Tobacco Quota Buyout Proposals in the 108th Congress
Released: 2004-11-12T00:00:00

Design and Impact of Marketing Quotas

The federal tobacco support program has worked through a combination of commodity pricesupport loans and marketing quotas. Price support loans guaranteed farmers minimum set prices fortobacco (the 2004 loan prices for the two principal types, flue-cured and burley, are $1.69 and$1.873/lb. respectively). These prices were mandated by a formula in the law. (2) Marketing quotas,which specified the maximum quantity of tobacco that could be sold, were assigned by the U.S.Department of Agriculture (USDA) each year to farms that had a history of tobacco production. Thepurpose of quotas was to limit supplies in order to force buyers to pay the loan prices or more (the2004 national basic quotas for flue-cured and burley were 471.3 million pounds and 302.1 millionpounds respectively). Together, the combination of guaranteed minimum prices and managed supplywas designed to create a stable market for farmers and tobacco product manufacturers. Also, thepattern of assigning quotas to farmland with a history of quotas confined production to the traditionalgrowing regions and farms. This system of support had operated since the 1930s and was authorizedin permanent law (7 U.S.C. 1311 et seq. ). (See CRS Report 95-129 , Tobacco Price Support: AnOverview of the Program .)

The economic stability that was desired and expected from the tobacco support program was not achieved. First, the support prices for U.S. tobacco, as mandated by law, were higher than pricesfor competing tobacco in world markets. As a consequence, U.S. farmers steadily lost both exportand domestic markets to foreign producers. The declines are pictured in Figures 1 and 2 (based onUSDA data). Second, tobacco support prices were higher than the costs of production. This createdeconomic profits that were capitalized into the marketing quota lease rates and land prices. So,marketing quotas became an asset that added substantial value to farmland, and became a source ofrental income for owners choosing not to grow tobacco themselves. Conversely, rent on quotasbecame a sizable expense for active producers renting quota in an attempt to expand or evenmaintain output in the face of shrinking markets.

As with other crops, the number of active tobacco producers has declined over time and production has become concentrated onto fewer but larger farms. In 1982 there were about 180,000farms producing tobacco. By 2002, just 20 years later, the number of active producers was about57,000, a 68% decline. (3) Most of these active tobaccofarmers owned some marketing quotathemselves and also rented quota from about 359,000 other absentee quota owners. (4) In themid-1990s, burley producers owned about 44% of their effective quota and leased the remaining56% at an average cost of $0.33/lb. Lease and transfer of quota had been prohibited for flue-curedtobacco since 1986. Instead, active flue-cured producers rent farmland that had quota attached toit, thereby obtaining the tobacco production rights. In the mid-1990s, flue-cured producers ownedabout 33% of their effective quota and rented the remaining 67% at an average cost of $0.37/lb. (5) Newer USDA cost of production data put the average rental cost of quota in 2003 at $0.63/lb. forflue-cured and $0.57/lb. for burley. (6)

One reason for increased consolidation and higher quota rental fees was the sharp decline in quota levels after 1997, as shown in Figure 3 and Table 1. The decline was due to the reversal ofpreviously rapidly growing export markets for U.S.-manufactured cigarettes. The basic quotas forflue-cured and burley tobacco declined 52% and 57% respectively after 1997. Farmers needed tomarket enough tobacco to maintain their revenue and to economically utilize their barns, equipment,and labor. This required renting more quota. Along with these economic pressures to consolidate,several sources of financial aid made it possible for farmers to pay higher rental rates for quota.

First, in conjunction with Phase II of the 1998 Master Settlement Agreement, cigarette manufacturers agreed to distribute $5.15 billion to tobacco producers and quota owners over a12-year period. (7) Second, to help offset decreasesin marketing quotas, Congress acted to provideassistance. Four separate emergency assistance laws ( P.L. 106-78 , P.L. 106-224 , P.L. 107-25 , P.L.108-7 ) included what the industry called direct "tobacco loss payments (TLPs)" totaling $860million. Third, Congress directed the Commodity Credit Corporation (CCC) to take ownership ofall 1999 tobacco pledged as price support loan collateral and to assume all financial losses ( P.L.106-387 , as amended). CCC finally completed disposal of this inventory in December 2003 byburying it in landfills. According to CCC data, the total cost of acquisition, interest on principal,storage, and disposal was about $625 million.

