oversight

Tobacco Taxes: Large Disparities in Rates for Smoking Products Trigger Significant Market Shifts to Avoid Higher Taxes

Published by the Government Accountability Office on 2012-04-18.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

             United States Government Accountability Office

GAO          Report to Congressional Committees




April 2012
             TOBACCO TAXES

             Large Disparities in
             Rates for Smoking
             Products Trigger
             Significant Market
             Shifts to Avoid Higher
             Taxes




GAO-12-475
                                                April 2012

                                                TOBACCO TAXES
                                                Large Disparities in Rates for Smoking Products
                                                Trigger Significant Market Shifts to Avoid Higher
                                                Taxes
Highlights of GAO-12-475, a report to
congressional committees




Why GAO Did This Study                          What GAO Found
In 2009, CHIPRA increased and                   Large federal excise tax disparities among tobacco products, which resulted from
equalized federal excise tax rates for          the Children’s Health Insurance Program Reauthorization Act (CHIPRA) of 2009,
cigarettes, roll-your-own tobacco, and          created opportunities for tax avoidance and led to significant market shifts by
small cigars. Though CHIPRA also                manufacturers and price sensitive consumers toward the lower-taxed products.
increased federal excise tax rates for          Monthly sales of pipe tobacco increased from approximately 240,000 pounds in
pipe tobacco and large cigars, it raised        January 2009 to over 3 million pounds in September 2011, while roll-your-own
the pipe tobacco tax to a rate                  tobacco dropped from about 2 million pounds to 315,000 pounds. For the same
significantly below the equalized rate          months, large cigar sales increased from 411 million to over 1 billion cigars, while
for the other products, and its large
                                                small cigars dropped from about 430 million to 60 million cigars (see figure).
cigar excise tax can be significantly
                                                According to government, industry, and nongovernmental organization
lower, depending on price. Treasury
collects federal excise taxes on
                                                representatives, many roll-your-own tobacco and small cigar manufacturers
tobacco products.                               shifted to the lower-taxed products after CHIPRA to avoid paying higher taxes.

Also passed in 2009, the Family                 FY 01-11 Monthly Sales for Roll-Your-Own and Pipe Tobacco, and for Small and Large Cigars
Smoking Prevention and Tobacco
Control Act (Tobacco Control Act)
granted FDA regulatory authority over
tobacco products. This act directed
GAO to report on trade in tobacco
products, including the effects of
differing tobacco tax rates. This report
(1) reviews the market shifts in
smoking tobacco products since
CHIPRA; (2) examines the impact of
the market shifts on federal revenue
and Treasury’s actions to respond; and
(3) describes differences in FDA’s
regulation of various smoking tobacco
products. GAO interviewed agency
officials, industry members, and public
health representatives. GAO analyzed            While revenue collected for all smoking tobacco products from April 2009 through
tax and revenue data and reviewed               fiscal year 2011 amounted to $40 billion, GAO estimates that federal revenue
relevant literature.
                                                losses due to market shifts from roll-your-own to pipe tobacco and from small to
                                                large cigars range from about $615 million to $1.1 billion for the same period.
What GAO Recommends                             The Department of the Treasury (Treasury) has limited options to respond to
As Congress continues its oversight of          these market shifts. Treasury has attempted to differentiate between roll-your-
CHIPRA and Tobacco Control Act                  own and pipe tobacco for tax purposes but faces challenges because the
implementation, it should consider              definitions of the two products in the Internal Revenue Code of 1986 do not
equalizing tax rates on roll-your-own           specify distinguishing physical characteristics. Treasury also has limited options
and pipe tobacco and, in consultation           to address the market shift to large cigars and faces added complexity in
with Treasury, consider options for             monitoring and enforcing tax payments due to the change in large cigar tax rates.
reducing tax avoidance due to tax
differentials between small and large           Unlike cigarettes and roll-your-own tobacco, pipe tobacco and cigars are not
cigars. Treasury generally agreed with          currently regulated by the Food and Drug Administration (FDA) and thus are not
GAO’s conclusions and observations.             subject to the same restrictions on characterizing flavors, sales, or distribution. In
                                                2011, FDA indicated its intent to issue a proposed rule that would deem products
View GAO-12-475. View related video clip. For   meeting the statutory definition of “tobacco product” to be subject to FDA’s
more information, contact David Gootnick at
(202) 512-3149 or gootnickd@gao.gov.            regulation. However, FDA had not issued the proposed rule as of March 2012.
                                                FDA officials told GAO that developing the rule was taking longer than expected.
                                                                                            United States Government Accountability Office
Contents


Letter                                                                                  1
               Background                                                               3
               Large Tax Disparities among Similar Tobacco Products Triggered
                 Significant Market Shifts to Avoid Higher Taxes                       14
               Market Shifts to Avoid Taxes Have Reduced Federal Revenue, and
                 Treasury Has Limited Options to Respond                               21
               FDA Currently Regulates Cigarettes and Roll-Your-Own Tobacco
                 but Not Pipe Tobacco and Cigars                                       36
               Conclusions                                                             41
               Matter for Congressional Consideration                                  43
               Agency Comments and Our Evaluation                                      43

Appendix I     Objectives, Scope, and Methodology                                      45



Appendix II    Sales of Smoking Tobacco Products in the United States, Fiscal
               Years 2001-2011                                                         50



Appendix III   Summary of Treasury’s Proposed Rulemaking Actions to
               Distinguish between Roll-Your-Own and Pipe Tobacco                      53



Appendix IV    Comments from the Department of the Treasury                            55



Appendix V     GAO Contact and Staff Acknowledgments                                   57



Tables
               Table 1: Definitions of Smoking Tobacco Products in the IRC              5
               Table 2: Federal Excise Tax Rates for Cigarettes, Roll-Your-Own
                        Tobacco, Pipe Tobacco, and Small Cigars, Before and
                        After CHIPRA                                                    8
               Table 3: Federal Excise Tax Rates for Large Cigars, Before and
                        After CHIPRA                                                   10
               Table 4: Treasury Actions on Roll-Your-Own and Pipe Tobacco
                        following CHIPRA, Industry Comments, and Status                28


               Page i                                             GAO-12-475 Tobacco Taxes
          Table 5: U.S. Sales of Cigarettes and Other Smoking Tobacco
                   Products, Fiscal Years 2001-2011 (in Billions of Sticks)          51


Figures
          Figure 1: Examples of Cigarette and Cigar Products                          6
          Figure 2: Tax Rates for Cigarettes, Roll-Your-Own Tobacco, Pipe
                   Tobacco, and Small Cigars, 1951-2010                               7
          Figure 3: Changes in Federal Excise Tax Rates as a Result of
                   CHIPRA—for Cigarettes, Roll-Your-Own Tobacco, Pipe
                   Tobacco, and Small Cigars                                          9
          Figure 4: Changes in Federal Excise Tax Rates as a Result of
                   CHIPRA—for Large Cigars under Three Different
                   Scenarios                                                         11
          Figure 5: Payment of Federal, State, and Local Excise Taxes in the
                   Supply Chain for U.S. Tobacco Products                            12
          Figure 6: Monthly and Annual U.S. Sales of Roll-Your-Own and Pipe
                   Tobacco, Fiscal Years 2001-2011                                   15
          Figure 7: Combined U.S. Sales of Roll-Your-Own and Pipe Tobacco,
                   Fiscal Years 2001-2011                                            16
          Figure 8: Number of Companies Producing Roll-Your-Own
                   Tobacco, Pipe Tobacco, or Both, 2007-2011                         18
          Figure 9: Examples of Maryland Retail Prices for Cartons of
                   Various Types of Cigarettes                                       19
          Figure 10: Monthly and Annual U.S. Sales of Small and Large
                   Cigars, Fiscal Years 2001-2011                                    20
          Figure 11: Combined U.S. Sales of Small and Large Cigars, Fiscal
                   Years 2001-2011                                                   21
          Figure 12: Estimated Revenue Losses for Roll-Your-Own and Pipe
                   Tobacco                                                           24
          Figure 13: Estimated Revenue Losses for Small and Large Cigars             26
          Figure 14: Post-CHIPRA Incentives for Some Manufacturers to
                   Switch from Small to Large Cigars                                 32
          Figure 15: Post-CHIPRA Incentives for Some Manufacturers and
                   Importers to Lower the Sale Price of Large Cigars                 34
          Figure 16: Basic Phases in FDA’s Rulemaking Process                        41
          Figure 17: U.S. Sales of Cigarettes and Other Smoking Tobacco
                   Products, Fiscal Years 2001-2011                                  52




          Page ii                                               GAO-12-475 Tobacco Taxes
Abbreviations

CHIPRA              Children’s Health Insurance Program
                    Reauthorization Act of 2009
FDA                 Food and Drug Administration
IRC                 Internal Revenue Code of 1986
RYO                 roll-your-own tobacco
Tobacco Control Act Family Smoking Prevention and Tobacco Control
                    Act
Treasury            Department of the Treasury




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Page iii                                                       GAO-12-475 Tobacco Taxes
United States Government Accountability Office
Washington, DC 20548




                                   April 18, 2012

                                   The Honorable Tom Harkin
                                   Chairman
                                   The Honorable Michael B. Enzi
                                   Ranking Member
                                   Committee on Health, Education, Labor, and Pensions
                                   United States Senate

                                   The Honorable Fred Upton
                                   Chairman
                                   The Honorable Henry A. Waxman
                                   Ranking Member
                                   Committee on Energy and Commerce
                                   United States House of Representatives

                                   Tobacco use is the leading cause of preventable death, disease, and
                                   disability and a significant contributor to health care costs in the United
                                   States. The Centers for Disease Control and Prevention reports that
                                   smoking and exposure to secondhand smoke account for over 440,000
                                   premature deaths per year and cost the United States an estimated $193
                                   billion annually in health care expenditures and productivity losses.
                                   Federal and state legislation has aimed to discourage tobacco use and
                                   raise revenues by increasing excise taxes on tobacco products. The most
                                   recent federal increase occurred in 2009 when Congress passed the
                                   Children’s Health Insurance Program Reauthorization Act of 2009
                                   (CHIPRA),1 which amended the Internal Revenue Code of 1986 (IRC) by
                                   raising excise tax rates on tobacco products. The Department of the
                                   Treasury (Treasury) is responsible for collecting these taxes. In addition,
                                   in order to reduce tobacco use and protect public health, in June 2009,
                                   Congress passed the Family Smoking Prevention and Tobacco Control
                                   Act (Tobacco Control Act),2 which granted the Food and Drug
                                   Administration (FDA) authority to regulate the manufacture, distribution,
                                   and marketing of tobacco products.




                                   1
                                    Pub. L. No. 111-3, 123 Stat. 8.
                                   2
                                    Pub. L. No. 111-31, Div. A, 123 Stat. 1776.




                                   Page 1                                              GAO-12-475 Tobacco Taxes
Title III of the Tobacco Control Act directed GAO to report on various
aspects of trade in tobacco products, including the effects resulting from
the differing tax rates applicable to tobacco products.3 This report
examines the federal revenue effects resulting from different federal
excise tax rates on various smoking tobacco products and differences in
FDA’s regulation of these products. Specifically, we (1) review the market
shifts among smoking tobacco products since CHIPRA went into effect on
April 1, 2009; (2) examine the impact of these market shifts on federal
revenue and Treasury’s actions to respond; and (3) describe differences
in FDA’s regulation of various smoking tobacco products. Our review
includes smoking tobacco products that are subject to federal excise tax:
cigarettes and four other tobacco products—roll-your-own tobacco
(sometimes called RYO), pipe tobacco, small cigars, and large cigars.4
However, in analyzing the market shifts among these products, we
focused solely on the four smoking tobacco products other than
cigarettes.

To address the three objectives in this study, we reviewed documents
and interviewed agency officials from Treasury’s Alcohol and Tobacco
Tax and Trade Bureau, FDA, and the Centers for Disease Control and
Prevention, as well as tobacco industry members, representatives of
public health and other nongovernmental organizations, and academics,
to obtain information on tobacco legislation and regulations, tobacco
product sales trends, and consumption patterns. We also reviewed
studies analyzing the relationship between tobacco tax increases and
smoking, including among youth. We analyzed Treasury removals data to
identify sales trends across the different tobacco products. As used in this
report, for smoking tobacco products, “removals” means the amount
removed for distribution in the United States from the factory or released
from customs.5 In this report, we consider removals to be equivalent to
sales and use the term sales. In addition, we collected and analyzed data


3
 Responding to this mandate, in March 2011, we issued a first report on illicit tobacco
trade and schemes. GAO, Illicit Tobacco: Various Schemes Are Used to Evade Taxes and
Fees, GAO-11-313 (Washington, D.C.: Mar. 7, 2011).
4
 Smokeless tobacco products that are subject to federal excise taxes, such as chewing
tobacco and snuff, were outside the scope of this review. “Processed tobacco” is not
subject to federal excise tax and is defined in the IRC by what it is not: processed tobacco
does not include the farming or growing of tobacco or the handling of tobacco solely for
sale, shipment, or delivery to a manufacturer of tobacco products or processed tobacco.
5
 26 U.S.C. § 5702(j).




Page 2                                                          GAO-12-475 Tobacco Taxes
             on federal excise tax rates for these tobacco products and the revenues
             generated from their sale. We estimated what the effect on tax revenue
             collection would have been if the sales trends for roll-your-own and pipe
             tobacco and for small and large cigars had not been affected by
             substitution between the products but had been affected by the increase
             in price due to the tax—in other words, if the market shifts resulting from
             the substitution of higher-taxed products with lower-taxed products had
             not occurred. In this report, we refer to this estimated effect on federal tax
             revenue collection as revenue losses. Our analysis takes into account the
             expected fall in quantity demanded due to the price increases resulting
             from higher federal excise tax rates that CHIPRA imposed on all four of
             these smoking tobacco products. See appendix I for more information on
             our objectives, scope, and methodology.

