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Prohibition by Price

By: Adam Hoffer, Kyle Hulehan, Dan Carvajal

Step into the shadows of illicit trade where taxation, incentives, and criminal networks intersect to fuel the lucrative cigarette smuggling market.

Adam Hoffer, Director of Excise TaxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. Policy, joins Kyle Hulehan to shed light on how substantial price markups on legal cigarettes pave the way for tempting taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. avoidance opportunities. They unravel the unintended consequences of cigarette taxation and explore strategies to combat this burgeoning illicit trade.



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There’s a prohibition you don’t know about. Today, we’re diving into the shadows, where billions of dollars change hands every year, all under the cloak of smoke and mirrors. A world where smugglers, counterfeiters, and black-market moguls have turned an age-old industry into a complex global operation, all over a product you might see every day, cigarettes.

We’ll explore the toll this underground economy takes on public health and government coffers, and see if there are solutions to these problems through better excise tax policy.

Kyle Hulehan: Hello and welcome to The Deduction, a Tax Foundation podcast. I’m still your host, Kyle Hulehan, and today we are joined by Adam Hoffer, our Director of Excise Tax Policy. Adam, I’m excited to have you here today.

This is actually one of my favorite parts of the job. I get to just chat with coworkers who I might not get to talk to as much and learn from them. So, this is going to be a fun episode, and I’ll start by just lobbing you a softball. Adam, how are you?

Adam Hoffer: Oh, hi Kyle. I’m well, thanks for having me on. It is fall here. I’m a virtual employee. I live in Wisconsin, and I absolutely love it this time of year. It’s a great day and I’m really excited to talk about taxes and illicit trade today.

Kyle Hulehan: Yeah, you’re going to be shoveling snow soon. But for now, we’ll just focus on the taxes. So, the last time you were on this podcast, you talked about the importance of tax design; today I was hoping we could discuss the consequences of taxes. Specifically, the rise in black markets and illicit trade. Could you just talk us through how those are connected to illicit trade?

Adam Hoffer: Yeah, I think this is a really important concept in the tax world. We have to remember that there’s a fundamental rule that we follow in economics and basic human psychology, and it’s that people respond to incentives. When policymakers increase the tax on a pack of cigarettes, for example, incentives are front and center.

As part of that discussion, we recognize that consumers will respond to higher prices by purchasing and smoking less. It’s a simple incentive story. However, incentives also create unintended consequences in tax policy. As tax-induced prices increase, the incentives also increase for both suppliers to illegally provide non-tax products and for customers to purchase those lower-priced, non-taxed products. Across the country, taxes add an average of about 77 percent to the price of a legally purchased pack of cigarettes. And that means that by changing nothing at all about the product other than dodging taxes, black market operators can sell products at a massive discount to consumers.

Kyle Hulehan: And some of the tax markups are a lot more than 70 percent?

Adam Hoffer: Yeah, I mean, they can go a lot higher. New York City, for example, the markup is more than 300 percent. I don’t think it’ll surprise many listeners to hear that there are robust smuggling and illicit trade activities going on in New York. Our data suggests that more than half the cigarettes consumed in the state of New York are not purchased in New York. They’re smuggled in or purchased in the black market or illegally somehow.

Kyle Hulehan: I mean, it feels like some policymakers and health advocates are trying to make cigarettes so expensive through taxes that no one could afford to buy them. That’s what they’re trying to do, right?

Adam Hoffer: That’s exactly what they’re trying to do. There’s a concept economists refer to as prohibition by price. At the extreme, if taxes were so high that a pack of cigarettes were as expensive as an entire year’s salary, nobody would buy them legally. So even without legislative action to prohibit the sale of a product, taxes can be so high that you functionally end up with a prohibition by price or by tax. I think it’s useful to think of taxes as putting products on a spectrum where on one end you have a basic, unencumbered market, and on the other extreme you have complete prohibition. Every dollar of tax that is added to a product in a market moves the market a little further from the free market and closer to prohibition, and with each movement toward prohibition, a separate black market grows.

Kyle Hulehan: So as these black markets grow, I mean, how significant does that make the global illicit trade, and what’s maybe triggering that growth?

Adam Hoffer: The global illicit market in tobacco is enormous. Let me start by saying that it’s really hard to get good data on illicit illegal markets, but using the best that we have, our estimates put the size of the Chinese counterfeit tobacco production market at more than 400 billion cigarettes per year.