These three sources of financial assistance, rather than income from the sale of tobacco, are the primary reason active producers were able to pay higher rental rates to absentee quota owners as theybid against each other for their share of a declining national tobacco quota. (See CRS Report RS20802 , Tobacco Farmer Assistance .)

Why a Quota Buyout

Make Tobacco Production Profitable for Active Producers

Active tobacco producers were being hurt financially both by declining marketing quotas, which reduced their sales revenue, and higher quota rental rates, which raised their production costs. Farmers felt there was little they could do to increase the demand for tobacco, especially since it wasfederal policy to discourage consumption of tobacco products. However, the elimination of quotarents, through a buyout of marketing quotas, could reduce the costs of production substantially forfarmers leasing substantial amounts of quota. At the same time, active producers might continue toreceive the price benefit of a continuing support program.

Advocates of this policy approach ( H.R. 245 , Fletcher; H.R. 986 , Goode) proposed to give marketing licenses (or permits specifying quantity limits) to activeproducers, just as with marketing quotas. However, the licenses would be issued only to activeproducers and all forms of rent would be prohibited. This restriction would prevent the licenses fromacquiring any exchangeable value. The initial recipients of the licenses would be current tobaccoproducers wanting to continue as active growers.

Active producers, not just absentee landlords, also would have received quota buyout payments under all of the legislative proposals that were offered. This provided the farmers who wanted toquit growing tobacco with sizable benefits. The farmers who remained active producers under thelicense scheme would receive a windfall from their buyout payment since they would have sufferedno losses (they would continue to get the extra income created by licenses and price support).

This framework for a quota buyout, of licensed future production and continued price support, was developed by the President's Commission on Improving Economic Opportunity in CommunitiesDependent on Tobacco Production While Protecting Public Health. (8) This commission includedadvocates for tobacco farmers, anti-smoking and health organizations, and rural communitydevelopment proponents. H.R. 245 and H.R. 986 largely were modeledon the Commission's recommendations.

Make U.S. Tobacco Price Competitive

There was little disagreement that U.S. tobacco could become substantially more competitive in the domestic as well as export markets if prices declined by the amount paid in quota rents. Sucha price reduction would happen if tobacco support program loan rates were reduced substantially oreliminated. The quota rent paid to absentee landlords would vanish. The decline in revenue fromlower tobacco prices largely would be offset by the elimination of quota rent payments, leaving theproducer in about the same net revenue situation. In fact, a North Carolina agricultural economistonce estimated that in the absence of the price support program, U.S. tobacco production couldincrease by possibly 50%. (9)

At the same time, the economic analysis noted there would be substantial adjustment costs associated with dropping support prices to free market levels or eliminating the program. Mostimmediately, the value in quotas would be wiped out. This would eliminate the rental income ofabsentee quota owners. Furthermore, all of the farmland with quota, whether owned by absenteelandlords or active producers, would drop in value. However, the economic adjustments associatedwith a reduction in tobacco prices could be minimized, if not eliminated, by compensating quotaowners for lost asset values.

This "free market" policy approach ( H.R. 140 , McIntyre; H.R. 4033 , Jenkins) was most appealing to active producers who wanted to see an expansion of their tobaccoenterprises. These producers likely had a sizable investment in barns and machinery, and probablyrented a large proportion of their annual effective marketing quota. This option was equallyappealing to farmers intending to exit from tobacco production. The farmers most disadvantagedwould have been small to medium sized operations and those that were inefficient because of highcosts or low yields who wanted to continue growing tobacco.

As compared to a system of licensed producers, this "free market" option would result in fewer but larger farms because of economies of size. Also, production likely would move within each ofthe tobacco states to the geographic locations with the most suitable soils and climate for economicalproduction. The very fact that production could increase substantially made the "free market" optionunappealing to some anti-smoking and health advocates.

Somewhere between the Commission concept of production licenses with continued price support and the free market proposal, S. 1490 (McConnell) proposed to eliminatequotas and price support but allocate a national crop acreage base among active producers. Shouldsupplies become excessive, an acreage limitation program would require reductions in planting. Thisacreage reduction concept was used in conjunction with the support programs for grains and cottonbefore being eliminated by the 1996 farm bill.

