicotine free product, which is determined to be not a tobacco product, there would be a decrease in the sale of tobacco products and therefore of funds available under the deal. As a result, the funds available under the deal could drop much more precipitously than the health risks and the costs to the states.

The inadequacy of funds is problematic for two reasons. First, by not fully compensating those injured and preventing those parties from suing in the future, the deal is unjust. Although there is always a risk associated with litigation, and settlements rarely compensate plaintiffs at 100%, the proportion of the damages for which the parties are actually receiving compensation is pennies on the dollar - greatly out of proportion to the litigation risks involved. Second, the failure to fully compensate the governmental agencies will necessitate a continued cost shifting of the damages associated with tobacco related diseases to the tax-payers. The deal will allow the tobacco companies to continue to externalize the true costs of their products and will maintain the market failure and artificial price structure which guarantees their profitability. Effectively, the deal creates a subsidy in perpetuity for the true costs of tobacco products.

The funding inadequacy problem is also not necessary. Because of the relatively inelastic demand for cigarettes, tobacco companies can elevate their profits to as much as $30 billion domestically. If the funds from international sales and companies related to the tobacco companies are made available, the available funding is magnified. Therefore, the shortfalls negotiated in the deal are not a result of industry inability to pay and maintain profitability, but instead represent a giveaway to the tobacco industry.

Prepared by:
Brion Fox, James Lightwood, Stanton Glantz
University of California Institute for Health Policy Studies
August 20, 1997 DRAFT

The Tobacco Deal: Funded Public Health Measures

The Tobacco Deal: Tax Issues

Subparagraph D to Title VI of the deal deems that all of the moneys paid pursuant to the deal will be deemed ordinary and necessary business expenses for the purposes of tax treatment. The present discounted value of the tax deduction over the first 25 years of the settlement is $97.6 billion dollars at a 2.5% real discount rate and 35% tax rate. As a result, taxpayers will absorb 30-40% of the cost of the deal.

All payments by the tobacco industry, including those made "in lieu of" punitive damages (which, in many cases, are not tax deductible), are tax deductible which results in a decrease in incentives to the industry and a cost shifting to American taxpayers. Although there has been much rhetoric that the goal of the deal is to compensate victims and not to penalize the industry, this greatly oversimplifies the issue. The claim that the deal is not intended to penalize the industry is also contrary to the preamble which implies that a fraction of the moneys collected in the deal is to offset the prevention of punitive damages for cases involving past conduct. Yet under many circumstances punitive damages, as with fines and penalties, are not tax deductible. Thus, this makes clear the artifice of "resolving" past punitive damages.

Other than as a necessary concession to the industry for the sake of getting its approval for the deal, there appears to be no public health benefit to this provision. The disadvantage is that this provision substantially changes the financial impact of the settlement for the industry. Tax deductibility will reduce the financial pressures on the industry and consumers. For example, the lookback provisions are based upon a disgorgement of the profits of the addicted youth smokers. Because the payments would be tax deductible, this would allow the industry to, in effect, keep some of the profit it was supposed to disgorge.

In addition, the deal envisions benefits as a result of the "passthrough" of industry costs to the consumer, to increase the price of tobacco products and decrease demand. This demand decrease will be blunted because of the costs incurred by the industry will be reduced by the tax deductibility. The before tax cost per pack is between 36 and 59 cents (an 18-30% price increase) over the first ten years, the tax deduction reduces this to between 23 and 39 cents (an 11-19% price increase). Alternatively, if the industry passes through the entire before tax cost of the deal, the tobacco companies will have a profit windfall.

This provision is sufficiently broad that an argument could be made that any fines resulting from the enforcement of any violation of the regulations or laws would also be deemed a payment under this deal and therefore tax deductible. This argument is even more persuasive when the deal establishes special treatment for the tobacco industry, such as the $10 million fine for violating the FDA disclosure requirements (Title III.A). Furthermore, this provision could weaken the enforcement of other state and federal laws by allowing the tobacco industry to deduct the cost of any civil fine levied against it.

This provision also gives rise to large collateral effects. First, a deal which implicates the tax system could restrict future efforts to increase the tax on tobacco products. (Indeed, the recent decision by Congress to give the tobacco industry a "credit" against the cost of the deal equal to the increase in the cigarette excise tax shows that this tradeoff already has been made.) Similarly, a settlement fund would not provide the flexibility to account for future understanding of the economic toll tobacco has on society. As a result, restricting future economic flexibility by entering into a global settlement would limit our ability in the future to apply economic incentives to modify the tobacco companies' behavior. Second, all of the money paid by the tobacco industry is accounted for in payouts, this deal could be internally revenue neutral. The industry will, however, be able to deduct the payments, so that there will be a net loss in general tax revenues. This shortfall, which could rise to as much as 40% of the annual payments (i.e. between $3.4 billion and $6 billion annually) is approximately twice the amount of the Public Health Funds. This money will need to be made up by either reducing spending for other public programs or by raising revenues on other taxpayers. This cost shifting is another way the industry will be able to externalize the costs related to its product to others.