             We conducted this performance audit from March 2011 to April 2012 in
             accordance with generally accepted government auditing standards.
             Those standards require that we plan and perform the audit to obtain
             sufficient, appropriate evidence to provide a reasonable basis for our
             findings and conclusions based on our audit objectives. We believe that
             the evidence obtained provides a reasonable basis for our findings and
             conclusions based on our audit objectives.


             Cigarettes continue to dominate the smoking tobacco product market,
Background   accounting for approximately 91 percent of sales in 2011. However, the
             use of other smoking tobacco products has increased over the past 10
             years. Between 2001 and 2011, combined sales of roll-your-own tobacco,
             pipe tobacco, and small and large cigars grew from 3 percent of the
             smoking tobacco market to 9 percent. Although cigarette use in the
             United States is declining, it is partially offset by growing use of other
             smoking tobacco products. (See app. II for data on U.S. sales of smoking
             tobacco products from fiscal year 2001 through fiscal year 2011.)

             Increasing the price of tobacco products by raising excise taxes is widely
             recognized as an effective policy for reducing smoking prevalence across




             Page 3                                                GAO-12-475 Tobacco Taxes
                        socioeconomic and racial groups.6 Public health and economic studies
                        have found that adolescents are more responsive than adults to tobacco
                        tax and price increases because they have less disposable income.7
                        However, the impact of tax increases on reducing overall smoking
                        prevalence is likely to be weaker if smokers can turn to tobacco products
                        that can be used as functional equivalents of factory-made cigarettes and
                        cost significantly less, according to public health officials and academics.


Tobacco Products Have   Smoking tobacco products are broadly defined in the IRC.8 Roll-your-own
Broad Definitions       tobacco and pipe tobacco are defined by such factors as the use for
                        which the product is suited and how they are offered for sale, as indicated
                        by their appearance, type, packaging, and labeling. Cigars are
                        differentiated from cigarettes by their wrapper and whether the product is,
                        for a number of reasons, likely to be offered to, or purchased by,
                        consumers as a cigarette. The tax rate for cigars is categorized into small
                        and large cigars, which are differentiated by a weight threshold alone—
                        small cigars are defined as weighing 3 pounds or less per thousand
                        sticks.9,10 The definitions found in the IRC characterize five types of




                        6
                          The World Health Organization, for example, recommends raising tobacco taxes as one
                        of the six components of its MPOWER framework, which provides guidance to countries
                        to implement tobacco control policies. The World Bank recommends that, to curb tobacco
                        use, excise taxes should account for two-thirds to four-fifths of the retail price of a pack of
                        cigarettes. In the United States, the Centers for Disease Control and Prevention, the U.S.
                        Surgeon General, and the Institute of Medicine of the National Academy of Sciences
                        report that tobacco excise tax increases are one of the most effective tobacco strategies
                        for reducing tobacco use. The Centers for Disease Control and Prevention, which through
                        its Office on Smoking and Health is the lead federal agency for tobacco control and
                        prevention, recognizes tobacco excise tax increases as an effective population-based
                        tobacco control and prevention intervention at the federal and state levels.
                        7
                         In 1989, GAO reviewed studies available at that time; see GAO, Teenage Smoking:
                        Higher Excise Tax Should Significantly Reduce the Number of Smokers,
                        GAO/HRD-89-119 (Washington, D.C.: June 30, 1989).
                        8
                         26 U.S.C. § 5702.
                        9
                         26 U.S.C. § 5701.
                        10
                          As with small and large cigars, the IRC distinguishes between small and large cigarettes
                        based on weight. Small cigarettes are defined as weighing 3 pounds or less per thousand
                        sticks. When we refer to cigarettes in this report, we are discussing small cigarettes, as
                        defined in the IRC. Treasury data show that no large cigarettes were manufactured in the
                        United States between fiscal years 2001 and 2011.




                        Page 4                                                             GAO-12-475 Tobacco Taxes
                                         smoking tobacco products that are relevant to our discussion, as shown
                                         in table 1.11

Table 1: Definitions of Smoking Tobacco Products in the IRC

Product                    Definition
Cigarette                  (1) Any roll of tobacco wrapped in paper or in any substance not containing tobacco or (2) any roll of
                           tobacco wrapped in any substance containing tobacco which, because of its appearance, the type of
                           tobacco used in the filler, or its packaging and labeling, is likely to be offered to, or purchased by,
                           consumers as a cigarette described in (1).
Roll-Your-Own tobacco      Any tobacco which, because of its appearance, type, packaging, or labeling, is suitable for use and
                           likely to be offered to, or purchased by, consumers as tobacco for making cigarettes or cigars, or for use
                           as wrappers thereof.
Pipe tobacco               Any tobacco which, because of its appearance, type, packaging, or labeling, is suitable for use and
                           likely to be offered to, or purchased by, consumers as tobacco to be smoked in a pipe.
Small cigar                Any roll of tobacco wrapped in leaf tobacco or in any substance containing tobacco (other than any roll
                           of tobacco which is a cigarette) that weighs 3 pounds or less per thousand.
Large cigar                Any roll of tobacco wrapped in leaf tobacco or in any substance containing tobacco (other than any roll
                           of tobacco which is a cigarette) that weighs more than 3 pounds per thousand.
                                         Source: 26 U.S.C. §§ 5701, 5702.


                                         Figure 1 shows a sample of different cigarette and cigar products. Several
                                         of the products closely resemble each other in size and shape. The three
                                         on the left are cigarettes. The first is a roll-your-own cigarette12 made by
                                         hand with roll-your-own tobacco. The second is a roll-your-own cigarette
                                         made in a commercial roll-your-own machine13 with pipe tobacco. And the
                                         third from the left is a factory-made cigarette. The three products on the
                                         right are cigars, which can vary widely in size, shape, flavor, and aroma.
                                         According to industry representatives, a nongovernmental organization,
                                         and government officials, traditionally, cigars are hand-rolled, wrapped in
                                         a tobacco leaf, large in size, and their smoke is not meant to be inhaled.
                                         However, they indicated that many small and large cigars now have
                                         filters, are wrapped in a type of paper made with tobacco, and can be
                                         similar in size and appearance to cigarettes.


                                         11
                                           The IRC also provides definitions for smokeless tobacco products, which are not listed
                                         here.
                                         12
                                           In this report, we define roll-your-own cigarettes as cigarettes made by consumers with
                                         loose tobacco, such as roll-your-own tobacco or pipe tobacco.
                                         13
                                           Commercial roll-your-own machines are located in some stores that sell tobacco
                                         products. These machines allow customers to make a carton of cigarettes in less than 10
                                         minutes. They are discussed in more detail in the next section of the report.




                                         Page 5                                                           GAO-12-475 Tobacco Taxes
                          Figure 1: Examples of Cigarette and Cigar Products




Federal Excise Taxes on   While the enactment of CHIPRA in 2009 represents the most recent
Tobacco Products Most     increase in federal excise taxes on tobacco products, Congress has taxed
Recently Increased by     tobacco products since its inception as a means to raise revenue.14 Of the
                          smoking tobacco products that we discuss in this report, Congress taxed
CHIPRA
                          only cigarettes, small cigars, and large cigars prior to 1989. Congress
                          began taxing pipe tobacco on January 1, 1989,15 and roll-your-own
                          tobacco on January 1, 2000.16 As the danger of tobacco became better
                          known, congressional debates surrounding tobacco taxes expanded from
                          increasing revenue to protecting the public from health risks of tobacco.



                          14
                           Act of August 10, 1790, ch. 39, §§ 1-2, 1 Stat. 24 (1789).
                          15
                            Technical and Miscellaneous Revenue Act of 1988, Pub. L. No. 100-647, § 5061(d), 102
                          Stat. 3342, 3679. This tax became effective after December 31, 1988.
                          16
                            Balanced Budget Act of 1997, Pub. L. No. 105-33, § 9302(g), 111 Stat. 251, 672. This
                          tax became effective after December 31, 1999.




                          Page 6                                                        GAO-12-475 Tobacco Taxes
                                        Figure 2 shows the tax rates for four smoking tobacco products from 1951
                                        to 2010.

Figure 2: Tax Rates for Cigarettes, Roll-Your-Own Tobacco, Pipe Tobacco, and Small Cigars, 1951-2010




                                        Note: Large cigar tax rates are not included in this figure because they are taxed at an ad valorem
                                        rate—a percentage of the manufacturer’s or importer’s sale price—up to a maximum tax per
                                        thousand sticks, rather than a rate based on units or weight.

                                        a
                                         Roll-your-own and pipe tobacco taxes are shown at an equivalent tax per stick rate based on the
                                        Master Settlement Agreement conversion rate for roll-your-own tobacco of 0.0325 ounces per stick.
                                        We are applying this conversion rate to pipe tobacco for the purpose of comparison because
                                        Treasury has not yet differentiated the physical characteristics of roll-your-own and pipe tobacco.


                                        The federal excise tax rates on different tobacco products are calculated
                                        in different ways. Cigarettes and small cigars are taxed on a unit basis—
                                        number of sticks. Roll-your-own and pipe tobacco are taxed by weight.
                                        Table 2 provides information on the different federal excise tax rates for
                                        cigarettes, roll-your-own tobacco, pipe tobacco, and small cigars before
                                        and after CHIPRA.




                                        Page 7                                                                  GAO-12-475 Tobacco Taxes
Table 2: Federal Excise Tax Rates for Cigarettes, Roll-Your-Own Tobacco, Pipe
Tobacco, and Small Cigars, Before and After CHIPRA

    Tobacco                                               Before               After      Percentage
    products                 Unit of taxation            CHIPRA              CHIPRA         increase
    Cigarettesa              thousand sticks               $19.50              $50.33            158%
    Roll-Your-Own            pounds                          $1.10             $24.78          2,159%
    tobacco
    Pipe tobacco             pounds                          $1.10              $2.83            158%
    Small cigars             thousand sticks                 $1.83             $50.33          2,653%
Source: GAO analysis of the IRC.


Note: Although we rounded the tax rates to the nearest cent for this table, we used the exact tax rate
in our calculations.
a
 The federal excise tax rate for large cigarettes up to 6.5 inches long was $40.95 per thousand sticks
prior to CHIPRA and became $105.69 per thousand sticks after CHIPRA. Large cigarettes over 6.5
inches long are taxed at the rate for small cigarettes, counting each 2.75 inches or fraction thereof of
the length of each as one cigarette.

Before CHIPRA, the federal excise tax rate on cigarettes was higher than
the rates on roll-your-own tobacco, pipe tobacco, and small cigars.
However, CHIPRA significantly raised the tax rates on these four
products and equalized the rates on cigarettes, roll-your-own tobacco,
and small cigars (see fig. 3). Congress equalized the tax rates on roll-
your-own tobacco and small cigars with the cigarette tax rate in part in
response to concerns that smokers had been using these two products as
substitutes for higher-taxed factory-made cigarettes, according to
nongovernmental organizations. CHIPRA also raised the federal excise
tax rate on pipe tobacco, but to a rate that is considerably lower. Prior to
CHIPRA, the tax rate on roll-your-own tobacco and pipe tobacco was the
same.




Page 8                                                                   GAO-12-475 Tobacco Taxes
Figure 3: Changes in Federal Excise Tax Rates as a Result of CHIPRA—for
Cigarettes, Roll-Your-Own Tobacco, Pipe Tobacco, and Small Cigars




a
 The roll-your-own tobacco and pipe tobacco cigarette stick equivalent is based on the weight of
0.0325 ounces of tobacco per cigarette stick using the Master Settlement Agreement conversion rate.


CHIPRA significantly changed the federal excise tax rate on large cigars.
Large cigars are unique among tobacco products in that the tax rate is ad
valorem—a percentage of the manufacturer’s or importer’s sale price per
thousand sticks—up to a maximum tax per thousand sticks. Before
CHIPRA, large cigars were taxed at 20.72 percent of the manufacturer’s
or importer’s sale price up to a maximum tax of $48.75 per thousand
sticks. After CHIPRA, the ad valorem rate increased to 52.75 percent of
the manufacturer’s or importer’s sale price, and the maximum tax per
thousand sticks increased to $402.60 (see table 3). According to an
industry association, the retail prices of premium handmade large cigars
range from $3 to $20. A public health organization noted that smaller
factory-made cigars that meet the legal definition of a large cigar can cost
as little as $0.07 per cigar.




Page 9                                                               GAO-12-475 Tobacco Taxes
Table 3: Federal Excise Tax Rates for Large Cigars, Before and After CHIPRA

Tobacco                                                                        Before      After          Percentage
product           Unit of taxation                                            CHIPRA     CHIPRA             increase
Large cigars      Ad valorem rate based on manufacturer’s or importer’s       20.72%      52.75%                155%
                  sale price up to a maximum tax rate
                  Maximum tax per thousand sticks                              $48.75     $402.60               726%
                                          Source: GAO analysis of the IRC.


                                          Figure 4 illustrates the tax structure for large cigars, before and after
                                          CHIPRA and includes three different scenarios. The sloped line
                                          represents the ad valorem rate, which becomes flat when it reaches the
                                          maximum tax per thousand cigars. The following are examples of the
                                          federal excise taxes manufacturers and importers would have to pay for
                                          differently priced large cigars, before and after CHIPRA (see examples
                                          corresponding with fig. 4):

                                          A. If the manufacturer’s or importer’s sale price per thousand large cigars
                                             is $100, before CHIPRA the ad valorem tax rate was $20.72 per
                                             thousand; after CHIPRA it became $52.75 per thousand.

