Implications of Elimination of the US Flue-Cured Tobacco Program:
Prepared for the United States Senate Committee on Agriculture, Nutrition, and Forestry
September 18, 1997
A. Blake Brown, Associate Professor
Department of Agricultural and Resource Economics
North Carolina State University
Summary
Flue-cured tobacco is currently a highly profitable and stable commodity
for farmers in the five state flue-cured producing region. If the tobacco
program is eliminated, the price of US flue-cured tobacco will decline
to $1.25 to $1.35 per pound and production will expand to around 1.5 billion
pounds. A primary reason for the current high return from tobacco under
the tobacco program is the return to quota. Quota is owned by both active
tobacco growers and non-growers, such as retired tobacco farmers. With
elimination of the tobacco program, this income from quota will be transferred
from quota owners to cigarette manufacturers and smokers. Participants
in the tobacco program will experience substantial adjustment costs as
a result of the program being eliminated. Besides the loss of income from
quota, the elimination of county barriers to production will lead to declines
in tobacco production and farm revenues in some regions, such as Virginia
and the piedmont of North Carolina. Other regions such as eastern North
Carolina, south Georgia and northern Florida will experience large increases
in production of tobacco. Some regions will experience sufficient production
expansion so that gross revenues from tobacco production also increase.
Price risk in growing tobacco will increase without a program. The decline
of tobacco production in some regions in combination with the current trends
in production technology will result in a net exit of tobacco farms despite
an overall expansion in production and sales.
The helpful comments and careful reviews of Professors Walter N. Thurman and Michael K. Wohlgenant are gratefully acknowleged. Any errors are the sole responsibility of the author. Implications of Elimination of the US Flue-Cured Tobacco Program
Tobacco production is an economically important crop in the Southeastern United States with gross farm revenues in recent years of $2.8 to $3.0 billion (USDA). The U.S. produces two major types of cigarette tobacco; flue-cured and burley. Gross revenues from sales of U.S. flue-cured tobacco have ranged from $1.3 to over $1.5 billion in recent years. Flue-cured tobacco is produced in five southeastern states with North Carolina being the largest producer. This paper addresses some of the farm level effects of the current government program for flue-cured tobacco and the potential effects of elimination of this program.
The Flue-Cured Tobacco Program
Like other "New Deal" farm programs set up under the Roosevelt administration, the purpose of the tobacco program was to both raise and stabilize prices received by farmers. Also like other "New Deal" farm programs, the method used to achieve this purpose was supply restriction at the farm production level. Perhaps the major difference between the tobacco program and other "New Deal" farm programs is that it was, and is, effective in both raising and stabilizing the farm price of tobacco. Supply restriction programs for other commodities have been eliminated for a number of reasons. First, these programs for other farm commodities were often ineffective in raising or stabilizing farm prices. Second, and partly as a result of this ineffectiveness, government expenditures for these programs were substantial. An increasingly urban congress was less inclined to support government expenditures on farm programs. Third, besides requiring substantial government expenditures, these programs transferred income from consumers to farmers in the form of higher food prices. Again, an increasingly urban congress was less inclined to permit this transfer. Finally, economists often pointed out the welfare losses associated with such programs due to restriction of production and higher commodity prices.
The reasons for the failure of farm programs similar to the tobacco program are important to note in understanding the survival of the tobacco program. While other supply restriction programs failed, often due to the existence of close substitutes in the world market, US flue-cured tobacco growers have enjoyed unprecedented pricing power in the world tobacco market due to a persistent quality differential between US tobacco and foreign tobaccos. While this quality differential has declined in recent years (and subsequently the market power of US tobacco), it continues to be sufficient for supply restrictions via the marketing quotas to maintain US tobacco prices above free-market levels. Unlike some other commodities, this quality differential has allowed the tobacco program to operate effectively for most of its life without import restrictions. While the 1994 domestic content law was a severe import restriction, the tariff rate quota under which the program currently operates is not currently binding. It should be noted that while the tobacco program does effectively stabilize price, price is stabilized at the expense of changing annually the quantity of tobacco that US farmers are allowed to sell. Also, as underscored by the political uncertainties currently facing the tobacco program, government intervention sometimes introduces additional uncertainty to markets.
