Tax Differentials on the Interstate Smuggling and Cross-Border Sales of Cigarettes in the United States
Background Paper No. 16
Recent increases in state excises on cigarettes offer an unusually rich opportunity to examine market behavior in response to changes in relative prices. In recent years, state governments have frequently turned to higher cigarette excise taxes as a means of both raising tax revenues and enforcing a particular social policy through their tax codes.
The escalation in state cigarette excise taxes, however, has not been uniform across the nation. While some states have raised their cigarette excise taxes by as much as 200 percent in recent years, others have not altered these taxes in nearly a quarter of a century. This has created a situation where a wide disparity exists among the states in both cigarette excise taxes and prices.
One possible response to higher cigarette prices is to lower consumption .The compact, lightweight nature of cigarettes, however, makes it an ideal product for both casual cross-border purchases and large scale, interstate smuggling. Thus the disincentive to consume tobacco products posed by higher taxes can be largely mitigated by changes in purchasing patterns. The incentives to engage in either of these activities clearly increase as the tax differentials between states rise.
This is not a new phenomenon. The avoidance of excise taxes has a long history both in the United States and the rest of the world. During the late 1960s and early 1970s differentials of a similar magnitude led the U.S .Advisory Commission on Intergovernmental Relations (ACIR) to declare that “[cigarette] tax evasion activities ….are a serious [or moderate] problem” “in nearly half of the states. In 1978, Congress responded by enacting legislation making it a federal offense to engage in large scale, interstate smuggling of cigarettes. This action, coupled with the high inflation of the period which reduced the real value of tax differentials, led to a decline in cross-border activity during the late 1970s and early 1980s.
Since 1983, however, there has been a marked increase in the variance of cigarette excise taxes among states. This has made both cross-border shopping and smuggling much more rewarding .In order to get an idea as to the consequences of this growing disparity in state cigarette excises, the Tax Foundation developed a model of cigarette supply and demand and used it to estimate changes in cross-border activity. Among the significant findings of this study are:
- The growing disparity in cigarette excise taxes among states has led to an increase in cross-border shopping. Increasingly, states with widely differing cigarette excises are bordering one another. In search of bargains, price conscious consumers in the high-tax states are crossing borders to purchase cigarettes. Such behavior led to a 395 percent increase in cross-border shopping between 1980 and 1994.
- Growing excise tax differentials have also made cigarette bootlegging a nationwide problem once again .The flashpoint, or point at which the bootlegging of cigarettes becomes sufficiently profitable to attract organized criminal elements, as identified in the original ACIR study, has now been reached in at least half of the states. As a result, cigarette smuggling is more profitable than ever. This led to a 253 percent increase in the number of cigarettes smuggled in the United States between 1980 and 1994.
- Rising state excise taxes on cigarettes also encourage individuals with access to cigarettes not subject to such taxes to alter their purchasing habits. The two primary sources of such cigarettes are Native American tribal reservations and commissaries on military bases. The Tax Foundation model shows that for states whose populations are comprised of large numbers of Native Americans and active duty military personnel and /or with high cigarette excise and sales taxes, this effect can be very dramatic. During FY 1994, for example, approximately 5 .7 percent of Alaska’s population was comprised of Native Americans with access to nontaxable cigarettes, while 3 .8 percent were active duty military personnel. During this year, sales and excise taxes added 53 cents to the price of each pack of cigarettes sold. As a result, the model predicts that per capita taxable sales fell 31 .2 packs within the state. Of this decline, 15.1 packs were attributable to sales on Native American tribal reservations while 16.1 packs were the result of sales on military bases. These results are consistent with the findings of other investigators.
- The effects of cross–border shopping have been especially pronounced along the U.S.-Canadian border. Between 1980 and 1994, states along the border near large Canadian population centers, where cigarette prices had generally been higher due to excise taxes, experienced per capita cigarette sales which were approximately 10.4 packs higher than the national average simply by virtue of their location.
The findings of this study are therefore similar in many respects to the original ACIR report on this problem. Cigarette excise tax differentials among states lead to variations in cigarette prices .These price differences encourage both cross-border shopping by price conscious consumers and the organized smuggling of cigarettes .State legislators need to be cognizant of this fact when they consider raising cigarette excises if for no other reason than because the expected increase in state revenues may not be forthcoming and the state may suffer an overall loss of revenue.