Their staple product is called a cheap white or illicit white. These are generic-looking cigarettes produced legally in their home country. So again, mostly China. But we also see several places both in Eastern Europe and throughout Eastern Asia. these generic-looking products are produced legally in their home country, but they’re often designed for exporting into high-tax markets.

Kyle Hulehan: So with these being designed to export in the high tax markets, what dangers do counterfeit cigarettes pose, especially from China, compared to legally manufactured ones?

Adam Hoffer: Yeah, I mean, we know legally manufactured cigarettes are dangerous to consume, but there are also even greater dangers from internationally smuggled products that don’t have to live up to any sort of quality control standard or product manufacturing standard. Researchers have found that counterfeit cigarettes have as much as seven times the amount of lead.

As authentic American brands and close to three times as much thallium, that’s a toxic metal. other reports have found things like insect eggs, dead flies, mold, and even human feces in these counterfeit cigarettes. It’s a whole different world whenever you move from producing something that’s sold, regulated, and done so legally, to something that gets smuggled, you know, inside and hidden in shipping containers.

Kyle Hulehan: Wow. As someone who’s only smoked just a few cigarettes in their day, it’s pretty scary to think that counterfeit cigarettes could really have these kinds of dangers. It kind of makes you think twice about it a little bit, but I don’t want to get too far from the point here. To stay on track, how does, you know the hike in cigarette tax rates correlate with the increase in smuggling as you’ve seen through the evidence in empirical studies?

Adam Hoffer: Yeah, our estimates suggest that a $1 increase per pack of cigarettes in the United States increases smuggling at the state level by an average of 31 percent. That’s a really big jump. Other academic studies have looked at this more globally, and, an estimate that we refer to quite often is that a one euro increase in the tax per pack of cigarettes would increase illicit market share of the total market by five to 12 percentage points, and then also increase illicit cigarette sales by 29 to up to 95 percent.

Kyle Hulehan: So how do individual states with their, you know, policies, those in, New York, Massachusetts, or California, how does that influence the local cross-border elicit cigarette trade?

Adam Hoffer: One of the beauties of the American system is that we get these, series of experiments at the state level. We can see what happens when states implement a policy.

So, Massachusetts and California were the first two states in the country to ban the sale of menthol cigarettes. Massachusetts did so in 2020, and California just did so in late 2022. Now we’re still gathering our data on California. We have some early impacts, but we have some good data and we’ve had time to collect it in Massachusetts. The flavor ban in Massachusetts, the year after the flavor ban passed, sales of cigarettes in Massachusetts fell 24 percent, but we could track nine out of 10 of every one of those packs no longer sold in Massachusetts. We could track them to increased sales in neighboring states.

In California, our early estimates suggest that we’re not seeing the uptick in sales and neighboring states. Instead what our preliminary data suggests is that the offset in sales in California is likely going to be driven from either product coming across the border from Mexico or it’s product that has been earmarked or labeled for export that is just vanishing out of warehouses and never really being exported.

New York just implemented a $1 per pack cigarette tax increase effective September 2023. For the first time in my career, I saw the state fiscal agency actually estimate that the rate hike was going to create a revenue loss. Or, in other words, the fiscal agency acknowledged that the increase in the tax per pack would drive even more consumers away from legal markets. Again, we already know that over half the market in New York exists on black markets or smuggled across state lines, and we just expect that percentage to increase after this new rate hike.

Kyle Hulehan: Not that, you know, Massachusetts, California, and New York were ever the bastions of tax policy or anything that we would necessarily recommend at times, but that’s pretty baffling that a state would enact something that they know would likely drive people away from legal markets. It’s hard to make sense of that for me. How might U.S. policy inadvertently boost elicit trade both domestically and globally?

Adam Hoffer: I think we’ve already seen the FDA play an enormous role in the development of the illicit tobacco trade by failing to approve any flavored vaping products whatsoever. The exact kinds of products that the FDA has stated, it wants more smokers to switch to.

The agency facilitated a thriving black market in the vaping space. Estimates suggest that non-approved disposable vaping products now make up the majority of the market for sale in the United States across the whole country. Products that are not approved for sale in the United States now make up the majority of disposable vaping sales. This is a really big problem, and all parties, the FDA, and authorities are having difficulty reigning this market in.