Income transfers and welfare effects
Since the tobacco program is a no-net-cost program, government expenditures are only in the form of the cost of USDA-FSA in administering the program. It is true that the tobacco program transfers income from purchasers of US tobacco to tobacco quota owners in the form of higher prices than will occur in an unregulated market environment. If one believes the studies that show the cigarette manufacturing industry to be oligopolistic (Appelbaum 1982; and Porter), then this income (economic rent) is, at least partially, transferred from the profits of cigarette manufacturers to tobacco farmers. Part of the income transfer (all if one believes the studies that show the existence of perfect competition in cigarette manufacturing; Sumner, 1987, Sullivan, 1985; Ashenfelter and Sullivan, 1987) is from cigarette smokers. Since about 45 percent of US flue-cured tobacco is exported in unmanufactured form and about 35 percent of cigarettes manufactured in the US are exported, most of the income transfer is from domestic and foreign cigarette manufacturers and foreign smokers. This has long been the case. Economists have shown that the transfer of income from consumers abroad more than offsets the domestic efficiency losses due to the program (Johnson and Norton).
The efficiency losses associated with the tobacco program are like those associated with any program that restricts supply and elevates price. Besides the transfer of income from purchasers of tobacco products, there is a loss of social welfare. However some groups opposed to smoking do not view this as a welfare loss, but as a desirable additional tax on cigarette manufacturers and smokers. It should be noted that the tobacco program "taxes" both foreign and US smokers and cigarette manufacturers.
As a result, some health advocates now support maintaining the tobacco program (Southern Tobacco Communities Roundtable).
On the other hand, leaf merchants are negatively affected by the supply restrictions since the amount of US tobacco available for purchase by merchants for cigarette manufacturers is limited. Although US tobacco is a very small share of the cost of producing cigarettes, cigarette manufacturers incur higher costs as a result of the higher prices they pay under the tobacco program. While the effect is very small, some of the additional cost of US tobacco may be passed to cigarette smokers.
Other effects
While the tobacco program successfully transfers income from tobacco purchasers to farmers, it also provides an umbrella under which intense international competition to US tobacco has developed. In the case of flue-cured tobacco, Brazil in particular has benefited from the restricted supply and higher prices of US flue-cured tobacco. Although Brazilian tobacco producers have not succeeded in developing a perfect substitute for US flue-cured tobacco, increased Brazilian production and improved quality has eroded the market power of US flue-cured tobacco producers. The combination of growing international competition, declining tobacco content per cigarette, and declining US cigarette consumption was primary factors in a decline in quota and a reduction in support price of US flue-cured tobacco in the mid-1980s. Lower price and growing cigarette exports have led to a recovery of US flue-cured tobacco use and quota in more recent years. Current Economic Impact of Tobacco Farming
Farm sales of tobacco are about $1 billion in North Carolina and make up around 15 percent of all cash farm receipts. In the southeast, farm sales of tobacco are around $3 billion. US flue-cured tobacco remains the most stable and most profitable crop for the vast majority of farmers in the five state flue-cured producing region. If a farmer owns his quota, his return to quota per acre can range from $700 to over $1100. Also, because tobacco is a management intensive crop, the per acre return to management and risk (which is a separate and different component of net returns from return to quota) is much higher than most field crops. While the return to management and risk varies considerably from farm to farm, the per acre return to a farmer's management and risk can average $300 or more (USDA-ERS). Cotton, the next most profitable field crop for many farmers, often averages no more than $50 per acre return to management and risk. (USDA-ERS budgets often show cotton, corn, and soybeans with a negative return per acre.) Some specialty crops have the potential to earn as high a net return as tobacco, but the markets are usually limited and their production involves substantial production and price risk. The high net return earned on tobacco is one of the main reasons that North Carolina is ranked second in the United States in terms of net farm income. Farm Level Effect of an Increase in Cigarette Prices
The effects of an increase in cigarette prices, whether due to a tobacco settlement, judgements from lawsuits, or increased cigarette taxes, will affect the market for US flue-cured tobacco. For example, an increase in the price of cigarettes of 66 cents per pack has the potential to decrease the annual use of flue-cured tobacco up to 103 million pounds under the current tobacco program. This could result in up to a $180 million reduction in annual farm revenues from flue-cured tobacco.