                                          B. If the manufacturer’s or importer’s sale price per thousand large cigars
                                             is $500, before CHIPRA the tax rate was the maximum tax of $48.75
                                             per thousand; after CHIPRA it became $263.75 per thousand based
                                             on the new ad valorem tax rate.

                                          C. If the manufacturer’s or importer’s sale price per thousand large cigars
                                             is $800, before CHIPRA the tax rate was the maximum tax of $48.75
                                             per thousand; after CHIPRA it became $402.60, which is the new
                                             maximum tax rate per thousand.




                                          Page 10                                             GAO-12-475 Tobacco Taxes
Figure 4: Changes in Federal Excise Tax Rates as a Result of CHIPRA—for Large
Cigars under Three Different Scenarios




Note: The sloped lines represent the ad valorem rates for large cigars before and after CHIPRA, with
the lines becoming flat when they reach the maximum rates of $48.75 (before CHIPRA) and $402.60
(after CHIPRA).

Treasury is responsible for administering and collecting the federal excise
tax on all tobacco products, among other things.17 In general, federal
excise taxes are collected when tobacco products leave the domestic
factory or, in the case of imports, when the products are released from




17
  Treasury’s Alcohol and Tobacco Tax and Trade Bureau administers Chapter 52 of the
IRC (26 U.S.C. Chapter 52) pursuant to section 1111(d) of the Homeland Security Act of
2002, codified at 6 U.S.C. § 531(d). The Secretary of the Treasury has delegated various
authorities through Treasury Department Order 120-01 (Revised), dated January 21,
2003, to Treasury’s Alcohol and Tobacco Tax and Trade Bureau Administrator to perform
the functions and duties in the administration and enforcement of this law. Treasury
conducts audits and investigations to enforce civil and criminal laws relating to tobacco tax
collection, sometimes referring criminal cases to the U.S. Attorney’s Office for prosecution.
It also operates a tobacco laboratory, which conducts analyses to evaluate products for
tax compliance and to support appropriate tax classification of different tobacco products.




Page 11                                                               GAO-12-475 Tobacco Taxes
customs custody.18 Tobacco manufacturers and importers are required to
obtain a Treasury permit to operate and must comply with Treasury’s
recordkeeping, reporting, and other requirements.19 Tobacco product
wholesalers and distributors are responsible for paying state and local
excise taxes, but they are not required to obtain a Treasury permit and
are not subject to Treasury recordkeeping requirements. Figure 5 shows
the major steps in the tobacco supply chain, including the key points at
which taxes are paid.

Figure 5: Payment of Federal, State, and Local Excise Taxes in the Supply Chain for
U.S. Tobacco Products




Note: Supply chains can differ by manufacturer/importer, and this figure does not represent all of the
steps in the distribution process.




18
  While Treasury collects federal excise taxes from domestic manufacturers, the U.S.
Customs and Border Protection within the Department of Homeland Security collects
federal excise taxes on imported tobacco products. Where tobacco products are imported
for distribution in the U.S. market and first deposited into a customs warehouse or foreign
trade zone, the federal excise taxes become due when they are removed from the first
warehouse, even when they are removed for transfer to another warehouse (26 U.S.C.
§ 5703).
19
   CHIPRA also extended Treasury’s permit requirement and related recordkeeping and
reporting requirements to manufacturers and importers of processed tobacco. Treasury’s
temporary regulatory definitions provide that the processing of tobacco includes, but is not
limited to, stemming, fermenting, threshing, cutting, or flavoring the tobacco, or otherwise
combining the tobacco with nontobacco ingredients. This definition is in effect until June
22, 2012.




Page 12                                                                 GAO-12-475 Tobacco Taxes
Tobacco Control Act Gave     In the Tobacco Control Act passed in June 2009, Congress amended the
FDA Broad Authority to       Food, Drug, and Cosmetic Act by inserting a chapter governing tobacco
Regulate Tobacco             products and granting FDA authority to regulate the manufacture,
                             distribution, and marketing of tobacco products under that chapter.20 The
Products to Protect Public
                             act aims to, among other things, reduce the use of tobacco products to
Health                       decrease health risks and social costs associated with tobacco-related
                             diseases. It recognizes that virtually all new users of tobacco products are
                             adolescents under the age of 18. According to the law, FDA’s regulation
                             of tobacco products is based, in part, on a public health standard rather
                             than the safety and effectiveness standard by which FDA regulates
                             pharmaceutical drugs and medical devices. For example, FDA can issue
                             restrictions on the sale, distribution, advertising, and promotion of a
                             tobacco product, if the public health standard is met. This standard
                             requires FDA to demonstrate that the proposed regulation is appropriate
                             for the protection of public health, based on a consideration of the risks
                             and benefits to the population as a whole, including users and nonusers
                             of tobacco products.

                             The act specifies that FDA’s authority over tobacco products under
                             Chapter IX of the Food, Drug, and Cosmetic Act shall apply to cigarettes,
                             roll-your-own tobacco, cigarette tobacco, and smokeless tobacco, as well
                             as any other tobacco products that the agency deems by regulation to be
                             subject to such authority.21 FDA does not at present regulate pipe tobacco
                             and small and large cigars. To implement the Tobacco Control Act, FDA
                             has established the Center for Tobacco Products.




                             20
                               Pub. L. No. 111-31. The Tobacco Control Act amended Chapter IX of the Food, Drug,
                             and Cosmetic Act, the main federal law that governs FDA’s work. Chapter IX provides the
                             primary authority for FDA’s regulation of tobacco products.
                             21
                               Pub. L. No. 111-31, § 101. The act defines cigarette tobacco as any product that
                             consists of loose tobacco that is intended for use by consumers in a cigarette and
                             smokeless tobacco as any tobacco product that consists of cut, ground, powdered, or leaf
                             tobacco and that is intended to be placed in the oral or nasal cavity.




                             Page 13                                                       GAO-12-475 Tobacco Taxes
                            Large federal excise tax disparities among tobacco products resulting
Large Tax Disparities       from CHIPRA caused sizable market shifts from higher to lower-taxed
among Similar               products. According to our analysis and interviews with knowledgeable
                            sources, the tax disparities created incentives for price sensitive
Tobacco Products            manufacturers and consumers to substitute higher-taxed products with
Triggered Significant       lower-taxed products. The market for roll-your-own tobacco shifted to pipe
Market Shifts to Avoid      tobacco and the growth rate of the combined market increased after
                            CHIPRA. Roll-your-own tobacco manufacturers shifted to pipe tobacco
Higher Taxes                with minimal, if any, changes to the products, and consumers substituted
                            pipe tobacco for use in roll-your-own cigarettes. At the same time, the
                            cigar market shifted from small to large cigars, and the combined cigar
                            market continued to grow after CHIPRA.


Market Shifted from Roll-   Market trends for roll-your-own and pipe tobacco changed immediately
Your-Own Tobacco to Pipe    after CHIPRA, with sales of pipe tobacco rising steeply while sales of roll-
Tobacco after CHIPRA        your-own tobacco plummeted. According to government officials and
                            representatives of industry and nongovernmental organizations,
                            manufacturers and consumers switched to lower-taxed pipe tobacco to
                            make roll-your-own cigarettes. After CHIPRA, the federal excise tax on
                            roll-your-own tobacco was over $20 per pound more than the tax on pipe
                            tobacco, whereas before CHIPRA, the taxes on both products were the
                            same. Figure 6 shows the market shift through monthly sales of roll-your-
                            own and pipe tobacco from fiscal year 2001 through fiscal year 2011.
                            Total annual sales of pipe tobacco grew from approximately 3.2 million
                            pounds in fiscal year 2008, the last year before CHIPRA, to 30.5 million
                            pounds in fiscal year 2011, representing an increase of about 869
                            percent. Over the same period, total annual sales of roll-your-own
                            tobacco declined from approximately 19.7 million pounds to 5.2 million
                            pounds, a decrease of about 74 percent. According to the representatives
                            of industry and nongovernmental organizations we interviewed, the shift
                            can be mostly attributed to consumers switching from using roll-your-own
                            tobacco to pipe tobacco in roll-your-own cigarettes, rather than to a
                            sudden increase in pipe smoking.




                            Page 14                                              GAO-12-475 Tobacco Taxes
Figure 6: Monthly and Annual U.S. Sales of Roll-Your-Own and Pipe Tobacco, Fiscal Years 2001-2011




                                        CHIPRA’s increase in the federal excise tax for roll-your-own tobacco did
                                        not dampen the overall sales of roll-your-own and pipe tobacco. Instead,
                                        the combined sales of roll-your-own and pipe tobacco increased because
                                        of the rapid growth in pipe tobacco sales following CHIPRA. Before
                                        CHIPRA, from October 2000 through March 2009, the combined average
                                        monthly growth rate was 0.63 percent; after CHIPRA, the combined
                                        average monthly growth rate increased to 2.00 percent. See Figure 7 for
                                        the trends in combined sales of roll-your-own and pipe tobacco from fiscal
                                        year 2001 through fiscal year 2011.




                                        Page 15                                                 GAO-12-475 Tobacco Taxes
Figure 7: Combined U.S. Sales of Roll-Your-Own and Pipe Tobacco, Fiscal Years 2001-2011




Manufacturers Switched                  According to government officials, representatives of nongovernmental
from Roll-Your-Own to                   organizations, and industry, after CHIPRA many manufacturers of roll-
Pipe Tobacco, and                       your-own tobacco switched to producing pipe tobacco in order to avoid
                                        higher taxes. According to these representatives and government
Consumers Began to Use                  officials, the new pipe tobacco products have minimal, if any, differences
Commercial Roll-Your-                   from roll-your-own tobacco. Roll-your-own tobacco and pipe tobacco are
Own Machines                            defined in the IRC by such factors as the use for which the product is
                                        suited and how they are offered for sale, as indicated by their
                                        appearance, type, packaging, and labeling. To meet the definition of pipe
                                        tobacco in the IRC and Treasury’s regulations,22 a product must be clearly
                                        labeled as pipe tobacco and not indicate other uses. The definitions of
                                        tobacco products in the IRC do not specify physical characteristics that


                                        22
                                          In June 2009, Treasury revised regulations on packaging and labeling roll-your-own and
                                        pipe tobacco to more clearly differentiate the two products. See table 4 for more
                                        information.




                                        Page 16                                                       GAO-12-475 Tobacco Taxes
would differentiate pipe tobacco from roll-your-own tobacco.
Representatives of industry and nongovernmental organizations provided
examples of current pipe tobacco brands that had been roll-your-own
brands prior to CHIPRA, with minimal differences in the packaging and
the appearance of the tobacco itself. We also found examples of Internet
retailers signaling to customers in their marketing that pipe tobacco was
suitable for smoking in roll-your-own cigarettes. One manufacturer of pipe
tobacco had designed its label with three-letter markings, to indicate to
customers the product’s similarity to brand-name cigarettes. For example,
the marking MRD indicated Marlboro Red and CML indicated Camel
Light.

We approached 15 pipe tobacco manufacturers to ask about their
companies’ actions in response to the CHIPRA tax changes. Each of the
three tobacco manufacturers that agreed to speak with us explained that
their companies switched from selling higher-taxed roll-your-own tobacco
to lower-taxed pipe tobacco in order to stay competitive. One company
changed the cut of its roll-your-own tobacco and labeled it as pipe
tobacco, although a company representative acknowledged that there
was no real difference between its pipe-cut tobacco and its roll-your-own
tobacco. A representative from another company that switched from
selling roll-your-own tobacco to selling pipe tobacco stated that she was
not aware of any difference in the two products other than the federal
excise tax rate.

Data show that the total number of companies exclusively manufacturing
pipe tobacco increased significantly since CHIPRA, while the number of
companies exclusively manufacturing roll-your-own tobacco decreased
sharply. Treasury emphasized that it is unclear whether these
manufacturers modified their roll-your-own tobacco beyond reclassifying it
as pipe tobacco. Data also show the number of companies producing
both roll-your-own and pipe tobacco has slowly increased since 2007
(see fig. 8).




Page 17                                             GAO-12-475 Tobacco Taxes
Figure 8: Number of Companies Producing Roll-Your-Own Tobacco, Pipe Tobacco,
or Both, 2007-2011




The rise in pipe tobacco sales coincided with the growing availability of
commercial roll-your-own machines. Treasury officials stated that there
has recently been significant growth in commercial roll-your-own
machines. These machines enable customers to produce a carton of
cigarettes using pipe tobacco and cigarette-paper tubes with filters. By
using pipe tobacco instead of roll-your-own tobacco, customers are able
to save almost $9 per carton in federal excise taxes.23 A common
commercial roll-your-own machine can produce a carton of cigarettes in
less than 10 minutes, providing a significant time saving compared with
making roll-your-own cigarettes by hand.




23
  Treasury officials also stated that processed tobacco, which is not subject to federal
excise tax, is being used in these machines to make roll-your-own cigarettes.




Page 18                                                          GAO-12-475 Tobacco Taxes
                              During our visit to a tobacco outlet store in Maryland, we used a
                              commercial roll-your-own machine to make a carton of 200 cigarettes
                              using pipe tobacco in about 8 minutes. We made a video showing this
                              machine being used to make cigarettes (See
                              http:www.gao.gov/multimedia/video#video_id=589493). The carton we
                              made in Maryland cost about $25, which included state and federal
                              excise taxes. The total price of $25 for our carton was about half the price
                              of a carton of discount cigarettes in nearby stores that sold tobacco24 (see
                              fig. 9).

