A First Look at HB11

This article is one of a series on privatizing wine and spirits sales in Pennsylvania. The full list of articles may be found on the Privatization Index Page.

Unless you live under a rock, you're probably aware that Representative Turzai held a press event yesterday afternoon to unveil his privatization legislation, House Bill 11. Oddly enough, he didn't actually make available the text of the bill, he just made a speech and handed out a "fact sheet" to the press. This fact sheet, along with a few other documents, can be found on Representative Turzai's website.

Fortunately, the Commonweath Foundation posted the full text of the bill on their blog. I've copied it here to make sure it remains available. (How's that for transparency? Legislation that completely rewrites the laws governing a nearly $2 billion retail market and a $1 billion wholesale market was provided to a right-wing lobbying group aligned with the GOP, but not to the press or the public. But I digress...) [Edit 7/28: Nathan Benefield of the Commonwealth Foundation offered a clarification of his organization's mission in the comments below.]

While I haven't yet had time to review the entire 100-page bill, I've put together some initial thoughts on the information presented in the fact sheets.

(An aside to the Twitteratti: can we standardize on #HB11 as the hashtag for privatization discussion? It's way shorter than #privatizeliquor.)

The good news

A number of important questions have been answered. First, contrary to early reports, there have been substantial changes from last year's privatization bill. GOP leadership appears to have taken heed of the advice offered to them by small producers, specialty distributors, consumer advocates and wine enthusiasts. Gone is the ridiculous system of regional wholesaler duopolies. Off-premise retail licenses have been broken into two classes: one class for stores with more than 15,000 square feet, capped at 750 licenses; and one class for smaller stores, capped at 500 licenses. There will be ownership quotas which will limit the number of licenses that can be purchased by a single owner, with the explicit intention of allowing most of the small-store licenses to be purchased by independent operators. Enforcement and compliance requirements have been strengthened. All in all, a great number of improvements have been made.

Unfortunately there are still some major problems with Turzai's proposed legislation that could harm consumers.

Issue #1: Wholesaler licenses

Representative Turzai seeks to move Pennsylvania to the standard three-tier model employed by most other license states. This system was invented after Prohibition was repealed as a way to avoid the abuses perpetrated by "tied houses"—saloons owned or financed by brewers—by requiring a middleman between producers and retailers. There are rising concerns that the three-tier model hands too much power to the wholesalers sitting in the middle, but it's a well-established system that everyone in the industry is familiar with. It's undoubtedly an improvement over the bizarre four-tier model proposed in last year's privatization bill.

By my reading of the fact sheet and the bill, Turzai intends to sell wholesaler licenses to whomever wants them, with no limit on the overall number of licenses. However, there is a catch: licenses will come with a strict list of which brands and products may be wholesaled by the licensee. Brand holders must appoint one wholesaler to exclusively represent their line in Pennsylvania, and then that wholesaler must pay the state a fee for the right to distribute that product line.

The concept doesn't sound too onerous, until you find out how much the fees will be. HB11 says, "the department shall impose a one-time license fee [...] in an amount equal to the blended brand valuation for each brand of liquor authorized by the license multiplied by the wholesale acquisition factor." Um...what? Let's consult the definitions section: "blended brand valuation" is "the sum of the wholesale profit margin on each product of a brand," where the "wholesale profit margin" is defined to be "20% of the total of costs of goods sold of the product over the most recent 12-month period for which information is available." The "wholesale acquisition factor" is "a factor of 2.5."

There we find the justification for this odd licensing system—Turzai is pegging the anticipated income from the one-time sale of wholesale licenses as a fixed percentage of the PLCB's cost of goods sold. This is a much more reliable number for his "windfall" than trying to estimate the proceeds from a license auction.

Let's do the math. A 20% wholesale mark-up is awfully optimistic—most PA distributors work with something more like 10% or 15%. But if that's what the bill says, we'll roll with it. A 20% mark-up corresponds to 17% of sales revenue, which multiplied by the "wholesale acquisition factor" of 2.5 gives 42% of annual sales revenue. Wow.