H.R. 3160 was introduced as a bipartisan consensus proposal by Fletcher, McIntyre, and Goode. This bill was similar to the McConnell bill in most respects. One majorvariation was a different basis for calculating the amount of money paid to quota owners and activeproducers. Under S. 1490 , payments would have totaled about $11 billion, comparedto about $15 billion under H.R. 3160. However, S. 1490 included somecommunity development assistance that was not present in H.R. 3160.

Paying for a Quota Buyout

The value of tobacco marketing quota depended on several factors, including expectations aboutthe future. Quota owners knew exactly how much rent they earned from active producers. Whatthey did not know was how long the tobacco program would continue to operate, or the size ofnational marketing quotas in future years.

Survey data from Kentucky revealed that the average sale price of marketing quotas was $2.58/lb. in 2001 (when lease rates averaged $0.62/lb.), and $2.08/lb. in 2000 (when lease ratesaveraged $0.58/lb.), and $1.75 in 1999 (when lease rates averaged $0.40/lb.). (10) One would expectto get much higher sale prices with annual rents of these magnitudes. These sale prices comparedto lease rates implied a time horizon of about five years, based upon a 5% interest rate. In otherwords, buyers were discounting the purchase price of quota relative to annual rent in anticipation offuture quota reductions or elimination of the program.

Most quota buyout bills proposed to pay owners $8/lb. This payment was equal to the present value of annual rental income of $0.40/lb. in perpetuity at an interest rate of 5%. The buyout priceof $8/lb. was a much higher price than sellers of quota were getting in the marketplace. Also, thebuyout offered to pay active producers an additional $4/lb. for all production on the farm. Thepayment to producers typically was described as a "transition payment."

A buyout program that payed $8/lb. to quota owners plus $4/lb. to active producers would pay $12/lb. for each pound of quota that qualifies for the program. Depending on the crop years usedto calculate payments and some assumptions about participation levels, a rough and unofficialestimate of the buyout and transition payments ranged from about $11 to $19 billion. How muchwould a typical tobacco farmer receive?

The average North Carolina tobacco farmer harvested about 21 acres in 2002, producing about 45,000 pounds. Buying out this average North Carolina producer, who owned 33%of the quota and rented 67%, would cost $298,800 ($118,800 in quota payments and $180,000 intransition payments).

In South Carolina, the average tobacco farmer harvested 35 acres in 2002,bringing in about 66,000 pounds. Buying out this average South Carolina producer, who owned 33%of the quota and rented 67%, would cost $438,240 ($174,240 in quota payments and $264,000 intransition payments).

Kentucky tobacco farms averaged 4 acres, producing about 7,500 pounds in2002. Buying out this average Kentucky producer, who owned 44% of the quota and rents 56%,would cost $56,400 ($26,400 in quota payments and $30,000 in transitionpayments).

The President's Commission recommended that federal excise taxes on cigarettes and other tobacco products serve as the source of revenue for the proposed buyout (estimated at $0.17 per packon cigarettes for five years). However, all of the legislative proposals described in this reportincluded an assessment on manufacturers and importers of tobacco products, or the use of U.S.Treasury funds, rather than an increase in excise taxes on cigarettes.

Certainly, manufacturers could benefit from a buyout if the support price for tobacco were reduced. One tobacco manufacturer, Philip Morris, stated its willingness to help pay for a tobaccobuyout program. If U.S. manufacturers could save $0.60/lb. on their 2004 purchase intentions ofabout 450 million pounds, the savings would amount to $270 million. Additional savings wouldaccrue if a drop in the price of U.S. tobacco pushed down the price of foreign supplies. Additionally,overseas operations also would save on the lower prices for both US. leaf and foreign leaf. Onetobacco analyst estimated it would take about 14 years for manufacturers to recover the cost of a $15billion quota buyout program. (11) Philip Morris (12) had coupled its offer to participate in a buyoutwitha proposal for FDA regulation of tobacco products. Health groups also advocated FDA regulation. (13) Philip Morris was the only major manufacturer known to support FDA regulation or a quota buyout. (See identical bills H.R. 4433 and S. 2461 ).

Doubts about whether strong divisions in Congress over proposed FDA regulatory authority could be overcome encouraged sponsors of H.R. 4033 (Jenkins; March 25, 2004) toseek about $9.6 billion in funding out of the U.S. Treasury, rather than from assessments onmanufacturers. The bill was cosponsored by most supporters of the so-called House consensus bill. This bill provided $1/lb. lower quota buyout and transition payment rates ($7/lb. and $3/lb.respectively). In contrast to other proposals, Phase II payments to growers would continue andprovide an additional benefit of about $2.6 billion. The Jenkins bill also was included as Title VIIin the House-passed H.R. 4520 , a tax bill called the American Jobs Creation Act of2004.

