A Taxing Business

Commonly a tool of the states, federal officials now turn to tobacco for funding

Hiking the tobacco excise tax has long been a tool used by state and local governments to close their ever-growing budget gaps. Every several years, federal officials also join the fray — and 2013 is one of those years.

Low grumblings made their way through the convenience and tobacco industries in April when President Barack Obama revealed his proposed 2014 federal budget, which includes a 94-cent levy increase on cigarettes, with a comparable raise in the levy on all tobacco products. While the move was rumored, some retailers were holding out hope the rumors would prove false.

According to Obama, the proposed tax increase is intended to help fund pre-kindergarten programs for 4-year-olds across the United States. If approved, the new federal cigarette tax rate would almost double in one fell swoop, jumping from $1.01 per pack to $1.95. The tax hike on the table is expected to generate approximately $78 billion over 10 years.

Convenience store retailers are obviously opposed to this move. More than increased revenue, they say another tax hike would add challenges to the already challenged world of tobacco retailing.

"It's not good," said Dave Williamson, retail vice president at Jubilee Food Stores, a division of Hill City Oil Co. in Louisiana. "I see the landscape changing so much."

Louisiana retailers and adult tobacco consumers in the state almost faced a double hit this year. At the beginning of the state's most recent legislative session, Rep. Harold Ritchie (D-75th District) proposed boosting Louisiana's cigarette tax from 36 cents a pack to $1.41. Retailers breathed a sigh of relief when he pulled the proposal in late May citing a lack of support.

According to Williamson, Louisiana c-store operators currently enjoy an advantage over neighboring states when it comes to excise taxes. Texas and Arkansas both have significantly higher tax rates — $1.41 per pack and $1.15 per pack, respectively — while neighboring Mississippi is only slightly more at 68 cents per pack.

"It is already a diminishing industry and to think you can tax it on its way out, for whatever reason, is not good," he said.

North Carolina-based Brewer-Hendley Oil Co.'s Market Express convenience stores are also bracing for the impact any federal tax increase would have on its tobacco sales. "It will definitely decrease sales and profits in an already declining category," said John Valeri, buyer and head district manager for Market Express, operator of 16 stores.

Overall, tobacco accounts for 41 percent of inside sales at Market Express and is the No. 1 category chainwide, he added.

In a switch from the industry standard, the tobacco category ranks No. 4 at Jubilee Food Stores' 44 locations; however, that in no way diminishes its importance, Williamson said.

"As a store category, it is No. 4 in gross sales. It's an important category for me, but I don't do a lot of deals to get [tobacco consumers] in," he explained. "How long can I do that, I don't know. If you give cigarettes away, you are making friends, but you are not making money."

Making matters worse, competition for the tobacco consumer continues to heat up. "Cigarettes are a profit piece for me. That is what's different about Walgreens or Dollar General selling cigarettes — for them, it is and it isn't," Williamson said. "They want to get you in the store and then they have a lot of other opportunities for you to buy items that have margin. You are either pushing a basket or carrying a basket there. In a convenience store, it's in-and-out trade."

HISTORY REPEATED?

If approved, the proposed federal levy increase would be the second in four years for cigarettes. Obama's signature ushered in a 62-cent-per-pack increase in 2009. At that time, the hike (up from 39 cents per pack) was the largest increase made to the federal cigarette tobacco tax rate in U.S. history. This new proposal would top that.

The last hike, according to Valeri, decreased sales and took margins down at Market Express.

"It forced us to revisit how to offer tobacco in ways that still gave customers the convenience and value that they have come to expect," he said.

David Bishop, managing partner at Barrington, Ill.-based sales and marketing firm Balvor LLC, said the 2009 increase wasn't as bad as retailers had initially thought. What the convenience industry saw was some "pantry loading" by consumers in the month or two leading up to the increase that went into effect in April.

"Retailers saw increased demand in their stores for cigarettes in anticipation. March, in particular, was a strong month for sales and conversely, profits for convenience store retailers. It didn't necessarily drop off dramatically after that load," Bishop said. "Year over year, volume did decline in calendar year 2009, but not [much] different than the prior year. In fact, it wasn't until 2010 that we actually saw a larger decline in demand for cigarettes." (That change may have been due to the way federal reports are compiled vs. industry reports.)

"From a classical standpoint, cigarettes exhibit a degree of price inelasticity. That is not to say they are perfectly inelastic because people aren't going to buy them no matter what [the] price, but people tend to buy them still even with higher prices," Bishop continued. "They don't tend to switch as much because the alternatives are not as plentiful."

In fact, retailers in 2009 enjoyed a slightly higher penny profit in sales, which he said was a function of the markup pricing that wholesalers and retailers have to factor into the manufacturer list price, as well as federal and state excise taxes.

"Retailers were making more penny profit per pack sold, to the extent that they were able to offset some of the volume decline," Bishop added.

But with all prices in the tobacco category going up in 2009, it did put more pressure on the premium segment as that consumer found it more difficult to purchase and consume the amount of cigarettes they normally would. "In many ways, that was probably part of the genesis of what we now see as the premium discount segment, where many premium brands have a two-tier pricing architecture," he said.

Some consumers also switched to lower-cost tobacco alternatives, with pipe and roll-your-own tobacco benefitting from the 2009 tax hike. The current proposal includes tax parity across all tobacco products so that would mitigate any demand shift this time around.

If Obama's proposal is approved, it's difficult to say definitively what the consequences will be, but it is likely that cigarettes will be a little more insulated this time because the alternatives wouldn't be as attractive as they were in 2009, according to Bishop.

The monkey wrench, though, could be electronic cigarettes, which weren't on the national radar in 2009 and are not, at this point, subject to federal taxation.

Jubilee Food Stores did not see a big hit to business as a result of the 2009 federal tobacco tax increase, but when you couple that with the several manufacturer price increases that have occurred since then, Williamson said it's getting harder to pencil the numbers. "The prevailing thought is consumers are still going to buy it — but to a degree," he said.

He acknowledges that tobacco products have to be taxed, but thinks they should be taxed fairly.