Turzai wants to charge existing distributors a fee equal to 42% of their annual sales revenue for the privilege of continuing to sell the same products they're already selling.

That's an insane number. Attempting to suck $420 million in one-time fees out of a $1 billion industry is going to cause a lot of hardship for distributors large and small.

What will be the effect on consumers? It's likely that product selection will be reduced, as distributors prioritize their available capital to buy licenses for only their most popular and reliably profitable products. It's unavoidable that prices will increase—those huge licensing fees will need to be paid back to whoever put up the money to pay them.

The impact of these initial fees will be bad enough, but what about new brands that aren't in the state yet? The license fee will be calculated on "the blended brand valuation for the brand from a comparable jurisdiction." It's not clear what a "comparable jurisdiction" would be, but let's pick Illinois, as it has about the same population as Pennsylvania. If a product is selling 5,000 cases annually in Illinois with a $200/case wholesale price, a PA distributor would need to pay the state an up-front fee of $420,000 just for the right to add that product to their portfolio. Keep in mind that this could be a product with virtually no recognition among Pennsylvania consumers and the distributor would be building their sales up from zero. That's a hell of a lot of money to gamble on a new brand.

Net effect? The only new products we'll ever see are "guaranteed blockbusters," where the distributor is strongly confident in the product's market success. It will be prohibitively expensive (and probably bureaucratically impossible) for distributors to act on customer requests to bring in niche products. (A possible secondary effect here is that independent operators are discouraged from opening specialty wine shops if the selection from wholesalers will be so strictly limited.)

That does it for up-front costs...let's look at ongoing taxes.

Issue #2: The revenue question

In today's budget climate, no privatization proposal could succeed unless it ensured state revenue flows from wine and spirits sales would continue at the same or higher levels. Last week's post addressed this issue, showing that an unusually high excise tax would need to be imposed on private retailers to maintain the existing revenue from the 18% liquor tax. The requisite excise tax rates would be far beyond those of our neighboring states, potentially creating a barrier to competitive pricing and encouraging cross-border shopping.

I laid out four options for Representative Turzai, proposing to shift some of the tax burden off certain market segments to encourage competitive pricing within those segments, but he ended up choosing an option that didn't appear in my list:
  1. Replace the liquor tax with a gallonage tax that places a 38% greater tax burden on wine and spirits sales. Assert, without explanation, that privatization will result in product pricing competitive with neighboring states where excise tax rates are 90% lower.
It reads like a joke, but it's not. HB11 specifies an excise tax on wine of $8.25 to $8.75 per gallon, depending on alcohol content, and a special rate of $9/gallon on sparkling wine. To put that into perspective, the national median excise tax rate for wine is $0.67 per gallon. Delaware, our neighbor with the highest rate, taxes wine at $0.97 per gallon. The "replacement rate", which would maintain the same level of tax revenue from wine that the state currently receives under the 18% liquor tax, is only $5.08 per gallon.

Spirits will be taxed at $11 to $12 per gallon. Again, for comparison, the national median is $3.75 and the replacement rate is $9.60.

For a rough comparison, if Turzai's taxes had been in effect during the 12 month period of my original study, the state would have received approximately $383,283,000 in tax revenue instead of the $277,445,000 it received under the 18% liquor tax—an overall increase of 38%. I have to wonder whether Turzai's proposed excise tax rates violate Governor Corbett's pledge to not raise taxes.

Let's take a look at how the proposed new wine tax compares to the 18% liquor tax, as well as the tax rates of one of our neighbors:

Retail price 18% tax Turzai tax NJ tax
Arbor Mist (750 ML) 4.99 0.76 1.63 0.17
Franzia (5 L) 12.49 1.91 10.90 1.16
Korbel Brut (1.5 L) 14.99 2.29 3.57 0.35
M&R Asti Spumante (1.5 L) 24.99 3.81 3.57 0.35
Stag's Leap Merlot (750 ML) 43.99 6.71 1.63 0.17

The overall effect is to shift much of the tax burden from premium products to value-priced products. 750 ML bottles of wine priced at $10.72 or higher would enjoy a reduction in tax while less expensive wine would see a tax increase. The tax on Stag's Leap Merlot would be reduced by a fantastic 75%. Five-liter boxes of Franzia would incur a mind-boggling six-fold tax hike to $10.90 per box—nearly the entire retail price of the unit.

