JLARC: McDonnell’s ABC privatization proposal is full of holes.

JLARC has published the results of their audit of Gov. McDonnell’s ABC privatization proposal. It’s harsh. Really harsh. If this plan had any chance of being revived, it seems to me that this must have killed it. Their overall conclusion is that McDonnell vastly overstated the amount of money that his plan would generate, through a combination of simple math errors, misunderstandings of how taxes work, claiming that ABC stores are located in municipalities other than where they really are, a bunch of erroneous assumptions, and flat-out not understanding how the ABC works. (I don’t think that the report provides a total amount by which much McDonnell overstated the value, unfortunately. For perspective, though, note that the administration claimed $458M in a one-time infusion from selling off the stores.) Some report lowlights follow.

One of the major aspects of McDonnell’s proposal is that the stores would be auctioned off. How? He’s not saying:

[T]he Administration proposal does not specify a structure or methodology for the auction of retail licenses. The structure of an auction can substantially impact revenues received, but this topic has not been addressed in the proposal. For example, in 1991 the design of West Virginia’s auction of retail licenses was one reason the state ultimately held three auctions instead of one, as originally planned, in order to sell all available licenses.

McDonnell’s staff didn’t take the time to figure out where ABC stores are located:

For example, the ABC store at 183 Community Street is located in Albemarle County, but the Administration proposal listed it in Charlottesville for the purposes of calculating minimum bids.

Working with ABC staff, JLARC staff identified a total of 16 localities which were affected by the error, with a total of 12 stores erroneously included as part of the wrong locality.

By not understanding grade-school math, McDonnell’s proposal overstated license income by $24M:

When Administration staff discounted minimum bid prices by removing the wholesale (20 percent) and retail (25 percent) markups, staff simply added the markups together and reduced the bid by multiplying the total by 0.55. This is arithmetically incorrect. If a wholesale markup of 20 percent were followed by a retail markup of 25 percent, total markup would be 50 percent, not 45 percent. The correct multiplier would therefore be 0.5, not 0.55. Adjusting the minimum bid prices to reflect compounded wholesale and retail markups would reduce potential revenue from the auction of retail licenses by $24.3 million, to $242.5 million.

How do liquor sales work? Well, McDonnell apparently just doesn’t know, accounting for another $57M mistake:

In calculating minimum bid prices for retail licenses, the Administration proposal used store-level adjusted net profits that include sales to on-premise licensees. Currently, on-premise licensees (e.g., restaurants) must purchase all distilled spirits served in their establishments from specified ABC retail stores. Statewide, ABC sales to on-premise licensees represent approximately 18 percent of total ABC revenue.

Sales to on-premise licensees at the current ABC stores range from 0 to 99 percent of total revenues. Post-privatization, on-premise licensees will be allowed to purchase distilled spirits directly from wholesalers. This likely means that off-premise retailers will not supply on-premise licensees with spirits, and thus will face a reduced base of consumers to which they may potentially sell spirits.

[…] Adjusting net profits at the store level to reflect the loss of sales to on-premise licensees reduces the total revenue from retail license auctions in the Administration’s model to $209.8 million, holding all else constant. This would represent a reduction of $57 million from the Administration’s estimate of $266.8 million.

And still more of that not-understanding-math:

There appear to be several problems with the total revenue estimate for the sale of wholesale licenses. First, use of the entire 20 percent wholesale markup rather than the five percent of wholesale gross receipts that is assumed to be wholesale profit appears to be incorrect. Wholesale markup differs from wholesale profit, because the markup includes the costs of wholesale activities such as warehouse rent and employee salaries. Wholesale profit nets out these costs and represents the actual return on investment to the wholesaler.

According to the staff presentation to the Governor’s Restructuring and Reform Commission on September 8, 2010, “Wholesale licenses will be sold at a cost of 2.5 times the gross profit of the spirit line being distributed.” To remain consistent with this claim, wholesale gross receipts should be calculated by applying the 20 percent wholesale markup to the cost of goods sold. Wholesale gross profits should then be calculated as five percent of wholesale gross receipts. This would have the effect of reducing the total revenue estimate.