                              Figure 9: Examples of Maryland Retail Prices for Cartons of Various Types of
                              Cigarettes




                              a
                              The retail price does not include sales tax.
                              b
                              These roll-your-own cigarettes were made in a commercial roll-your-own machine.




Cigar Market Shifted from     CHIPRA’s 2009 changes in federal excise tax rates on tobacco products
Small to Large Cigars after   also resulted in an immediate shift in the cigar market, with sales of lower-
CHIPRA                        taxed large cigars rising sharply while sales of higher-taxed small cigars
                              dropped. Figure 10 shows the market shift through monthly sales of small
                              and large cigars from fiscal year 2001 through fiscal year 2011. Total
                              annual sales of large cigars increased from approximately 4.8 billion
                              sticks in fiscal year 2008 to about 10.3 billion sticks in fiscal year 2011,
                              representing an increase of about 116 percent. For the same period, the
                              total annual sales of small cigars declined from 5.3 billion sticks to 0.8


                              24
                                This is not nationally representative because states have varying tobacco tax rates.
                              According to the Campaign for Tobacco-Free Kids, state cigarette taxes vary from $0.17
                              to $4.35 per pack, and pipe tax rates vary from a tax per ounce to a percent of
                              manufacturer’s or wholesale price. Maryland’s cigarette tax is $2.00 per pack, and pipe
                              tobacco tax is 15 percent of the wholesale price. The price shown for the roll-your-own
                              cigarettes made in a commercial roll-your-own machine with pipe tobacco includes a $10
                              fee charged by the store for the use of the machine.




                              Page 19                                                            GAO-12-475 Tobacco Taxes
                                        billion sticks, a decrease of 85 percent. According to government officials
                                        and representatives of nongovernmental organizations, because weight is
                                        the only characteristic that distinguishes small cigars from large cigars,
                                        many cigar manufacturers made their small cigars slightly heavier to
                                        qualify for the large cigar tax rate and avoid higher taxes levied on small
                                        cigars after CHIPRA. Figure 10 shows an increase in large cigar sales in
                                        the months immediately prior to the tax change. Treasury officials stated
                                        that although they have not specifically investigated the cause of this
                                        increase, there was an incentive for retailers and wholesalers to purchase
                                        and stockpile large cigars after the date CHIPRA was signed into law
                                        (February 4, 2009) and before the tax increase went into effect (April 1,
                                        2009). In addition, these officials noted that a floor stocks tax is typically
                                        imposed to prevent stockpiling just before a tax increase, but the floor
                                        stocks tax imposed by CHIPRA did not apply to large cigars.

Figure 10: Monthly and Annual U.S. Sales of Small and Large Cigars, Fiscal Years 2001-2011




                                        Page 20                                               GAO-12-475 Tobacco Taxes
                                        The combined sales for small and large cigars continued to increase after
                                        CHIPRA, though at a slightly lower rate. Before CHIPRA, from October
                                        2001 through March 2009, the combined average monthly growth rate
                                        was 0.75 percent, compared with a 0.17 percent growth rate from April
                                        2009 through September 2011. See figure 11 for trends in overall cigar
                                        sales from fiscal year 2001 through fiscal year 2011.

Figure 11: Combined U.S. Sales of Small and Large Cigars, Fiscal Years 2001-2011




                                        While tax revenue collected for all smoking tobacco products from April
Market Shifts to Avoid                  2009 through the end of fiscal year 2011 amounted to $40 billion, we
Taxes Have Reduced                      estimate that the market shifts from roll-your-own to pipe tobacco and
                                        from small to large cigars reduced federal revenue by a range of
Federal Revenue, and                    approximately $615 million to $1.1 billion for the same period. We
Treasury Has Limited                    estimated what the effect on tax revenue collection would have been if
Options to Respond                      the sales trends for roll-your-own and pipe tobacco and for small and
                                        large cigars had not been affected by substitution between the products
                                        but had been affected by the increase in price due to the tax—in other
                                        words, if the market shifts resulting from the substitution of higher-taxed



                                        Page 21                                               GAO-12-475 Tobacco Taxes
                          products with lower-taxed products had not occurred. In this report, we
                          refer to this estimated effect on federal tax revenue collection as revenue
                          losses. Although Treasury has taken steps to respond to these market
                          shifts, it has limited options. For example, Treasury has pursued
                          differentiating between roll-your-own and pipe tobacco for tax collection
                          purposes but faces challenges because the definitions of the two
                          products in the IRC do not specify distinguishing physical characteristics.
                          Furthermore, Treasury also has limited options to address the market
                          shift to large cigars.


Estimated Federal         We estimated that federal revenue losses due to the market shifts from
Revenue Losses from       roll-your-own to pipe tobacco and from small to large cigars range from
Market Shifts after       $615 million to $1.1 billion. This range includes combined tax revenue
                          losses for the roll-your-own and pipe tobacco markets, as well as the
CHIPRA Range from $615    small and large cigar markets. We conducted analyses of data from
Million to $1.1 Billion   Treasury and the Bureau of Labor Statistics to estimate tax revenue
                          losses in these markets.25,26 Our methodology takes into account the
                          expected fall in demand for a product following a price increase, holding
                          other variables constant. To calculate the range of federal revenue
                          losses, we included high and low estimates based on assumptions about
                          the effect of a price increase on projected sales.27 Economic studies show
                          that, when the price of a product increases, the quantity demanded for the
                          product will adjust downward, decreasing at an estimated rate based on
                          the quantity demanded for the product, that is, price elasticity.28 Based on
                          our interviews with government officials and academics and our literature
                          review, we determined that the price elasticity for the smoking tobacco


                          25
                            In the absence of this market shift due to differential tax rates, more tax revenue would
                          have been collected because roll-your-own tobacco and small cigars had historically much
                          higher levels of sales than pipe tobacco and large cigars, and after CHIPRA these tobacco
                          products also had a much higher tax rate.
                          26
                            Cigarettes are taxed at the same rate as roll-your-own tobacco and small cigars, but the
                          analysis does not take into account the likely impact of a similar market shift from
                          cigarettes to pipe tobacco and large cigars. See appendix II for information on sales of
                          cigarettes and other smoking tobacco products.
                          27
                            Using a somewhat similar approach, Treasury estimated that in 2010, over $400 million
                          in revenue was lost due to the shift from roll-your-own to pipe tobacco. Treasury’s
                          estimate did not take into account the expected decline in demand following a price
                          increase.
                          28
                            For example, a price elasticity of demand of -0.6 means that when prices go up by 10
                          percent, demand will decrease by 6 percent.




                          Page 22                                                        GAO-12-475 Tobacco Taxes
                                  products ranges from -0.6 to -0.3 for the low and high revenue estimates,
                                  respectively. Our projections also take into account the historic sales
                                  trends for these products and the tax component of the price.29 Appendix
                                  I contains more information on our methodology for developing these
                                  estimates.

Tax Revenue Losses in the Roll-   Treasury collected $573 million in tax revenue from roll-your-own and
Your-Own and Pipe Tobacco         pipe tobacco from April 2009 through September 2011.30 We estimate
Markets                           that during the same period the market shift from roll-your-own to pipe
                                  tobacco reduced federal revenues by between $255 million and $492
                                  million (see fig. 12).




                                  29
                                   For a detailed explanation of this methodology, see Frank Chaloupka and Jidong
                                  Huang, “A Significant Cigarette Tax Rate Increase in Illinois Would Produce a Large,
                                  Sustained Increase in State Tobacco Tax Revenues” (Chicago, IL: University of Illinois at
                                  Chicago, Jan. 3, 2011, working paper).
                                  30
                                    That is about $228 million per year after CHIPRA compared with $25.5 million for fiscal
                                  year 2008.




                                  Page 23                                                        GAO-12-475 Tobacco Taxes
Figure 12: Estimated Revenue Losses for Roll-Your-Own and Pipe Tobacco




                                       a
                                        Low projected revenue loss is calculated as the difference between the projected revenue in the low
                                       scenario and the actual collected revenue. When the actual revenue is higher than the low projected
                                       revenue, the estimated figure of $255 million includes the difference.




                                       Page 24                                                               GAO-12-475 Tobacco Taxes
Tax Revenue Losses in the       Treasury collected $1.7 billion in tax revenue from small and large cigars
Small and Large Cigar Markets   from April 2009 through fiscal year 2011.31 We estimate that during that
                                same period the market shift from small to large cigars reduced federal
                                revenue by between $360 million to $559 million (see fig. 13).32,33




                                31
                                  That is about $680 million per year after CHIPRA compared with $217.5 million for fiscal
                                year 2008.
                                32
                                  Treasury estimates that $723 million in revenue was lost due to the shift from small to
                                large cigars over the 2 years after CHIPRA was enacted. Treasury did not include the
                                price elasticity of demand in their estimate.
                                33
                                  As with the roll-your-own and pipe tobacco estimates, the low and high scenarios are
                                calculated using the price elasticity of demand of -0.6 and -0.3, respectively. Because
                                cigar taxes are based on price, our estimate included price data. Small cigar revenues
                                were calculated by multiplying the number of unit sales in each month by the tax rate.
                                Large cigar revenues were calculated by subtracting small cigar revenue from cigar
                                revenue. Once the large cigar revenue was calculated, the average tax paid was
                                estimated by dividing the large cigar revenue by the number of large cigar units. From
                                March 2007 through March 2009, this average was 4.3 cents per stick.




                                Page 25                                                         GAO-12-475 Tobacco Taxes
Figure 13: Estimated Revenue Losses for Small and Large Cigars




                                       a
                                        Low projected revenue loss is calculated as the difference between the projected revenue in the low
                                       scenario and the actual collected revenue. When the actual revenue is higher than the low projected
                                       revenue, the estimated figure of $360 million includes the difference.



Developing Standards to                Differentiating between roll-your-own and pipe tobacco for tax collection
Differentiate between Roll-            purposes presents challenges to Treasury because the definitions of the
Your-Own and Pipe                      two products in the IRC are based on such factors as the use for which
                                       they are suited and how they are packaged and labeled for consumers
Tobacco Presents                       and do not specify distinguishing physical characteristics. Treasury
Challenges to Treasury                 officials and representatives of nongovernmental organizations we spoke
                                       with stated that because the two products were taxed at the same rate
                                       prior to CHIPRA, there was no revenue-related reason to clarify the
                                       differences between the two products beyond the existing statutory
                                       definitions. However, according to Treasury comments in the Federal
                                       Register, the large differences in tax rates resulting from CHIPRA created




                                       Page 26                                                               GAO-12-475 Tobacco Taxes
an incentive for industry members to present roll-your-own tobacco as
pipe tobacco products, thus enabling them to pay a lower tax rate.34

After the CHIPRA tax changes and the market shift from roll-your-own to
pipe tobacco that immediately followed, Treasury took steps through
rulemaking notices in an effort to more clearly differentiate the two
products for tax collection purposes. However, Treasury has not yet
issued a final rule to distinguish the two products based on physical
characteristics. The tobacco industry members’ comments on the June
2009 temporary rule and the July 2010 advance notice of proposed
rulemaking highlighted the complexity and difficulties in developing
objective standards that clearly differentiate the two tobacco products.
Treasury also issued a ruling determining that retail establishments that
make cigarette-making machines available for use by customers are
manufacturers of tobacco products.35 However, a U.S. District Court
enjoined Treasury’s enforcement of the ruling pending the outcome of a
court case on this ruling, which was still pending as of March 2012. Table
4 summarizes Treasury’s actions on roll-your-own and pipe tobacco
following CHIPRA, the resulting tobacco industry comments, and the
status of Treasury’s actions.




34
 74 Fed. Reg. 29,401 (June 22, 2009).
35
  Treasury refers to the machines as cigarette-making machines rather than roll-your-own
machines. Treasury’s position is that the retailers who make these machines available for
use are manufacturers of cigarettes.




Page 27                                                       GAO-12-475 Tobacco Taxes
Table 4: Treasury Actions on Roll-Your-Own and Pipe Tobacco following CHIPRA, Industry Comments, and Status

Date             Treasury action                          Tobacco industry commentsd            Status
                                    a
June 2009        Temporary rule. Treasury revised           New requirements are                  Market continued to shift
                 regulations on packaging and labeling of    insufficient to prevent                from roll-your-own to pipe
                 roll-your-own and pipe tobacco to more      misclassification of roll-your-own     tobacco.
                 clearly differentiate the two products.     tobacco as pipe tobacco.
                 The temporary rule is set to expire in     Alternative standards based on
                 June 2012.                                  physical characteristics are
                                                             suggested.
July 2010        Advance notice of proposed                 Significant differences in views      Treasury has not issued a
                               b
                 rulemaking. Treasury requested public       on proposed standards are              subsequent rulemaking
                 comments on proposed standards to           expressed.                             establishing standards to
                 differentiate between roll-your-own and                                            differentiate roll-your-own
                 pipe tobacco based upon physical                                                   and pipe tobacco.
                 characteristics. Treasury reopened the                                            Market shift from roll-your-
                 notice requesting comments in August                                               own to pipe tobacco
                        c
                 2011.                                                                              continued.
September 2010   Ruling on cigarette-making                                                                  A manufacturer of these
                 machines. Treasury determined that                                                           machines sued Treasury,
                 the owner of a retail establishment who                                                      and a U.S. District Court
                 facilitates the making of cigarettes by or                                                   enjoined Treasury’s
                 for others by providing the use of                                                           enforcement of the rule
                 commercial cigarette-making machines                                                         pending the outcome of the
                 for use on the premises is engaged in                                                        case.
                 the business of a tobacco product                                                           Use of cigarette-making
                 manufacturer and must obtain a                                                               machines in retail
                 Treasury permit to engage in such                                                            establishments is growing.
                 business.
                                           Source: GAO analysis of Treasury information.