The question becomes even more pressing: how are retailers in border markets supposed to compete with retailers in other states in the face of this huge tax difference? Won't this simply worsen the "border bleed" problem we have now?

The coming debate

Obviously, HB11 has a long road to travel before reaching a vote. The House is in recess until September, so the bill can't even be formally introduced until then. Once the bill has been debated and amended in the House and its various committees, a similar measure must be introduced in the Senate, where enthusiasm for privatization is weaker. Only after matching bills have been passed in both chambers will Governor Corbett have the opportunity to sign them into law.

I expect to see some fireworks over the summer, as the state store workers unions and temperance groups such as MADD blast away at the deplorable notion of putting liquor sales in the hands of the greedy and irresponsible private sector. Representative Taylor, chair of the House Liquor Control Committee, intends to hold hearings on HB11 over the summer as well, which is where I anticipate we'll get the best sense of what lawmakers think of the current text.

As HB11 stands now, I'll be blunt: I honestly can't see how Representative Turzai expects the private market to provide regionally-competitive prices on wine and spirits given the massive taxes and fees he expects to extract from the industry. Heavy taxation takes its toll on every aspect of the supply chain—not only do prices remain consistently high, but retailers cut costs any way they can: selection is slashed to the bone, customer service is sacrificed to keep labor costs down, and inventory is pared to a minimum causing less popular items to be frequently out of stock. It's likely that many of the 500 "independent shop" licenses that Turzai auctions off will not go to specialty wine boutiques, but to high-volume discounters that will resemble a typical mass-market beer distributor, with Bacardi, Cuervo and Yellowtail cases stacked floor-to-ceiling on industrial metal shelving.

What are the chances of HB11 being signed into law within the next year? It'll be a steep climb, but not insurmountable. Privatization is widely backed by Republican lawmakers, including Governor Corbett, who were able to pass this year's budget in the face of one massive protest demonstration after another, and with virtually zero input from the Democrats. (Not only were the Dems not consulted about HB11, they weren't even provided a copy.)

There is a lot to like about HB11, but unless the free market advocates in the legislature can bring the taxes and license fees down to a reasonable level, the existing state stores are likely to give Pennsylvanians a better deal.

Updated 7/18 to boldface certain text for emphasis. None of the wording was changed.

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"How's that for transparency? Legislation that completely rewrites the laws governing a nearly $2 billion retail market and a $1 billion wholesale market was provided to a right-wing lobbying group aligned with the GOP, but not to the press or the public."

Uh no - it was actually given to the press at Rep. Turzai's press conference. I saved the PDF a reporter scanned and posted it to make it easier to find. Also, the bill hasn't been formally introduced, so the draft could change. Way to throw out accusations that are the opposite of reality.

And The Commonwealth Foundation is by no means "aligned with the GOP", nor is our primary mission lobbying, but education (like posting the details of a bill for you), and "right-wing" is a meaningless, demeaning phrase. We make no bones that we support free market policies, but we are also grounded in research, with a guarantee of quality scholarship challenge--i.e., if you ever find any errors in our analysis, we welcome you to point them out, rather than just label us.

Hi Nathan,

Thank you for your comment. I spoke to two different reporters between Turzai's press conference and my publishing of this post, and both of them received HB11 press packets which included the hand-outs on the House GOP website but did not include the bill text. One of them had phoned Turzai's office to ask for the bill text but did not receive a response. In addition, Democratic leadership publicly stated that they did not have a copy of the bill either. But apparently you did, and I thank you for providing the only public copy that I'm aware of.

I'll update the post with regard to the Commonwealth Foundation's mission.

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