Effects of Elimination of the Tobacco Program
With this description of the tobacco program as a foundation, the effects of eliminating the tobacco program can now be explored. Numerous adjustments at the farm level will occur if the program is eliminated. These adjustments involve a decline in market price, expansion of production, regional changes in production levels, a net exit of tobacco farms, increased incentives for innovation and investment in new technologies, increased price risk to farmers, and a transfer of income from quota from farmers to cigarette manufacturers and smokers.
Changes in price and level of tobacco production
Not accounting for any increase in cigarette prices, research (Brown, Thurman, and Dugan) indicates that in the short run after program elimination the average market price for flue-cured tobacco will decline to approximately $1.55 per pound. US flue-cured production will likely expand by about 30 percent to around 1.2 billion pounds in this immediate period after program elimination. In the short term, production is likely to expand in all the current flue-cured producing regions. In the short run, production could expand in Virginia by 8 percent or more. Flue-cured production in North Carolina will expand by at least 30 percent in this initial period. Within North Carolina, production will expand by 13 percent or more in the piedmont, by 46 percent or more in eastern North Carolina, and by at least 16 percent in the southern tobacco producing region of North Carolina. Production in South Carolina will likely expand by at least 13 percent. Production in Georgia and Florida could expand by at least 43 percent.
In the short run, farmers with lower than typical production costs will grow more tobacco. Other farmers, even those with high production costs will maintain or cut back slightly their production as they continue to use up their specialized assets. Many older farmers who had been planning retire and rent their quota will continue to raise tobacco since a major portion of their retirement income, quota rental, will be eliminated. However, as low cost producers continued to expand, price will continue to fall. As their tobacco equipment wears out, higher cost producers, mostly in high cost-of-production regions, will exit production.
Consequently, higher cost-of-production regions, primarily Virginia and the piedmont of North Carolina will experience declines in tobacco production in the long term. Tobacco currently occupies a small percentage of the crop land in the lower cost-of-production areas such as eastern North Carolina and south Georgia. As a result, expansion in eastern North Carolina, eastern South Carolina, and especially in Georgia and Florida will continue. While difficult to predict, flue-cured tobacco could be produced outside the current production area as well. Even with some increases in cigarette prices, in the long run, the farm price for flue-cured tobacco likely will fall to $1.25 to $1.35 per pound and US production of flue-cured tobacco likely will expand to around 1.5 billion pounds.
Elimination of income from quota
The most obvious effect of elimination of the tobacco program is the resulting elimination of the income from tobacco quota. Since under the tobacco program only ownership or rental of tobacco quota gives a tobacco farmer the right to sell tobacco, quota is an asset with both a sales value and a rental value. Almost all flue-cured tobacco farmers own quota. The return on a farmer's investment in quota is an important component of the income of tobacco farmers. Many small tobacco farmers own all of the quota they grow. Larger farmers both own and rent quota. Most often quota is rented to farmers by retired tobacco farmers or their heirs.
Currently, annual quota rental rates range mostly from 35 to 45 cents per pound. A small quantity of quota is sold each year. The market value of this quota is affected by the current quota rental rate, the outlook for future quota increases or decreases, and the perceived probability of how long the tobacco program may remain intact. In determining an appropriate level of compensation for quota owners in the event of program elimination, the length of the capitalization period for annual quota rental is a critical factor. For example, since the tobacco program is permanent legislation, some will argue that the annual income from quota should be capitalized for perpetuity, yielding quota values ranging mostly from $7 to $9 per pound.
With elimination of the tobacco program, no income from quota will be earned by non-producers or farmers. This loss of income is significant. Annual income from quota (both owned and rented) is over $325 million in the flue-cured producing region. In the short run most of this annual income will be transferred to cigarette manufacturers or their customers, with a smaller portion going to farms that survive program elimination. In the long run when supply is more responsive, all of this annual income likely will be transferred to cigarette manufacturers or smokers if the tobacco program is eliminated.