                                           a
                                               74 Fed. Reg. 29,401 (June 22, 2009).

                                           b
                                               75 Fed. Reg. 42,659 (July 22, 2010).

                                           c
                                               76 Fed. Reg. 52,913 (Aug. 24, 2011).

                                           d
                                            Treasury received comments from a range of tobacco companies and associations, and the
                                           comments cited in this table do not reflect industry consensus. Rather, they are intended to
                                           summarize key comments made by companies or associations.


                                                  Temporary rule36 on packaging and labeling requirements: Following
                                                   the CHIPRA tax changes that took effect in April 2009, Treasury



                                           36
                                             A temporary rule is issued without an advance notice of proposed rulemaking, but in the
                                           publication of the rule the agency may request comments and state that it may modify the
                                           rule in response to the comments.




                                           Page 28                                                                GAO-12-475 Tobacco Taxes
    published a temporary rule in June 2009, set to expire in June 2012,
    that outlined new labeling and packaging requirements for roll-your-
    own and pipe tobacco to more clearly differentiate the two products.
    The temporary rule required that, to be classified as pipe tobacco, the
    packaging must clearly indicate the product type by bearing the words
    “pipe tobacco” wherever the brand name appears, and that the
    packaging cannot suggest a use other than as pipe tobacco. Treasury
    also stated in the temporary rule that it was evaluating analytical
    methods and other standards to differentiate between roll-your-own
    tobacco and pipe tobacco, and it expected to publish rulemaking
    proposals on this subject for comment in the future. In response to
    this temporary rule, Treasury received comments from tobacco
    industry members indicating that its new labeling and packaging
    requirements were insufficient to prevent the misclassification of roll-
    your-own tobacco as pipe tobacco and that standards to further
    differentiate the products were urgently needed. Treasury received
    comments from industry members proposing alternative standards to
    distinguish between roll-your-own and pipe tobacco based on physical
    characteristics such as moisture content, cut, and variety of tobacco
    used. The market shift from roll-your-own to pipe tobacco continued
    despite Treasury’s issuance of this temporary rule.

   Advance notice of proposed rulemaking37 on standards to differentiate
    roll-your-own and pipe tobacco: In July 2010, Treasury published an
    advance notice of proposed rulemaking issuing a request for public
    comments on standards and characteristics proposed by commenters
    to differentiate between roll-your-own and pipe tobacco, but it has not
    issued a subsequent rule proposing the standards it would use. In the
    notice, Treasury discussed the heightened need for more regulatory
    detail to clarify the difference between the two products and stated its
    primary concern that the standards be objective and enforceable. The
    industry members’ comments to Treasury highlighted the complexity
    and difficulties in developing objective standards that clearly
    differentiate the two tobacco products. Industry members disagreed
    on the standards and physical characteristics that should be
    implemented, with some commenters noting that the two products
    overlap greatly. Some industry commenters also expressed concerns
    that proposed standards could easily be manipulated by consumers.


37
  An advance notice of proposed rulemaking can announce and explain agencies’ plans
to solve problems and accomplish goals and give interested persons an opportunity to
submit comments to improve the final regulation.




Page 29                                                     GAO-12-475 Tobacco Taxes
    For example, a proposed standard for the cut width of pipe tobacco
    could be compromised by a consumer using basic kitchen or
    hardware appliances to grind wider cut tobacco into a smaller width
    for use in cigarettes.
    In August 2011, Treasury issued a second advance notice of
    proposed rulemaking, thereby reopening the period for receiving
    comments on the proposed standards. Treasury said it did so
    because it had received an additional set of proposed standards after
    the original comment period closed. Treasury received a number of
    additional comments, many by the same companies that commented
    on the earlier notices, and the comments continued to reflect
    significant differences within the industry on standards that define and
    distinguish roll-your-own tobacco from pipe tobacco. This second
    comment period closed in October 2011. As of March 2012, Treasury
    has not issued a subsequent rulemaking based on the comments
    received, and no anticipated issuance date has been communicated.
    Throughout this period, the market shift from roll-your-own to pipe
    tobacco has continued, with negative impacts on federal revenue.
    Appendix III contains a more detailed summary of the Federal
    Register notices issued by Treasury related to differentiating between
    roll-your-own and pipe tobacco and the industry comments in
    response to these notices.

   Ruling on commercial cigarette-making machines: Treasury also
    issued a ruling in September 2010 determining that retailers who
    make commercial cigarette-making machines available for use on
    their premises are tobacco product manufacturers and are thus
    subject to the permit and tax requirements of the IRC. In October
    2010, RYO Machine Rental LLC, the maker of the RYO Filling
    Stations, sued Treasury over this ruling. In December 2010, a federal
    district court judge in Ohio ordered a preliminary injunction on the
    enforcement of the Treasury rule, and the case is currently on appeal
    in the U.S. Court of Appeals for the Sixth Circuit. During the period
    that enforcement has been delayed, several organizations told us that
    businesses continue to maintain these machines on their premises,
    and the number of machines in use has increased. These machines,
    which cost the retailer about $30,000 each, have also been the focus
    of government regulation at the state level. A number of states are
    taking action against commercial roll-your-own machines, including
    Arkansas, Michigan, New Hampshire, and West Virginia. For




Page 30                                              GAO-12-475 Tobacco Taxes
                                  example, Arkansas passed a law prohibiting tobacco retailers
                                  licensed, permitted, appointed, or commissioned under Arkansas
                                  tobacco tax law from possessing or using the machines.38


CHIPRA’s Changes to Tax      CHIPRA’s changes to the federal excise tax rate on large cigars also
Rates on Large Cigars Also   present challenges to Treasury. The first challenge resulted from
Present Challenges to        CHIPRA’s tax rate on the most inexpensive large cigars, which was
                             significantly lower than its rate for small cigars. This disparity in tax rates
Treasury                     provided an incentive for some small cigar manufacturers to make
                             minimal changes to their product to meet the legal definition of a large
                             cigar. The second challenge came about because CHIPRA’s rate for
                             large cigar taxes resulted in more large cigar manufacturers and
                             importers paying taxes based on the manufacturer’s or importer’s sale
                             price rather than simply paying the maximum set tax rate. This added
                             complexity to Treasury’s monitoring and enforcement of large cigar tax
                             payments and appears to have motivated some manufacturers and
                             importers of large cigars to restructure their market transactions to lower
                             the taxes they have to pay.

                             The first challenge resulted from CHIPRA’s changes to the federal excise
                             tax rate on large cigars, which created an incentive for small cigar
                             manufacturers to switch to making large cigars when the manufacturer’s
                             or importer’s sale price is less than $95.42 per thousand cigars. Before
                             CHIPRA, there was little incentive for small cigar manufacturers to alter
                             their product to meet the definition of a large cigar. Because small cigars
                             are taxed at a fixed rate, and large cigars are taxed at an ad valorem rate,
                             when CHIPRA raised the small cigar tax from $1.83 per thousand to
                             $50.33 per thousand, manufacturers of inexpensive small cigars had an
                             incentive to change their product to fit the lower-taxed large cigar
                             category. According to Treasury officials and other industry experts, prior
                             to CHIPRA, many small cigars weighed close to 3 pounds per thousand
                             sticks, which is the dividing line between small and large cigars set by the
                             IRC.39 Small cigars that weighed just under or exactly 3 pounds per
                             thousand sticks would be able to qualify as large cigars with minimal
                             changes. After CHIPRA, the same companies could use the same
                             machines to add a small amount of weight to their product, turning small


                             38
                              Ark. Code Ann. § 26-57-263.
                             39
                              The IRC does not distinguish small and large cigars by any characteristic other than
                             weight.




                             Page 31                                                       GAO-12-475 Tobacco Taxes
                                        cigars into a product legally defined and taxed as large cigars. For
                                        example, manufacturers could add weight by packing the tobacco more
                                        tightly. Some manufacturers then changed their labels from “small cigars”
                                        to “filtered cigars” or “cigars”—often with the same packaging and design.
                                        For example, if a manufacturer sold cigars for $50 per thousand before
                                        CHIPRA, by manufacturing small cigars instead of large cigars, it would
                                        pay $1.83 per thousand in taxes, a tax savings of $8.53 per thousand.
                                        After CHIPRA, the same manufacturer selling cigars for $50 per thousand
                                        would pay $26.38 per thousand in taxes, a tax savings of $23.95 per
                                        thousand, by manufacturing large cigars instead of small cigars (see fig.
                                        14). Treasury officials stated that the agency lacks the authority to
                                        remedy the tax revenue losses resulting from manufacturers’ legitimate
                                        modifications of small cigars to qualify them for the lower tax rate on large
                                        cigars.

Figure 14: Post-CHIPRA Incentives for Some Manufacturers to Switch from Small to Large Cigars




                                        Note: The large cigar tax structure before CHIPRA is represented on the left side of the figure, with
                                        the sloped line showing the ad valorem rate and the line becoming flat upon reaching the maximum
                                        rate of $48.75 per thousand large cigars. For space reasons, the right side of the figure does not
                                        include the maximum rate of $402.60 per thousand large cigars.

                                        The second challenge resulting from CHIPRA’s changes to tax rates on
                                        large cigars is the complexity that has been added to Treasury’s efforts to


                                        Page 32                                                                 GAO-12-475 Tobacco Taxes
monitor and enforce tax payments because many more manufacturers
and importers must now determine the correct tax by applying the tax rate
to the manufacturer’s or importer’s sale price per stick (ad valorem) rather
than simply paying the maximum set tax rate. According to Treasury
officials, prior to CHIPRA, the majority of domestic manufacturers of large
cigars paid the federal excise tax at the maximum rate of $48.75 per
thousand cigars. Specifically, manufacturers or importers that sold large
cigars priced at $235.30 per thousand and above paid the set maximum
tax. The increase in the large cigar maximum tax after CHIPRA resulted
in many more manufacturers and importers of large cigars paying taxes
based on the ad valorem rate, according to Treasury officials. Currently,
the maximum tax rate does not apply until the manufacturer’s or
importer’s price is $763.22 per thousand or above, and then, the
maximum rate is $402.60 per thousand. For example, if a manufacturer
sold large cigars for $400 per thousand, before CHIPRA, it would pay
$48.75—based on the maximum tax. After CHIPRA, the manufacturer’s
tax would increase to $211 per thousand—based on the ad valorem rate.
If the manufacturer is able to lower its price for the large cigar product
from $400 to $300 per thousand, its tax would decrease to $158.25 per
thousand, a tax savings of $52.75 per thousand. Before CHIPRA, if the
manufacturer had lowered its price from $400 to $300, its tax rate would
have remained at the maximum rate of $48.75 (see fig. 15).




Page 33                                              GAO-12-475 Tobacco Taxes
Figure 15: Post-CHIPRA Incentives for Some Manufacturers and Importers to Lower
the Sale Price of Large Cigars




Note: The sloped lines represent the ad valorem rates for large cigars before and after CHIPRA, with
the lines becoming flat when they reach the maximum rates of $48.75 (before CHIPRA) and $402.60
(after CHIPRA) per thousand large cigars.

After CHIPRA, according to Treasury officials, some large cigar
manufacturers and importers began to restructure their market
transactions to lower the manufacturer’s or importer’s sale price for large
cigars in order to obtain the tax savings of a lower ad valorem rate,
creating enforcement challenges. These Treasury officials stated that
some manufacturers and importers are “structuring” or “layering” sales
transactions by including an additional transaction at a low price before
the sale to the wholesaler or distributor, and using this low initial price to
calculate the tax. This transaction is conducted with an intermediary that
may have a special contract arrangement with the manufacturer or
importer. A large markup may then be added to the intermediary’s
subsequent sale to the wholesaler or distributor. This added transaction
effectively lowers the manufacturer’s or importer’s sale price, and thus
reduces the taxes collected. According to Treasury officials, these layered



Page 34                                                               GAO-12-475 Tobacco Taxes
transactions have become more common after CHIPRA. Treasury
officials noted that manufacturers and importers of large cigars have
approached the agency for advice on different proposals to structure their
sales transactions to lower their taxes and still comply with the law. They
also stated that Treasury has not determined the legality of all of the
proposals under consideration, and that while Treasury can investigate
individual cases, its authority to enforce additional tax collection from
these kinds of large cigar transactions is limited. Officials stated that
Treasury is carefully examining the tobacco importer and manufacturer
pricing arrangements and taking corrective actions where appropriate on
a case by case basis.

The impact of the federal excise tax increases and the resulting actions
by industry to mitigate the CHIPRA tax increase on large cigars are
evidenced by large cigar pricing trends. Prior to CHIPRA, the average
manufacturer’s or importer’s sale price for large cigars was $244 per
thousand, Treasury officials stated. After the CHIPRA tax increases, the
average manufacturer’s or importer’s sale price dropped to $189 per
thousand. According to Treasury officials, since large cigar federal excise
taxes increased by a minimum of 155 percent, and the federal excise tax
is included in the sale price, large cigar manufacturer’s and importer’s
sale prices were expected to increase, not decrease.