And a smattering of not-having-taken-econ-101:

One of the most significant factors that may affect the volume of spirits sold under the Administration proposal and thus the excise tax revenue collected is how potential price increases may impact consumers’ demand for distilled spirits (referred to as the “price elasticity”). […] The Administration proposal does not take elasticity into account even though there would almost certainly be an impact on volume if prices increase.

[…]

JLARC staff estimated how these alternative volumes would cause the estimated sales tax revenues to change. [I]f prices increase…the likely result could be as much as $15.4 million less sales tax revenue than assumed in the Administration proposal.

This certainly isn’t everything in the twenty page report, just some of the bits that really stood out for me.

To be clear, not all of the errors brought the price tag down. There were also some serious mistakes that went the other way. For example, by not understanding how much retailers mark up liquor, the proposal understated potential income by $47M. That said, the net effect of all of these mistakes is a significant overstatement of the income likely to result from the governor’s plan.

The effect of this is going to be to show McDonnell’s plan as being haphazard and ill-conceived, precisely the sort of talking point that opponents are looking for to justify their often-ideological opposition. The governor doesn’t have the political capital to get Republicans in the General Assembly to support this, and Democrats already oppose it either because they’re broadly against privatization of government services, they worry about the social effects of making liquor more readily available, or because they don’t favor taking a one-time cash infusion from selling off the stores while giving up a steady source of revenue from continuing to sell liquor.

I think this privatization plan is dead.

4 thoughts on “JLARC: McDonnell’s ABC privatization proposal is full of holes.”

  1. Well..it’s not like other states have not successfully moved from a state-run system to a state-sanctioned system – to the benefit of the state, private industry and citizens/taxpayers.

    But you have to get the right people with the right expertise to move the issue and it sounds like the people McDonnell have running the show are lacking in some basics.

    It’s one thing to have one’s act together and then lose te political end of it… crap does happen…

    but it’s quite another to have the wheels come off as you are driving your vehicle… before the politicos ever get the chance to kick the tires.

  2. If Bob McDonnell feels as a matter of political orthodoxy that alcohol sales should be in the hands of private enterprise rather than the state, let’s have that debate on philosophical grounds. But the notion that we would somehow pave roads with the new-found profits from privatizing booze sales was always bogus. Democrats — and the Washington Post — tried to point that out during the campaign, but no one was listening.

  3. I don’t have a horse in this race, but would like to point out what I think may be a flaw in the criticism.

    The 20% wholesale markup means, I think, that when the state sells liquor to a bar, restaurant, club etc. that the ABC marks up the price by 20%. And when the ABC sells liquor to the public at a retail store it marks up the price by 25%. That’s only 5% more than wholesale, if my assumption is correct.

    While it is true that bars and restaurants mark up the cost of liquor, usually by the drink for distilled spirits, when it is resold to their customers there is no standard markup that can be identified. A small blue collar bar/cafe may mark up modestly while a 4-star fine dining establishment may markup substantially more.

    In any case, the retail markup should not be considered in a criticism of the public-to-private proposal. Except for standard sales tax which would be unchanged whether the system is public or private, it is not relevant to the discussion. The current ABC system makes its revenue by selling liquor by the bottle or case at a wholesale price to licensees, and at a retail price by the bottle directly to the public.

  4. I think part of the problem is non-businessman tinkering around with the percentages at the various levels.

    The bottom line for a businessman is to find the sweet spot of retail price verses income and competitiveness.

    That’s why I think you put this thing out as a concessionaire RFP and then go from there instead of having a flock of non-business folks … political operatives, etc trying to figure it out.

    Isn’t it ironic that the philosophy is to get govt out of this because of the belief business will do it better than govt but we have a bunch of govt folks trying to figure out the business end of it.

    Not sure why we did not go towards the concessionaire path in the first place.

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