But on the horizon, the FDA has major action items that could make these effects look really small. On the FDA’s upcoming agenda, we see a final decision on whether to implement a nationwide menthol flavor ban. And then also, they have expressed interest in putting out a new product ruling that would essentially be a prohibition on cigarettes by mandating that all tobacco products carry a very low nicotine content. Either of these would fuel illicit activity to heights that we haven’t seen in this country. It has the potential to really change the entire market, and illicit activity is likely to explode.

Kyle Hulehan: And with illicit activity likely to explode, there’s this government report that you had shown to me about the global illicit trade in tobacco, and I see on there that there are these operations like Operation Black Poseidon, which was a seizure of 30 tons of cut tobacco with nearly 350,000 ready-to-sell cigarettes.

That was, you know, estimated at this value of $560,000. And then there was Operation Smoke Out, which was a seizure of 4,000 cartons of untaxed cigarettes, 22,000 untaxed cigars, and nearly $400,000 in cash property. And that’s before these measures have been put in place. So, you know, beyond the lost revenue, how does cigarette smuggling link to these other illicit activities?

Adam Hoffer: Well, this is the bigger problem. Yes, there are dangers of bad products in illegal markets, but on top of those problems, every successful illegal sale funds the operations of these criminal organizations and all the other activities those criminal organizations do. Cigarette smuggling is a cash cow operation for these criminal organizations. Really low risk, really high reward. Studies have linked cigarette smuggling organizations and the funds generated through cigarette smuggling to corruption, money laundering, and even terrorism. These illegal markets are a really big problem.

Kyle Hulehan: Yeah, very clearly they are a huge problem and something that needs to get sorted out and something maybe that tax policy could have a little say in. But what are the potential solutions for government? We don’t want to just talk about issues here. We want to provide something, some solutions and, what could international bodies employ, you know, to combat the rising illicit tobacco trade without creating even more market distortions.

Adam Hoffer: I think the most important first step is to recognize and acknowledge that smuggling activity exists and it’s a threat to public policy. So, let’s remember that the goal of public policy should be to improve well-being. Smuggling and illicit trade threaten the ability of excise taxes to improve well-being.

We’ve seen a direct effort by organizations around the globe to sort of pretend like smuggling doesn’t exist, and to say that, well smuggling might exist, but if so, all you need is some more enforcement and the problem will go away. I’d like to see smuggling estimates incorporated into the actual estimates of what the impact of a policy is going to be.

And I’d also like to offer an alternative perspective for public policy here to consider. What if public policy tried to minimize and eliminate illicit market activity through lower taxes and friendlier regulation, not just from brute police force or trying to manipulate and control the decisions of consenting adults participating in legal markets?

I think that reducing illegal market activity would have a much more profound impact on human well-being, both here in the United States and around the world.

Kyle Hulehan: Adam, as, as we’re closing out here, I mean, this is a fascinating episode. I really could not have guessed that illegal tobacco trade had all of these webs of connections out to these illegal markets, to all of these different things. So, as we’re closing, maybe we’ll have you on some day to discuss something just a little bit more wholesome than black markets and illicit trade.

But is there anything that you’d like to promote or share with our audience or throw out that you’re working on right now?

Adam Hoffer: Yeah, I mean, I would like to also say we spent the whole episode talking about tobacco. This is also the case for all other things to get excise taxes and there’s a lot more public policy on the horizon in the U.S. and around the world, on issues like alcohol, sports betting, and cannabis. There’s going to be a real change in public policy in the future, and again, I would like to see this public policy improve the well-being of people around the world.

In the upcoming months, we have a new edition of our cigarette smuggling report coming out. This will be our first year with data covering the full Massachusetts flavor ban, and we’ll be able to show exactly how much smuggling increased in Massachusetts. To give a slight teaser of the results, it’s a lot. Smuggling went up a lot in the state.

We also have one of the things we’re going to try to estimate later this year, I mentioned the illegal, disposable vaping market. We’re going to try to do some research into whether or not these vendors are remitting taxes on these vapor sales.

So, there’s a lot of really interesting work going on in the excise space, and I very much look forward to doing that and being able to come back on the podcast to talk about it.

Kyle Hulehan: Absolutely Adam, you’re welcome here anytime.

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