Page 35                                              GAO-12-475 Tobacco Taxes
                       When the Tobacco Control Act amended the Food, Drug, and Cosmetic
FDA Currently          Act in June 2009, it granted FDA immediate regulatory authority over four
Regulates Cigarettes   tobacco products, including cigarettes and roll-your-own tobacco, but did
                       not specify authority over pipe tobacco and small and large cigars.40
and Roll-Your-Own      According to the law, FDA has the authority to deem by regulation any
Tobacco but Not Pipe   other tobacco products, including pipe tobacco and small and large
Tobacco and Cigars     cigars, to be subject to the tobacco provisions in Chapter IX of the Food,
                       Drug, and Cosmetic Act.41 Deeming additional products to be subject to
                       these tobacco provisions of the Food, Drug, and Cosmetic Act requires
                       FDA to go through the process of developing and issuing a regulation
                       (known as the rulemaking process).

                       Because FDA does not currently regulate pipe tobacco and small and
                       large cigars, these products are not subject to the tobacco product
                       provisions in Chapter IX of the Food, Drug, and Cosmetic Act or
                       regulations that FDA has issued since June 2009 to implement the
                       Tobacco Control Act. Some of act’s provisions and key FDA regulations
                       address, for example, (1) the use of characterizing flavors, (2) the sale
                       and distribution of tobacco products, and (3) the requirements for new
                       health warnings depicting negative health consequences of smoking:

                           Ban on the use of characterizing flavors: FDA implemented a ban on
                            cigarettes with characterizing flavors in September 2009 (with the




                       40
                          The Food, Drug, and Cosmetic Act and the IRC each maintain their own definitions of
                       tobacco products, including the smoking tobacco products discussed in this report. The
                       laws and implementing regulations of the Food, Drug, and Cosmetic Act utilize the
                       definitions found at 21 U.S.C. § 387. The laws and implementing regulations of the IRC
                       utilize the definitions found at 26 U.S.C. § 5702. These statutes have slightly different
                       definitions for cigarettes and roll-your-own tobacco. The IRC's definition of a cigar is
                       slightly different from the Food, Drug, and Cosmetic Act's definition of a little cigar. In
                       addition, while the IRC defines pipe tobacco, the Food, Drug, and Cosmetic Act does not.
                       41
                          Pub. L. No. 111-31, § 101(b). The law states that “[t]obacco products … shall be
                       regulated by the Secretary [of Health and Human Services] under this chapter …” and that
                       “[t]his chapter shall apply to all cigarettes, cigarette tobacco, roll-your-own tobacco, and
                       smokeless tobacco and to any other tobacco products that the Secretary by regulation
                       deems to be subject to this chapter.”




                       Page 36                                                         GAO-12-475 Tobacco Taxes
      exception of tobacco or menthol).42 However, pipe tobacco and small
      and large cigars—some of which look similar to cigarettes (see fig.
      1)—are available in multiple flavors because this Tobacco Control Act
      provision does not apply to these products. Smokers can make roll-
      your-own cigarettes with flavored pipe tobacco and buy cigars in
      candy, berry, fruit, or other flavors. According to the U.S. Surgeon
      General, the growing popularity of cigars among younger adults
      (those under the age of 30) appears to be linked to the marketing of
      flavored tobacco products, including cigars, that might be expected to
      be attractive to youth.43

     Restrictions on the sale and distribution of cigarettes and smokeless
      tobacco to protect children and adolescents:44 Pipe tobacco and small
      and large cigars are not subject to FDA’s rule containing numerous
      youth access and marketing restrictions that was issued in March
      2010.45 One restriction generally prohibits the sale and distribution of
      individual cigarettes or packs containing fewer than 20 cigarettes.46 In
      contrast, cigars can be sold individually, and filtered cigars are often
      sold in packs containing fewer than 20. A second restriction generally


42
   21 U.S.C. § 387g. The law states that “a cigarette or any of its component parts
(including the tobacco, filter, or paper) shall not contain, as a constituent (including a
smoke constituent) or additive, an artificial or natural flavor (other than tobacco or
menthol) or an herb or spice, including strawberry, grape, orange, clove, cinnamon,
pineapple, vanilla, coconut, licorice, cocoa, chocolate, cherry, or coffee, that is a
characterizing flavor of the tobacco product or tobacco smoke.” On April 4, 2012, the
World Trade Organization (WTO) Appellate Body issued a report finding that this
restriction is inconsistent with the United States’ WTO obligations. Unless the Dispute
Settlement Body rejects the report by consensus, the United States has 30 days from the
time the report is adopted to state its intention regarding the implementation of the
recommendations of the Appellate Body.
43
  U.S. Department of Health and Human Services, Preventing Tobacco Use Among Youth
and Young Adults: A Report of the Surgeon General (Atlanta, GA: U.S. Department of
Health and Human Services, Centers for Disease Control and Prevention, National Center
for Chronic Disease Prevention and Health Promotion, Office on Smoking and Health,
2012).
44
   75 Fed. Reg. 13,225 (Mar. 19, 2010) (codified in 21 C.F.R. pt. 1140).These restrictions
apply to roll-your-own tobacco, and the rule stipulates that the definition of a cigarette
“[i]ncludes tobacco, in any form, that is functional in the product, which, because of its
appearance, the type of tobacco used in the filler, or its packaging and labeling, is likely to
be offered to, or purchased by, consumers as a cigarette or as roll-your-own tobacco.”
45
    21 C.F.R. pt. 1140.
46
    21 C.F.R. § 1140.14.




Page 37                                                            GAO-12-475 Tobacco Taxes
      requires that retail sales of cigarettes and smokeless tobacco be
      conducted in a direct, face-to-face exchange.47 This restriction does
      not apply to pipe tobacco and cigars, and these products are sold on
      the Internet. A third restriction bans brand-name sponsorship of
      sporting and cultural events by manufacturers, distributors, or retailers
      of cigarettes and smokeless tobacco48 and does not currently apply to
      pipe tobacco and cigars. A cigar company recently signed a multiyear
      sponsorship deal for a major collegiate sporting event, but the deal
      was canceled due to public pressure, as has been reported in the
      press.49

     Requirements for new health warnings depicting negative health
      consequences of smoking: Pipe tobacco and cigar packs are not
      subject to FDA’s rule that requires each cigarette pack and
      advertisement to bear one of nine new textual warning statements
      accompanied by color graphics, issued in June 2011.50 According to
      the law, the new warnings must cover the top half of the front and
      back of cigarette packs and at least 20 percent of cigarette
      advertisements and must contain color graphics depicting the
      negative health consequences of smoking.51 FDA selected nine color


47
  21 C.F.R. § 1140.14. An exception is made for vending machines and self-service
displays that are located in facilities where no person under the age of 18 is present, or
permitted to enter, at any time.
48
  21 C.F.R. § 1140.34. The regulation does not ban a manufacturer, distributor, or retailer
from sponsoring sporting and cultural events in the name of the corporation that
manufactures the tobacco product, provided that, among other things, the corporate name
does not include any brand name used for any brand of cigarettes or smokeless tobacco.
49
  In December 2011, the parent company of Camacho Cigars, according to a company
press release, signed a 3-year sponsorship deal with the Orange Bowl Committee, a
nonprofit organization that stages an annual football game and the supporting Orange
Bowl Festival in South Florida. The press release stated that under the sponsorship
agreement, Camacho Cigars intended to have a substantial presence at Sun Life Stadium
in Miami Gardens, FL, with cigar lounges for football fans and a special Camacho Club
Lounge at the Orange Bowl Game Day Fan Zone, the largest pregame event. News
organizations reported that the Camacho Cigars logo had been featured on the official
Orange Bowl website until the sponsorship agreement was canceled in response to
appeals from three U.S. senators and public health groups urging the Orange Bowl
Committee to call off the deal that promoted tobacco use.
50
  Most cigar packs and some individual cigars sold in the United States are required to
display a Surgeon General warning as the result of an agreement reached in 2000
between the Federal Trade Commission and seven largest cigar companies. There are no
federal requirements for pipe tobacco packages to display a Surgeon General warning.
51
    Pub. L. No. 111-31, § 201.




Page 38                                                          GAO-12-475 Tobacco Taxes
     graphic health warning messages after reviewing relevant scientific
     literature, 1,700 public comments, and the results of its experimental
     18,000-person study to assess the effectiveness of the warnings.
     While the Tobacco Control Act mandates that the warnings take effect
     no later than 15 months after FDA issues regulations, that is, by
     September 2012, pending litigation may impact implementation.52

FDA indicated its interest in deeming additional tobacco products to be
subject to the agency’s tobacco product authorities in the four recent
issues of the U.S. government’s semiannual regulatory agenda.53 In the
spring and fall 2010 agendas, FDA announced that it planned to issue a
proposed rule that would deem cigars to be subject to the provisions of
the Food, Drug, and Cosmetic Act.54 In the spring and fall 2011 agendas,
FDA announced that it planned to broaden the proposed rule’s scope to
encompass all products that meet the statutory definition of “tobacco
product”55 under Chapter IX of the Food, Drug, and Cosmetic Act.56 The
fall 2011 announcement, the most recent, indicated that the proposed rule
would be issued in December 2011; however, FDA had not issued the
proposed rule as of March 2012, and FDA officials told us that developing
the rule is taking longer than they expected.

A typical rulemaking process consists of three basic phases—initiation of
rulemaking actions, development of proposed rules, and development of


52
  In August 2011, several tobacco companies filed a lawsuit to stop FDA from
implementing the new warning requirements. In February 2012, the U.S. District Court for
the District of Columbia granted the plaintiff’s motion for summary judgment and ordered a
permanent injunction to halt FDA from enforcing the rule until 15 months after resolution of
the plaintiff’s claim on the merits. As of March 2012, the case is on appeal before the U.S.
Court of Appeals for the District of Columbia Circuit.
53
  The semiannual agenda, also known as unified agenda, summarizes the rules and
proposed rules that each federal agency expects to issue.
54
 75 Fed. Reg. 21,791 (Apr. 26, 2010) and 75 Fed. Reg. 79,771 (Dec. 10, 2010).
55
  Section 201(rr)(1) of the Food, Drug, and Cosmetic Act defines the term “tobacco
product” as any product made or derived from tobacco that is intended for human
consumption, including any component, part, or accessory of a tobacco product (except
for raw materials other than tobacco used in manufacturing a component, part, or
accessory of a tobacco product). By comparison, according to the IRC, “‘[t]obacco
products’ means cigars, cigarettes, smokeless tobacco, pipe tobacco, and roll-your-own
tobacco.”
56
 76 Fed. Reg. 40,052 (July 7, 2011) and 77 Fed. Reg. 7,946 (Feb. 13, 2012).




Page 39                                                         GAO-12-475 Tobacco Taxes
final rules—and involves internal review by the rulemaking agency,
external review by the Office of Management and Budget, and public
comments on proposed rules (fig. 16). In developing the proposed rule
deeming additional products, including pipe tobacco and cigars, to be
subject to the agency’s regulatory authority, FDA is in the second phase
of the process. FDA officials told us that, as of March 2012, the proposed
rule was undergoing review by the agency and the Department of Health
and Human Services and that FDA had not yet submitted the proposed
rule to the Office of Management and Budget. In a 2009 report on the
federal rulemaking process, we found—based on an analysis of 16 rules
at different federal agencies, including FDA—that the average time
needed to initiate, develop, and complete a rulemaking was about 4
years, with considerable variation among agencies and rules.57




57
  The time needed to complete the 16 rules ranged from 1 to 14 years. One of the
recommendations we made in the report was that FDA routinely track major milestones for
significant rules in its rulemaking process. See GAO, Federal Rulemaking: Improvements
Needed to Monitoring and Evaluation of Rules Development as Well as to the
Transparency of OMB Regulatory Reviews, GAO-09-205 (Washington, D.C.: Apr. 20,
2009).
However, FDA does not generally track rulemaking milestones during the early phases of
rule development, that is, before the agency prepares proposed rules for publication in the
Federal Register. FDA informed us that it takes several actions to track major milestones,
such as maintaining the Federal Register Document Tracking System database to track
the progress of all its Federal Register documents through the agency’s rule development
and clearance process and holding monthly and quarterly meetings where senior agency
officials discuss major milestones in the rulemaking process for potentially significant
regulations.




Page 40                                                         GAO-12-475 Tobacco Taxes
Figure 16: Basic Phases in FDA’s Rulemaking Process




                                       FDA will be able to exercise authority over the deemed products once the
                                       rulemaking process is completed and the final rule is published in the
                                       Federal Register. At that time, the deemed products will be subject to the
                                       provisions of Chapter IX the Food, Drug, and Cosmetic Act that are
                                       applicable to tobacco products in general. Examples of such provisions
                                       include a requirement for annual registration with FDA of establishments
                                       engaged in the manufacture of tobacco products, payment of user fees by
                                       manufacturers and importers of specified classes of tobacco products, as
                                       well as restrictions and penalties for misbranded products. However, if
                                       FDA decides to expand the scope of its existing regulations applicable to
                                       cigarettes and roll-your-own tobacco to encompass the deemed products,
                                       it will have to amend those regulations through the rulemaking process.
                                       For example, FDA would have to amend its rule covering the sale and
                                       distribution restrictions for cigarettes and smokeless tobacco in order to
                                       make it applicable to the deemed products.


                                       Federal legislation has aimed to discourage tobacco use and raise
Conclusions                            revenues by increasing excise taxes on tobacco products. In 2009,
                                       Congress passed CHIPRA, which increased taxation on all smoking
                                       tobacco products, but by different levels for pipe tobacco and for large
                                       cigars. Also in 2009, Congress passed the Tobacco Control Act, which
                                       gave FDA immediate regulatory authority over four tobacco products,
                                       including cigarettes and roll-your-own tobacco, but did not specify
                                       authority over pipe tobacco and small and large cigars.



