The steady decline in smoking is unquestionably positive from a public health perspective. But what does it mean for states, such as California, that sold bonds backed by annual payments from tobacco companies following a landmark 1998 settlement? A recent New York Times article suggests an answer: Reductions in smoking could mean that several states, including California, will receive payments that are too small to cover the principal and interest due on the bonds. Why? Because the size of the payments partly depends on how well cigarettes are selling. Less smoking leads to smaller payments. States could dip into reserves to make up the difference – California already has done so – but “if smoking keeps declining at the current pace, some of the reserves set up as backstops will run dry,” according to the Times. “At that point, investors – including individuals, insurance companies and mutual funds – will be at a loss” because states, in general, are not legally obligated to step in and make the payments with their own tax dollars.
California, which sold tobacco bonds to help close budget shortfalls in the early 2000s, is a case in point. The state is not required to make up the difference if annual payments and reserve funds fall short, as we explain in our recent analysis of Proposition 29, the June ballot measure that would increase the state cigarette tax by $1 per pack. Some of the tobacco bonds, however, include a back-up state “guaranty,” which requires the Governor to ask the Legislature for funding to make bond investors whole. Does the Legislature have to provide the funds? No. But if tobacco payments and reserves drop below the level needed to repay the bonds, policymakers would either have to make up the difference from the state’s General Fund or allow the bonds to slip into default – a decision that most policymakers would probably hope to avoid.
– Scott Graves