It would be cheaper for the Congress to simply appropriate funds for the public health programs from general revenues or a dedicated tobacco tax.

Prepared by:
Brion Fox, James Lightwood, Stanton Glantz
University of California Institute for Health Policy Studies
August 20, 1997 DRAFT

The Tobacco Deal: Effects of the Passthrough Provision

The passthrough provision says that legislation will specify that the annual payments will be "reflected" in the price charged for tobacco products. It does not say whether costs imposed by other provisions of the settlement can be included in the passthrough, or whether future price changes are going to be tightly linked to the annual total payments. It does not say whether before or after tax costs are relevant. There are two main effects of the passthrough. The first is that the resulting price increases will reduce consumption. Most analyses of the settlement assume that the passthrough price increases are one of the principle means of reducing youth smoking. The second effect is on industry pricing structure. Presumably the passthrough will result in some mandated price increases. It would be redundant for the settlement to stipulate that any net costs of the settlement to the industry will be passed on to consumers. Elementary economics indicates the industry would attempt to do this anyway. If the before tax annual payments are mandated to be passed through to the consumers, this results in a mandated price increase. This will remove the problem of how the individual firms in an oligopolistic industry should change their pricing strategy to account for the costs of the settlement. This may reinforce the current market and pricing structure and limit competition.

This brief will focus on the demand effects of the passthrough price increases. The effect on adult consumption will be relatively straightforward. Almost all adult smokers are addicted, so the relatively modest price increases alone will not change the prevalence of smoking. There is general agreement that the adult price elasticity of demand is about 0.4. This analyses assumes that a one per cent change in the price of cigarettes will change adult consumption by 0.4 per cent, keeping prevalence constant.

Depending on the assumptions on what costs are subject to a pass-through, the price per pack of cigarettes will increase from between 15 to 25 per cent on average over the first 10 years of the settlement. This will reduce volume of adult sales by an average of 6 to 10 per cent. Revenue will increase as result of this by 4 to 6 per cent on average. It must be remembered, however, that because of the volume adjustment provisions the tobacco companies will reduce their total payments under the deal with this reduction in consumption. This reduction in payments could range as high as 10%, depending on the cost conditions of the industry and the application of the volume adjustment provisions.

The effects of the pass-through provision on youth consumption and uptake is controversial because estimates of youth price elasticity of demand are very uncertain. Some studies indicate that it is one or even higher, others that it is close to zero. The measurement is difficult because youth smoking is illegal, youth themselves purchase only one half to two-thirds of the tobacco they consume, and new smokers often consume sporadically. Secondly, how the youth elasticity of demand is relevant to the target reductions of the settlement is unclear. The target reductions are in terms of prevalence of daily smoking. This is not directly comparable to consumption. Apparently it is assumed that a given price increase will decrease consumption, the decreased consumption will result in decreased uptake of daily smoking. This analysis will look at the case of a 0.6 price elasticity, which is applied to both youth consumption and youth uptake. So a one per cent increase in price will decrease consumption by 0.6 per cent, and also decrease the rate of new youth daily smokers by 0.6 per cent. Then the passthrough price increases can have a significant impact on youth consumption, and significantly reduce the surcharges paid under the lookback provision. (The lower pass-through price increase would be sufficient to meet one third of the initial 30% youth daily smoking reduction and about 15% of the final 60% reduction. The higher increase would meet about half of the initial 30% reduction, and about a third of the final 60% target.) Finally, it is unclear what effect, if any, price increases have on the uptake of youth smoking. In short, the price elasticity many only reflect total numbers of cigarettes smoked by youth and not the number of youth smokers.

Prepared by:
Brion Fox, James Lightwood, Stanton Glantz
University of California Institute for Health Policy Studies
August 20, 1997 DRAFT

The Tobacco Deal: The Lookback Provision

The lookback provision attempts to deny tobacco companies any incentive to sell to underage consumers (youth). It sets target reduction levels for tobacco consumption by youth aged 13 to 17. For cigarettes, the initial target reduction is 30% in year 5 and 6 after the beginning of the settlement, 40% in years 7 to 9, and 60% thereafter. The reductions for smokeless tobacco are slightly smaller. The idea of the provision is to remove the incentive to sell to youth by confiscating the value of the lifetime profit stream of any tobacco product sold to youth above the target reduction. The manufacturer is denied not only the profits from current sales, but any that will occur on average in the future. If the incentive works as planned, tobacco companies would avoid selling product to youth above the targeted reduction, because all prospective profits from selling to anyone in that portion of the market will be lost forever.