                                       Page 41                                             GAO-12-475 Tobacco Taxes
In equalizing the federal excise tax rates on small cigars and roll-your-
own tobacco with the tax rate on cigarettes, CHIPRA was responding to
concerns that these products were increasingly used as substitutes to
factory-made cigarettes. However, by introducing large tax disparities
between cigarettes, roll-your-own tobacco, and small cigars, on the one
hand, and pipe tobacco and large cigars, on the other, CHIPRA has
contributed to the substitution of higher-taxed tobacco products with
lower-taxed products. Sales of the lower-taxed pipe tobacco and large
cigars saw significant growth following CHIPRA, as manufacturers and
consumers sought to take advantage of lower-taxed products. We
estimate that this tax avoidance has resulted in between approximately
$615 million and $1.1 billion in lost federal revenue since 2009.

Treasury has not succeeded in addressing the continued tax avoidance
behavior reflected in the market shifts to pipe tobacco and to large cigars.
In the absence of legislative changes, Treasury has limited options for
effective action. First, roll-your-own and pipe tobacco are similar and, in
some cases, may be substitutable products, and the IRC lacks specificity
on how they should be distinguished based on physical characteristics.
Treasury is currently considering and analyzing various proposals to more
clearly and objectively differentiate the two products based on their
physical characteristics. However, the lack of consensus on which
characteristics or criteria truly define and differentiate roll-your-own from
pipe tobacco reveals the complexity and difficulty in attempting to develop
standards and tests to distinguish the products from each other. In
addition, there is the concern that products could easily be manipulated to
negate any newly established standards or tests.

Because small and large cigars are distinguished in the IRC only by
weight, and because many small cigars already weighed at or close to the
3 pounds per thousand threshold for classification as large cigars, many
small cigar manufacturers were able to legally shift to the lower-taxed
large cigar category with minimal changes to their products. In addition,
the large cigar tax structure, which consists of an ad valorem tax rate up
to a maximum rate, is complex and creates an incentive to lower the
manufacturer’s or importer’s sale price to avoid paying higher federal
excise taxes.

FDA, which implements the Tobacco Control Act, currently regulates
cigarettes and roll-your-own tobacco but does not regulate pipe tobacco
and small and large cigars. These regulatory disparities make pipe
tobacco and small and large cigars more accessible and attractive to
current and potential smokers. While FDA announced its intent to issue a


Page 42                                              GAO-12-475 Tobacco Taxes
                     proposed rule that would subject additional products, including pipe
                     tobacco and small and large cigars, to its regulation, it had not issued the
                     proposed rule as of March 2012.


                     Disparities in tax rates on smoking tobacco products have negative
Matter for           revenue implications because they create incentives for manufacturers
Congressional        and consumers to substitute higher-taxed products with lower-taxed
                     products. In light of that fact, as Congress continues its oversight of
Consideration        CHIPRA and Tobacco Control Act implementation, it should consider
                     modifying tobacco tax rates to eliminate significant tax differentials
                     between similar products. Specifically, Congress should consider
                     equalizing tax rates on roll-your-own and pipe tobacco and, in
                     consultation with Treasury, also consider options for reducing tax
                     avoidance due to tax differentials between small and large cigars.


                     We provided a draft of this report to the Secretary of the Treasury and the
Agency Comments      Secretary of Health and Human Services for their review and comment.
and Our Evaluation   We received technical comments from Treasury and the U.S. Department
                     of Health and Human Services, which we have incorporated in the report
                     as appropriate. We also received written comments from Treasury, which
                     are reprinted in appendix IV.

                     Treasury generally agreed with our overall conclusion that CHIPRA’s
                     introduction of large tax disparities between similar products contributed
                     to the substitution of higher-taxed tobacco products with lower-taxed
                     products. Treasury also agreed with our observation concerning
                     modifying tobacco tax rates to eliminate significant tax differentials
                     between similar products, which is consistent with our Matter for
                     Congressional Consideration.

                     Treasury noted our use of the term “revenue losses” and commented that
                     our estimates did not pertain to actual losses of revenues but rather were
                     estimates of revenue increases that would be realized if Congress were
                     to change the law to eliminate the tax disparities or had the market shifts
                     due to the disparities not occurred. We state in the report that our
                     analysis does not incorporate the hypothetical case of equal tax rates
                     among smoking products; rather, we estimate the revenues Treasury
                     would have collected under current law—but in the absence of the market
                     shifts from higher-taxed products to lower-taxed products. The difference
                     between the revenues collected under current law and our estimate of the



                     Page 43                                              GAO-12-475 Tobacco Taxes
higher revenues that would have been due in the absence of the market
shifts is what we refer to as “revenue losses.”

In response to Treasury’s comment about the use of this term, we note
that Treasury’s Alcohol and Tobacco Tax and Trade Bureau developed its
own estimates of what it termed revenue losses stemming from the
market shifts involving these products, and we discuss these estimates in
our report. In addition, the Alcohol and Tobacco Tax and Trade Bureau’s
2011 Annual Report uses the term revenue losses when estimating the
effect of the market shifts since CHIPRA. Appendix I contains a more
detailed discussion of our methodology for developing our estimates.


We are sending copies of this report to the appropriate congressional
committees and to the Secretaries of Health and Human Services and
Treasury, and other interested parties. This report also is available at no
charge on the GAO website at http://www.gao.gov.

If you or your staff members have any questions about this report, please
contact me at (202) 512-3149 or gootnickd@gao.gov. Contact points for
our Offices of Congressional Relations and Public Affairs may be found
on the last page of this report. Individuals who made key contributions to
this report are listed in appendix V.




David Gootnick
Director, International Affairs and Trade




Page 44                                              GAO-12-475 Tobacco Taxes
Appendix I: Objectives, Scope, and
              Appendix I: Objectives, Scope, and
              Methodology



Methodology

              The Family Smoking Prevention and Tobacco Control Act (Pub. L. No.
              111-31) directed GAO to report on various aspects of cross-border and
              illicit trade in tobacco products, including the effects of differing tax rates
              applicable to tobacco products.1 In accordance with our agreement with
              Senate Committee on Health, Education, Labor, and Pensions and House
              Energy and Commerce Committee staff, this report provides information
              on the federal revenue effects of differing tax rates applicable to tobacco
              products. Our objectives for this report are to (1) review the market shifts
              among smoking tobacco products since the Children’s Health Insurance
              Program Reauthorization Act (CHIPRA) of 2009 went into effect on April
              1, 2009; (2) examine the impact of these market shifts on federal revenue
              and the Department of the Treasury’s (Treasury) actions to respond; and
              (3) describe differences in regulation of various smoking tobacco products
              by the Food and Drug Administration (FDA). Our review includes smoking
              tobacco products that are subject to federal excise tax: cigarettes and
              four other tobacco products—roll-your-own tobacco (sometimes called
              RYO), pipe tobacco, small cigars, and large cigars.2 However, in
              analyzing the market shifts among these products, we focused solely on
              the four smoking tobacco products other than cigarettes.

              To address the three objectives in this study, we reviewed documents
              and interviewed agency officials from Treasury’s Alcohol and Tobacco
              Tax and Trade Bureau, FDA, and the Centers for Disease Control and
              Prevention, as well as tobacco industry members, representatives of
              public health and other nongovernmental organizations, and academics
              to obtain information on tobacco legislation and regulations, tobacco
              product sales trends, and consumption patterns. Tobacco industry
              members that we spoke with included industry associations and individual
              companies. We identified and contacted 15 pipe tobacco manufacturers
              to ask about their companies’ actions in response to the CHIPRA tax
              changes, and 3 of the manufacturers agreed to speak with us. We also
              reviewed studies analyzing the relationship between tobacco tax



              1
               Responding to this mandate, in March 2011, we issued a first report on illicit tobacco
              trade and schemes, GAO-11-313.
              2
               Smokeless tobacco products that are subject to federal excise taxes, such as chewing
              tobacco and snuff, were outside the scope of this review. “Processed tobacco” is not
              subject to federal excise tax and is defined in the Internal Revenue Code of 1986 by what
              it is not: processed tobacco does not include the farming or growing of tobacco or the
              handling of tobacco solely for sale, shipment, or delivery to a manufacturer of tobacco
              products or processed tobacco.




              Page 45                                                         GAO-12-475 Tobacco Taxes
Appendix I: Objectives, Scope, and
Methodology




increases and smoking, including among youth. We also collected data
from Treasury, the Bureau of Labor Statistics, and the Department of
Agriculture and determined that they were sufficiently reliable for our
purposes.

We analyzed Treasury removals data3 to identify sales trends across the
different tobacco products before and after CHIPRA took effect. In
addition, we collected and analyzed price data and data on federal excise
tax rates for roll-your-own tobacco, pipe tobacco, small cigars, and large
cigars, as well as the federal tax revenue generated from their sale. We
estimated what the effect on federal tax revenue collection would have
been if the market shifts resulting from substitution of higher-taxed
products with lower-taxed products had not occurred once CHIPRA’s
higher tax rates went into effect. In this report, we refer to this estimated
effect on federal tax revenue collection as revenue losses. Our analysis
takes into account the expected fall in quantity demanded due to the price
increases resulting from the higher federal excise tax rates that CHIPRA
imposed on these smoking tobacco products.

To estimate federal tax revenue losses due to market shifts after
CHIPRA, we analyzed Treasury’s monthly sales and revenue data from
fiscal year 2001 through fiscal year 2011 for roll-your-own and pipe
tobacco and for small and large cigars. Our analysis compares the actual
tobacco tax revenue collected by Treasury with a counterfactual scenario.
Our counterfactual model draws from one used by Dr. Frank Chaloupka,
an economist who has investigated the effect of prices and taxes on
tobacco consumption in numerous publications. In particular, we follow
the methodology used in a paper from January 2011 in which Dr.
Chaloupka calculates the effect of raising cigarette taxes in the state of
Illinois.4 This methodology projects the effect of a future tax increase
based on the historic sales trend, the amount of the tax, and the effect of



3
 As used in this report, for smoking tobacco products, “removals” means the amount
removed for distribution in the United States from the factory or released from customs, as
measured in pounds for roll-your-own and pipe tobacco or in the number of sticks for
cigarettes and small and large cigars. 26 U.S.C § 5702(j). In this report, we consider
removals to be equivalent to sales and use the term sales.
4
 For a detailed explanation of this methodology, see Frank Chaloupka and Jidong Huang,
“A Significant Cigarette Tax Rate Increase in Illinois Would Produce a Large, Sustained
Increase in State Tobacco Tax Revenues” (Chicago, IL: University of Illinois at Chicago,
Jan. 3, 2011, working paper).




Page 46                                                        GAO-12-475 Tobacco Taxes
Appendix I: Objectives, Scope, and
Methodology




a price increase on projected sales (that is, price elasticity of demand).5
Our counterfactual model, then, projects post-CHIPRA sales of roll-your-
own and pipe tobacco and small and large cigars according to the historic
sales trends for these products, adjusted downward to account for the fall
in demand due to the higher post-CHIPRA tax component of the price.6
To calculate the impact on demand due to the higher taxes on these
products, we included high and low estimates for price elasticity. Based
on our interviews with experts and a review of the relevant literature,7 we
assumed that the price elasticity for the smoking tobacco products in our
analysis ranges from -0.6 to -0.3, which set, respectively, the low and
high boundaries of the estimated revenue losses.8

Our analysis does not incorporate the hypothetical case of equal tax rates
among smoking tobacco products; rather, we estimate the revenues that
Treasury would have collected in the absence of the market’s substitution
of higher-taxed products with lower-taxed products. An analysis that
projected the impact of equal tax rates across all smoking tobacco
products would necessarily produce a much higher estimate of lost tax
revenues. We did not attempt to develop such a model, however,
because doing so was beyond the scope of our analysis. The reliability of
any such model would depend on the assumptions made, particularly with
regard to large cigars—the only tobacco product for which excise taxes
are calculated as a percentage of price. Compared with determining the
tax on all other tobacco products, according to Treasury, determining the
tax on large cigars is extremely complex. Modeling hypothetical
consumption trends for smoking tobacco products after equalizing tax



5
 Economic theory states that when the price of a product increases, the quantity
demanded for the product will decrease at a rate that is computed from the underlying
demand curve.
6
 Hence, it is assumed that the actual change in revenue is based on the new tax
differential. If changes in sales were due to other market forces, such as changes in the
prices of other products or changing demand, this would cause our estimates to be over or
under stated.
7
 For an extensive literature review of tobacco price elasticity studies, see Qiang Li, The
Effects of Cigarette Price and Tax on Smokers and Government Revenue. Unpublished
doctoral dissertation (Buffalo, NY: The State University of New York, 2007).
8
 In our counterfactual scenario, a lower decrease in demand results in a higher estimate
of revenue losses. A price elasticity of -0.6 means that when prices go up by 10 percent,
demand will decrease by 6 percent; a price elasticity of -0.3 for the same price increase
means that demand will decrease by 3 percent.




Page 47                                                          GAO-12-475 Tobacco Taxes
Appendix I: Objectives, Scope, and
Methodology




rates on them would require a complex set of assumptions not
necessarily grounded in reliable data.