Regional changes in income
Regions that experience a decline in tobacco production, such as Virginia and the piedmont of North Carolina, will also experience a decline in gross farm revenues. Regions that experience large enough increases in tobacco production to offset the effects of the decline in price will have increases in gross farm revenues from tobacco. The production increases in eastern North Carolina and south Georgia likely will be large enough so that gross receipts from tobacco increase. With an increase in gross farm revenues, these areas will experience an increase in overall economic activity as well. While the structure of agribusinesses supplying tobacco farms is likely to change considerably due to changes in the location of tobacco production, more inputs to tobacco production will be sold. However, as tobacco production displaces acreage currently in other crops such as cotton or soybeans, sales of inputs for the displaced crops will decrease.
Effect of changes in location of production on farm size and numbers
Currently a number of technological innovations are being adopted that are increasing the economies of scale of producing tobacco. Under the current program the scope of these changes is limited by program barriers that prevent quota from moving across county lines. These technologies creating economies of scale are not as widely adopted in the higher production cost areas (such as the piedmont of North Carolina and Virginia) where topography and field size make expanding farm size more expensive. Thus, the restrictions on movement of quota across county lines tend to preserve smaller farms. With the elimination of the tobacco program, long-term production of tobacco will decline in higher cost areas such as the piedmont of North Carolina and Virginia where topography and soils make expansion and successful adoption of new technologies difficult.
With average flue-cured tobacco acreage per farm currently approximately 30 to 35 acres (Clauson and Grise), over 12,000 farmers produce over 900 million pounds of flue-cured tobacco. If average acreage moves to 200 to 300 acres, only 2,000 to 3000 farmers will be needed to produce 1.5 billion pounds of flue-cured tobacco. While considerable consolidation will occur even if the tobacco program remains intact, elimination of the program will magnify increases in farm size and the number of farms exiting tobacco production. In low cost-of-production regions where production expands, some new farms may enter tobacco production. However, given the current rates of adoption of technologies that increase economies of scale, it seems likely that most of the expansion in production will occur through expanded farm size. Consequently, a net exit of tobacco farmers is expected.
Price risk
Under the tobacco program a system of price supports places a price floor under most grades of tobacco preventing prices from dropping in the event of large world supplies or negative shocks to demand. For example, in 1992 the average flue-cured tobacco price was $1.72 per pound in the US and $1.31 per pound in Zimbabwe. In 1993 poor world market conditions caused the Zimbabwe average flue-cured price to drop to $0.58 per pound. However, in the US flue-cured producers received an average price of $1.69 per pound due the support price system of the tobacco program. In the absence of a tobacco program, US producers will be subject to the same price volatility as producers in Zimbabwe.
Unlike grain crops and cotton, there is currently no futures market in which tobacco producers can hedge away price risk. Agricultural lenders, used to the stable and predictable lending environment under the tobacco program, likely will be especially cautious in the uncertain environment of deregulation. The increased price uncertainty will likely lead to vertical coordination by leaf merchants through forward contracting with farmers for tobacco production.
Tobacco farmers after program elimination
Most farmers that exit tobacco production will move into off-farm employment. According to a 1991 survey of tobacco farms by USDA (Clauson and Grise), 58 percent of tobacco farmers were less than 54 years of age. With a net exit of tobacco farms expected, many farmers in this group will change careers. In areas such as Virginia and the piedmont of North Carolina where the largest exit from tobacco farming is expected, few farm enterprise alternatives exist that are as profitable and stable as tobacco under the current program. A few innovative farmers close to urban centers will find niche markets for specialty products, such as pick-your-own operations. However, the market for such products is limited. Further, success in niche markets often requires a different set of skills from traditional farming operations and involves more price and production risk to the farmer.
In eastern North Carolina tobacco farmers are already very diversified. Eastern North Carolina has one of the most diversified agricultural sectors in the United States. (North Carolina has the third most diverse agricultural sector of any state in the US.) Most tobacco farmers are involved in a number of field crop and/or livestock enterprises in addition to growing tobacco. However, few, if any, farm enterprises approach the profitability and stability of tobacco. With elimination of the quantity restraints, tobacco production will expand in eastern North Carolina because returns to management and risk likely still will be larger than the return to management and risk for other field crops.
The adjustment will be particularly difficult for farmers that are unable to continue farming, but have incurred substantial farm debt. These farmers may be faced with the choice of selling their land or paying off farm debt with off-farm jobs. Younger farmers will have to acquire some new skills for off-farm jobs in order to come close to the same income level that they earned from tobacco under the tobacco program
According to the 1991 USDA survey, 42 percent of tobacco farmers were age 55 or older. For many of these farmers, most of their wealth is in the form of land and tobacco quota. Most are planning on quota and farm rental as a major source of farm income in retirement. Farm land rental will remain an important source of income in areas where tobacco production expands, but the rental value of farm land will decline in areas that lose tobacco production. Since quota will lose all value, farmers can no longer depend on quota rental for retirement income. Tobacco farmers who already are retired or their surviving spouses also rely heavily on quota rental as a source of income. With no income from quota rental, farmers at or near retirement may have few alternatives for other income. This group of farmers is perhaps most dramatically affected by program elimination since alternative sources of income may be limited.
Farmers who successfully compete in the unregulated tobacco environment, will have to successfully invest in and adopt new technologies and successfully manage additional marketing risk. Whether or not the net incomes of remaining tobacco farmers increases depends of whether additional net revenues from expanded tobacco production offset the sum of their loss of quota income and the loss of net revenues from crop acreage they choose to replace with increased tobacco acreage.
Research and extension efforts
North Carolina State University, as well as other land grant universities, has conducted and continues to conduct research and extension programs on a multitude of crop and livestock enterprises. Accompanying this report is information on some of the most recent efforts of the College of Agriculture and Life Science on development and evaluation of farm enterprises. The accompanying example is the newly formed Specialty Crops Program which will focus existing and new resources on the development and evaluation of new crops. Some professors in the College of Agriculture and Life Sciences, such as Professor Bill Fike (Department of Crop Science), have devoted their entire careers to the evaluation of alternative crops for North Carolina farmers. Further, the North Carolina Department of Agriculture has one of the most aggressive market development and promotion programs in the country. These efforts have contributed to North Carolina's rank as one of the most agriculturally diverse states in the nation.
Effects on other groups
Other groups are affected by the elimination of the tobacco program as well. Tobacco warehouses, where farmers currently market their tobacco, will not be needed as farm size increases and leaf merchants begin purchasing tobacco directly from the farm. Cigarette manufacturers, on the other hand, will be able to purchase US tobacco at lower prices. Leaf merchants, who purchase tobacco around the world for cigarette manufacturers, will be able to increase the volume of business they do in the US. Other producers of quality flue-cured tobacco such as Brazil and Zimbabwe likely will reduce their production in the long run as world prices for tobacco fall with a declining US flue-cured tobacco price. Leaf merchants have large investments in Brazil and likely will try to prevent Brazilian flue-cured production from falling dramatically. However, Zimbabwe, with internal problems and a loss of preferential treatment with the European Union, may have difficulty competing against deregulated US flue-cured production.
Summary
Flue-cured tobacco is currently a highly profitable and stable commodity for farmers in the five state flue-cured producing region. If the tobacco program is eliminated, the price of US flue-cured tobacco will decline to $1.25 to $1.35 per pound and production will expand to around 1.5 billion pounds. A primary reason for the current high return from tobacco under the tobacco program is the return to quota. Quota is owned by both active tobacco growers and non-growers, such as retired tobacco farmers. With elimination of the tobacco program, this income from quota will be transferred from quota owners to cigarette manufacturers and smokers. Participants in the tobacco program will experience substantial adjustment costs as a result of the program being eliminated. Besides the loss of income from quota, the elimination of county barriers to production will lead to declines in tobacco production and farm revenues in some regions, such as Virginia and the piedmont of North Carolina. Other regions such as eastern North Carolina, south Georgia and northern Florida will experience large increases in production of tobacco. Some regions will experience sufficient production expansion so that gross revenues from tobacco production also increase. Price risk in growing tobacco will increase without a program. The decline of tobacco production in some regions in combination with the current trends in production technology will result in a net exit of tobacco farms despite an overall expansion in production and sales.
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