Following the lead of the House in using the tax bill as the legislative vehicle for the tobacco quota buyout, the Senate retrieved its previously adopted S. 1637 , the Jumpstart OurBusiness Strength (JOBS) Act, and amended it by attaching the slightly modified McConnell buyoutbill ( S. 1490 ) and the DeWine-Kennedy FDA tobacco product regulation authority( S. 2461 ).

Conferees took up the tax legislation (the differing House and Senate versions of H.R. 4520 ) on October 5, 2004. The Chairman's mark for the conference committeeincluded tobacco quota buyout provisions (Title VI). The tobacco provisions largely reflected theHouse version, but funded the buyout with an assessment on manufacturers and importers of tobaccoproducts rather than from the U.S. Treasury. Like the House version of H.R. 4520, theChairman's mark contained no authority for FDA regulation of tobacco products.

The Chairman's mark, like both the House and Senate proposals, eliminated tobacco marketing quotas, acreage allotments, and nonrecourse loan price support authority. It contained no provisionsto control how much tobacco might be grown in the future, who could produce it, or where it couldbe produced. As compensation, the roughly 416,000 current quota owners would be paid $7 perpound (in 10 equal annual installments) on their 2002 basic marketing quotas (totaling about $6.7billion). Similarly, the roughly 57,000 active producers would be paid $3 per pound on their 2002effective marketing quotas (totaling about $2.9 billion). Nearly all of the active producers also werequota owners, and they would get both payments on that portion of the effective quota they alsoowned.

Total expenditures were limited to a maximum of $10.140 billion. The expenditures would be made over a 10-year period from FY2005 through FY2014. If domestic cigarette consumptionremained at the current level of about 19.75 billion packs, the cost to manufactures would be about5ï¿½ per pack each year for 10 years. Remaining Phase II payments of about $2.6 billion frommanufacturers to farmers (adopted in conjunction with the Master Settlement Agreement betweenmajor manufacturers and states) would terminate.

Table 1. National Quota Levels and Actual Marketings of Flue-Cured and Burley Tobacco, 1990-2004

Source: Data are from Economic Research Service, Tobacco Outlook , Sep. 2004,and theFarm Service Agency.

Table 2. Comparison of Tobacco Quota BuyoutProposals Sent to Conference in the 108th Congress

Table 3. Tobacco Quota Holder and Producer Transition Payment Estimates, by State

Source: Based on basic and effective quota data from USDA's, Farm ServiceAgency.

Table 4. Summary of the Tobacco Quota Buyout Law

For More Information

CRS Products

CRS Report RS21642(pdf) , Comparing Quota Buyout Payments for Peanuts and Tobacco .

CRS Report RL32619 , FDA Regulation of Tobacco Products: A Policy and Legal Analysis.

CRS Report RS20802 , Tobacco Farmer Assistance .

CRS Report 95-129 , Tobacco Price Support: An Overview of the Program .

CRS Report RL31528, Tobacco Quota Buyout Proposals in the 107th Congress .

CRS Report RL30947(pdf) , U.S. Tobacco Production, Consumption, and Export Trends .

Other Resources

Three university-based sites with a focus upon tobacco policy issues are as follows:

NC State University, Tobacco Economics http://www.ces.ncsu.edu/depts/agecon/tobacco_econ/

University of Kentucky, Tobacco Economics Online http://www.uky.edu/Agriculture/TobaccoEcon/

University of Tennessee, Tobacco Policy and Economics http://www.agpolicy.org/tobacco.html

The Economic Research Service maintains a Tobacco Briefing Room http://www.ers.usda.gov/Briefing/Tobacco/ .

The National Agricultural Statistics Service (NASS) keeps track of production and publishes data by commodity http://www.usda.gov/nass/pubs/estindx1.htm .

Farm Service Agency (FSA) administers tobacco quota and price support loan programs and publishes fact sheets describing program operations along with activitydetails http://www.fsa.usda.gov/pas/publications/facts/pubfacts.htm .

The Foreign Agriculture Service keeps track of tobacco exports and imports by the United States and other countries http://www.fas.usda.gov/currwmt.html .