We used data from two sources to build our counterfactual model
projecting post-CHIPRA sales of roll-your-own and pipe tobacco and
small and large cigars. The first source is Treasury’s data from fiscal year
2001 through fiscal year 2011 on smoking tobacco product tax revenues
and removals (the amount of tobacco removed for sale from the factory or
released from customs). The second data source is tobacco products
price data from the Bureau of Labor Statistics, which it uses to calculate
the Consumer Price Index for tobacco products. The Bureau of Labor
Statistics data contain retail price information collected each month
throughout the country; the prices include the cost of production, markup,
and excise taxes from federal, state, and local governments—shipping,
handling, sales tax, and fuel surcharges have been removed from the
data.9

For roll-your-own and pipe tobacco and for small and large cigars, we
calculated an average taxable manufacturer’s or importer’s sale price for
the year before CHIPRA was enacted. We then estimated the post-
CHIPRA price by adding the corresponding post-CHIPRA tax to the pre-
CHIPRA price.10 Thus, our counterfactual model includes only the effect
of CHIPRA on tax revenue.

To calculate the average taxable manufacturer’s or importer’s sale price
for large cigars, we used Treasury’s revenue data and removals data.
Treasury collects revenue data for cigars but does not collect separate
revenue data for small and large cigars. However, Treasury’s removals
data are separated by small and large cigars, reporting the number of
sticks removed for sale from the factory or released from customs. After
CHIPRA, small cigars are taxed at $50.33 per thousand sticks, whereas
large cigars are taxed at 52.75 percent of the manufacturer’s or importer’s
price up to a maximum tax rate per thousand sticks. We calculated small


9
 The price data for cigars, pipe tobacco, and roll-your-own tobacco are subsets of the
sample used to calculate the Consumer Price Index for Tobacco products other than
cigarettes. The Bureau of Labor Statistics cautioned that these data be interpreted with
care because they do not meet its standard publication criteria.
10
  Using an average post-CHIPRA price from the Bureau of Labor Statistics would be
misleading as it would include increases in state and local taxes and would artificially
inflate the effect of CHIPRA on prices.




Page 48                                                          GAO-12-475 Tobacco Taxes
Appendix I: Objectives, Scope, and
Methodology




cigar revenue by multiplying the number of sticks reported in Treasury’s
removals data in each month by the tax rate. We then calculated large
cigar revenues by subtracting small cigar revenues from total cigar
revenues. Once we had calculated the large cigar revenues, we
estimated the average tax paid by dividing the large cigar revenues by the
number of large cigar sticks reported in the removals data for each month
and calculating the average price. From March 2007 through March 2009,
the average large cigar tax collected was 4.3 cents per stick. These
figures corroborate Treasury’s statement that a majority of manufacturers
were paying the maximum rate. CHIPRA raised this maximum rate from
4.8 cents to 40 cents per stick. We estimated that the average taxable
manufacturer’s or importer’s sale price before CHIPRA was 20.65 cents.
Hence, the average tax paid after CHIPRA using the new tax rate should
be 10.9 cents per cigar, and this is the number we used to estimate post-
CHIPRA tax revenues in our counterfactual model. Treasury does not
maintain records of the manufacturers’ and importers’ sale prices of large
cigars where the manufacturer or importer paid the maximum rate,
thereby making it impossible to determine the magnitude of
underestimation in our model caused by the maximum rate.

To describe FDA’s regulation of tobacco products under Chapter IX of the
Food, Drug, and Cosmetic Act, we examined FDA’s regulatory actions
and announcements and interviewed officials from FDA’s Center for
Tobacco Products, including the Offices of Compliance and Enforcement,
Policy, Regulations, and Science.

We conducted this performance audit from March 2011 to April 2012 in
accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe that
the evidence obtained provides a reasonable basis for our findings and
conclusions based on our audit objectives.




Page 49                                            GAO-12-475 Tobacco Taxes
Appendix II: Sales of Smoking Tobacco
               Appendix II: Sales of Smoking Tobacco
               Products in the United States, Fiscal Years
               2001-2011


Products in the United States, Fiscal Years
2001-2011
               Treasury’s data on taxable removals (sales) show that the decline in
               cigarette sales in the last decade has been partially offset by the
               combined growth in sales of roll-your-own tobacco, pipe tobacco, small
               cigars, and large cigars.1 Table 5 provides annual sales data for
               cigarettes, roll-your-own tobacco, pipe tobacco, small cigars, and large
               cigars from fiscal year 2001 through fiscal year 2011. Figure 17 uses the
               same data to depict the concomitant decline in cigarette sales and growth
               in combined sales of the other four smoking tobacco products.

               From fiscal year 2001 through fiscal year 2011, sales of the smoking
               tobacco products—cigarettes, roll-your-own tobacco, pipe tobacco, small
               cigars, and large cigars—in the United States decreased by about 26
               percent. Sales of cigarettes, which continue to dominate the market,
               declined by 30 percent from about 414 billion sticks in fiscal year 2001 to
               about 289 billion sticks in 2011. However, combined sales of roll-your-
               own tobacco, pipe tobacco, small cigars, and large cigars increased by
               131 percent during the same period from about 12 billion sticks or
               cigarette stick equivalents (for roll-your-own and pipe tobacco) in fiscal
               year 2001 to about 29 billion sticks or cigarette stick equivalents. The
               share of these four products grew from 3 percent of the smoking tobacco
               market in fiscal year 2001 to 9 percent in fiscal year 2011.




               1
                As used in this report, for smoking tobacco products, “removals” means the amount
               removed for distribution in the United States from the factory or released from customs, as
               measured in pounds for roll-your-own and pipe tobacco or in the number of sticks for
               cigarettes and small and large cigars. 26 U.S.C. (§ 5702(j). In this report, we consider
               removals to be equivalent to sales and use the term sales.




               Page 50                                                        GAO-12-475 Tobacco Taxes
                                         Appendix II: Sales of Smoking Tobacco
                                         Products in the United States, Fiscal Years
                                         2001-2011




Table 5: U.S. Sales of Cigarettes and Other Smoking Tobacco Products, Fiscal Years 2001-2011 (in Billions of Sticks)

                                                   Other smoking tobacco products
                                                                                                                         Totalb for cigarettes
                               Roll-your-own             Pipe         Small                                               and other smoking
Fiscal year    Cigarettes            tobaccoa        tobaccoa         cigars     Large cigars         Subtotalb            tobacco products
2001               414.17                4.33                 2.42       2.18              3.50            12.42                          426.60
2002               406.59                4.74                 2.35       2.26              3.70            13.05                          419.61
2003               376.14                6.02                 2.13       2.28              3.95            14.38                          390.52
2004               372.24                6.02                 1.96       2.49              4.17            14.64                          386.88
2005               367.23                7.16                 1.79       3.45              4.39            16.78                          384.01
2006               363.01                8.10                 1.77       4.15              4.54            18.56                          381.58
2007               356.05                8.37                 1.58       4.58              4.57            19.10                          375.15
2008               337.64                9.68                 1.55       5.34              4.76            21.33                          358.98
2009               316.40                7.96                 4.31       3.35              6.88            22.50                          338.90
    c
2010               296.23                3.03                10.25       0.91              9.88            24.07                          320.29
2011               288.50                2.56                15.02       0.80             10.27            28.65                          317.14
                                         Source: Treasury.

                                         a
                                          The roll-your-own tobacco and pipe tobacco cigarette stick equivalent is based on the weight of
                                         0.0325 ounces. of tobacco per cigarette stick using the Master Settlement Agreement conversion
                                         rate.
                                         b
                                             The subtotal and total may not add up due to rounding.
                                         c
                                          2010 is the first full fiscal year following April 1, 2009, when the new federal excise tax rates on
                                         tobacco products resulting from CHIPRA took effect.




                                         Page 51                                                                    GAO-12-475 Tobacco Taxes
Appendix II: Sales of Smoking Tobacco
Products in the United States, Fiscal Years
2001-2011




Figure 17: U.S. Sales of Cigarettes and Other Smoking Tobacco Products, Fiscal
Years 2001-2011




a
 The roll-your-own tobacco and pipe tobacco cigarette stick equivalent is based on the weight of
0.0325 ounces. of tobacco per cigarette stick using the Master Settlement Agreement conversion
rate.




Page 52                                                               GAO-12-475 Tobacco Taxes
Appendix III: Summary of Treasury’s
              Appendix III: Summary of Treasury’s Proposed
              Rulemaking Actions to Distinguish between
              Roll-Your-Own and Pipe Tobacco


Proposed Rulemaking Actions to Distinguish
between Roll-Your-Own and Pipe Tobacco
              Treasury published a temporary rule and request for public comments in
              June 2009 that outlined new labeling and packaging requirements for roll-
              your-own and pipe tobacco to more clearly differentiate the two products
              on those bases. Treasury also noted the need for additional rulemaking
              on other standards and methods to differentiate the products. In response
              to its June 2009 rulemaking notice, industry members proposed
              standards to distinguish between roll-your-own and pipe tobacco based
              on physical characteristics. For example, Treasury received comments
              setting forth certain criteria for distinguishing between the products based
              on whether the product met a certain number of factors, including
              moisture content; cut width; percentage of weight consisting of reducing
              sugars; and percentage of weight consisting of flavoring, casing, or other
              nontobacco content.

              In July 2010, Treasury published an advance notice of proposed
              rulemaking issuing a request for public comments on these and other
              standards proposed by commenters to differentiate between roll-your-own
              and pipe tobacco. The industry members’ comments responding to
              Treasury’s 2010 request highlighted the complexity and difficulties in
              developing objective standards based on physical characteristics that
              clearly differentiate the two tobacco products. Industry members
              disagreed on the number of criteria that should be used and the specific
              thresholds for differentiating between the products. For example, while
              some industry members generally agreed that pipe tobacco traditionally
              has had a thicker cut and greater moisture content than roll-your-own
              tobacco, they disagreed on the specific cut width or moisture content that
              defines pipe tobacco. Some comments noted that the physical
              characteristics of the two products overlap greatly, emphasizing the
              numerous types of roll-your-own and pipe tobacco products on the market
              and various manufacturing methods, all of which make it difficult to
              develop concrete definitions that clearly differentiate between the two
              products. Other comments emphasized the challenges of conducting
              tests to distinguish the two products as, for example, test results can be
              influenced by factors such as the age of the sample used and the
              temperature of the facility, potentially creating different results on tests of
              the same tobacco products. Some industry members also proposed that
              Treasury take into consideration the preexisting or established pipe
              tobacco brands prior to CHIPRA and continue to classify them as pipe
              tobacco through a grandfathering clause, regardless of how the tobacco
              might fare in any tests based on objective standards. Other industry
              members disagreed, however, stating that a grandfathering clause would
              favor existing companies, reduce competition, and give some companies



              Page 53                                                GAO-12-475 Tobacco Taxes
Appendix III: Summary of Treasury’s Proposed
Rulemaking Actions to Distinguish between
Roll-Your-Own and Pipe Tobacco




the opportunity to introduce misclassified pipe tobacco into the market
without accountability.

Other industry members expressed concerns that the proposed standards
could easily be manipulated by consumers. For example, the tobacco cut
width standard for pipe tobacco could be compromised by a consumer
using a blender or coffee grinder to obtain a smaller width for use in
cigarettes. Additionally, the moisture content standard could also prove to
be ineffective because end users could dry out the moister pipe tobacco
for use in cigarettes.

After the initial public comment period closed in September 2010,
Treasury did not issue a subsequent rulemaking on clarifying standards.
Treasury said it received an additional proposal after the close of the
comment period and, as a result, issued a second advance notice of
proposed rulemaking in August 2011 reopening the period for receiving
comments on the standards proposed by commenters, including the new
proposal. Treasury received a number of additional comments, many by
the same companies that commented on the earlier notices, and the
comments continued to reflect significant differences within the industry
on standards that define and distinguish roll-your-own tobacco from pipe
tobacco. This second comment period closed in October 2011, and
Treasury has not issued a subsequent rulemaking as of March 2012.

Within the 2011 notice, Treasury also published the results of the
preliminary analysis conducted by its laboratory on a sample of roll-your-
own and pipe tobacco products. For this analysis, Treasury purchased a
sample of products labeled as roll-your-own and pipe tobacco from local
retail vendors in Maryland. These samples were purchased just prior to
the CHIPRA tax increases going into effect. Treasury officials
emphasized that their sample was not a representative market sample
and thus not generalizable. Treasury officials stated that the purpose of
the preliminary analysis was to investigate what could be learned about
the initial proposed standards rather than to complete a definitive test
differentiating the products or attempting to determine whether the
products were roll-your-own or pipe tobacco, as they were labeled.
Treasury tested for several of the proposed standards, including total
reducing sugars and moisture content. Treasury’s results, in some cases,
appeared to show a lack of a clear distinction between the roll-your-own
and pipe tobacco samples.




Page 54                                             GAO-12-475 Tobacco Taxes
Appendix IV: Comments from the
             Appendix IV: Comments from the Department
             of the Treasury



Department of the Treasury




             Page 55                                     GAO-12-475 Tobacco Taxes
Appendix IV: Comments from the Department
of the Treasury




Page 56                                     GAO-12-475 Tobacco Taxes
Appendix V: GAO Contact and Staff
                  Appendix V: GAO Contact and Staff
                  Acknowledgments



Acknowledgments

                  David Gootnick (202) 512-3149 or gootnickd@gao.gov
GAO Contact
                  In addition to the individual named above, Christine Broderick, Assistant
Staff             Director; Sada Aksartova; Pedro Almoguera; David Dayton; Etana
Acknowledgments   Finkler; Jeremy Latimer; Grace Lui; and Alana Miller made key
                  contributions to this report. In addition, Barbara El Osta, Joyce Evans,
                  Marc Molino, Theresa Perkins, Jena Sinkfield, and Cynthia S. Taylor
                  provided technical assistance.




(320838)
                  Page 57                                             GAO-12-475 Tobacco Taxes
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