Current sales to youth is indexed by the prevalence of daily youth smoking measured using the weighted average of age specific prevalence of daily smoking for ages 13 to 17. The base year average is calculated using data up to 1996. The average daily smoking prevalence is calculated in the relevant settlement year, and the two are compared to determine if the target reduction is met. The industry will pay a surcharge of $80 million for each percentage point that the current prevalence exceeds the targeted reduction set for that year. ($80 million is the estimated value of the lifetime profit stream for one percentage point of the annual cohort of new youth smokers.) There is a cap of $2 billion on the surcharge for any year. There is also a rebate provision. Each firm can recover up to 75% of its portion of the surcharge if it can show it acted in compliance with the deal, had taken "all reasonable" measures to reach the target, or deserved a rebate because of "other relevant evidence."

The lookback provision is unlikely to be a significant deterrent to the tobacco industry recruiting youth. The cost of complete noncompliance will be less than 10 per pack. It will be trivial if firms receive a large portion of the 75% abatement for good faith effort. The provision uses inappropriate measures of youth consumption which underestimate actual youth consumption, will probably overestimate reductions in consumption, are liable to manipulation by the tobacco industry.

The Level of Surcharge is Too Low. If youth sales do not decline at all and current sales volume is maintained, the $2 billion cap will limit the impact of the provision. Since the industry cannot track the sales of individual cigarettes, they will amortize the cost over all current sales. Then noncompliance can be measured as cost per pack. Current sales are 23.7 billion packs per year. The cost of no change in youth daily smoking would only be 8.5 per pack before tax and 5.5 after tax. If firms receive the full 75% "good faith" rebate the costs will be reduced to 2.1 before tax, and 1.4 after tax. These costs could easily be absorbed by the tobacco companies as a cost of doing business. If youth demand elasticity is 0.6, then the total sales volume will eventually decline and the cost per pack will eventually increase slightly until the before tax cost is 10 per pack.

The Surcharge Level is Frozen. Another potential problem is that the surcharge is fixed for perpetuity. Adjustments are only made for the general level of inflation and changes in the size of the 13 to 17 year old cohort. However, reasonable variations in assumptions can alter the actual value of a new youth smoker by up to 30%. Changing economic conditions, industry marketing, distribution and production costs may change the value of lifetime profits substantially. An increase in the value of the profit stream of a new smoker may not be reflected in any adjustments in the surcharge, and the incentive effect of the lookback will be weakened. An alternative surcharge could be based on a proportion of total revenue from youth sales. This could be adjusted using a moving average of historical financial ratios, and would be more reliable in the long run.

Rebate for Good Behavior. If companies receive a significant portion of the 75% abatement for good faith compliance, then the lookback provision loses all force since the cost of noncompliance becomes trivial. The surcharge is paid out of a common fund, and each firm pays into the fund according to its share of the market. Each firm applies for the rebate individually. The individual companies will have more incentive to attempt to get a rebate than reduce youth smoking. Brand preference of the youth market can be observed, so each firm could be penalized for its individual sales to youth. It is also not clear how the industry's "good faith compliance" could be assessed, particularly since the industry is well practiced in developing "anti-smoking" programs that subtly promote smoking.

Daily Smoking Prevalence is the Wrong Measure. The settlement language indicates that the goal is to reduce youth smoking. However, the measure used is the prevalence of daily smoking, and this is only a portion of youth consumption. By the age of eighteen, only 75% of adult smokers have started daily smoking, but around 90% have already initiated some smoking. The gap between daily smoking and first use is larger for 13 to 16 year olds. Therefore, this measure misses 25% of youth smoking that leads to an adult habit. In addition, the measured daily smoking prevalence may fall while less intense youth consumption remains about the same, so changes in daily smoking will overestimate the actual reduction. Almost as many frequent smokers have symptoms of addiction as daily smokers. If the industry can keep frequent smoking rates relatively high while delaying daily smoking for just a year or two, they will evade the surcharges completely, with little change in the overall number of people who initiate smoking as youth and go on to become addicted smokers.

Prepared by:
Brion Fox, James Lightwood, Stanton Glantz
University of California Institute for Health Policy Studies
August 20, 1997 DRAFT

The Tobacco Deal: Elimination of Liability for the Tobacco Industry

The Tobacco Deal: Added Protections Against Most Civil Liability for the Tobacco Industry

The tobacco industry desired complete protection from all lawsuits; public health advocates wished to protect the right of individuals to sue the tobacco industry. The deal tries to tread a middle-ground in which limitations are placed on the right to sue, but plaintiffs would still retain the right to sue the industry. The deal also provides predictability for the tobacco industry and plaintiffs by requiring a fund to be set aside from the industry payments to pay for damages in future cases. The size of the fund, begins at $2 billion in year one and rises to $5 billion in year nine. In addition, Subparagraph B to Title VIII of the deal provides a series of restrictions on lawsuits for the recovery of damages due to the past conduct of the tobacco companies, including: