oversight

Cigarette Smuggling: Interstate and U.S.-Canadian Experience

Published by the Government Accountability Office on 1997-12-09.

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

                   United States General Accounting Office

GAO                Testimony
                   Before the Subcommittee on Health and Environment,
                   Committee on Commerce, House of Representatives




For Release
on Delivery
Expected at
                   CIGARETTE SMUGGLING
10:00 a.m. EST
Tuesday
December 9, 1997
                   Interstate and
                   U.S.-Canadian Experience
                   Statement of Robert A. Robinson, Director
                   Food and Agriculture Issues,
                   Resources, Community, and Economic
                   Development Division




GAO/T-RCED-98-50
    Mr. Chairman and Members of the Subcommittee:

    Thank you for the opportunity to discuss the preliminary results of our
    work on cigarette smuggling. As you know, this is part of a larger body of
    work we are conducting on issues surrounding the proposed tobacco
    settlement. In conducting this work, we are addressing a wide variety of
    issues, including the national and regional economic impacts of the
    tobacco industry, smoking trends among youth in the United States and
    Canada, and the effect of a settlement on state excise taxes. As you
    requested, our statement today focuses on information developed to date
    concerning cigarette smuggling; in particular, interstate cigarette
    smuggling in the United States and Canada’s recent experience with
    international smuggling. In summary, we found the following:

•   Smuggling cigarettes from low- to high-tax states, or interstate smuggling,
    prominent in the 1970s, may now be a reemerging problem. Such activity
    is likely to occur when the differences in cigarette taxes across the states
    are significant enough to make it profitable. Recently, many states have
    opted to sharply increase their cigarette taxes. Yet most low-tax states
    have not. As a result, studies suggest that the level of interstate smuggling
    activity may now be increasing. In fact, recent estimates suggest that
    smuggling is responsible for states collectively losing hundreds of millions
    of dollars in annual tax revenues.
•   In addition, recent experiences demonstrate that international smuggling
    can occur when cigarette tax rates are substantial. International smuggling
    has occurred recently between Canada and the United States. According
    to the Canadian government, sharp increases in Canadian federal and
    provincial cigarette taxes in the late 1980s and early 1990s led to
    large-scale smuggling between the United States and Canada conducted
    almost entirely by organized crime. Violence increased, merchants
    suffered, and in one year alone, Canada and its provinces lost over
    $2 billion (in Canadian dollars) in tax revenues. Canada responded in 1994
    by sharply reducing federal and provincial cigarette taxes and increasing
    its enforcement efforts, among other steps. Since then, smuggling has
    declined considerably.

    To address these issues, we discussed U.S. interstate cigarette smuggling
    and U.S.-Canadian international smuggling with the Bureau of Alcohol,
    Tobacco, and Firearms (ATF) officials; reviewed a study conducted by the
    Washington State Department of Health; and developed our own economic
    model to estimate the level of interstate cigarette smuggling in the United
    States. To understand Canada’s experience with international smuggling,



    Page 1                                                      GAO/T-RCED-98-50
                         we also reviewed the Canadian Government Action Plan on Smuggling, a
                         study conducted for the National Coalition Against Crime and Tobacco
                         Contraband,1 and a report by the Canadian Office of the Auditor General.
                         Again, we would like to stress that the information that follows is
                         preliminary and will be part of a larger effort that we plan to complete in
                         April 1998.


                         According to ATF, cigarettes are currently being smuggled across state
Interstate Smuggling:    borders to avoid payment of state excise taxes, which can violate federal
a Reemerging             and/or state laws.2 The opportunity for individuals to profit from interstate
Problem as               smuggling exists because of the wide disparity in excise taxes across
                         states. Currently, state excise taxes on cigarettes range from more than 70
Differences in States’   cents a pack to less than 10 cents a pack. (See attachment 1 for a listing of
Taxes Increase           state excise tax rates.) According to estimates that we and the Washington
                         State Department of Health developed on the extent of current smuggling
                         activity, some states are losing as much as $100 million or more annually
                         in potential tax revenues.3

                         The incentives to smuggle cigarettes into any particular state obviously
                         depend on the amount that the state’s tax rate exceeds that of neighboring
                         or other states. Substantial differences in states’ tax rates in the late 1960s
                         and early 1970s encouraged significant smuggling activity. By the early
                         1980s, the nominal value of tax rate differentials had stabilized, but
                         because of inflation, the constant dollar value of the differentials—and
                         thus the profitability from smuggling—had eroded. For example, a 25-cent
                         difference in tax rates in 1997 dollars is worth less than a 25-cent
                         difference in tax rates in 1980 dollars. In addition, law enforcement efforts
                         may have added to the risk of smuggling. As a result, smuggling declined.
                         Since the mid-1980s, however, tax rates have increased substantially in
                         some states. By 1996, differences in states’ tax rates had returned to
                         mid-1970s levels in constant dollars—thereby restoring incentives for

                         1
                          The National Coalition Against Crime and Tobacco Contraband is a U.S. coalition composed primarily
                         of retailers, wholesalers, and tobacco manufacturers. The coalition’s report on smuggling entitled
                         Cigarette Smuggling in the United States (Aug. 15, 1994) was prepared by Lindquist Avey Macdonald
                         Baskerville, Inc.
                         2
                          Under the Trafficking in Contraband Cigarettes Act, it is unlawful for any person to ship, transport,
                         receive, sell, distribute, or purchase 60,000 cigarettes or more that bear no evidence of state tax
                         payment in the state in which the cigarettes are found, if such state requires a stamp to demonstrate
                         payment of taxes. States may also have stricter laws related to cigarette smuggling. For example, in
                         Maryland, it is generally illegal for a consumer to bring more than two packs of cigarettes into the state
                         for which Maryland taxes have not been paid.
                         3
                          Both estimates treat all forms of tax avoidance—both large and small—as “smuggling,” even though
                         some actions, such as local cross-border purchases in small quantities, may not be illegal.



                         Page 2                                                                             GAO/T-RCED-98-50
smuggling. Consequently, according to recent studies, the profitability, and
therefore the extent, of interstate smuggling activity is likely to have
increased in recent years.

In 1997, the state of Washington estimated the extent of interstate
smuggling activity in terms of tax per day by state—which we converted to
the associated loss (or gain) of state tax revenue. The Washington State
estimates were derived using an approach that statistically determines
how demographic factors, such as income and religious preferences, and
differences in tax rates relative to other states affect cigarette sales on
which state taxes were paid. The estimated relationships can then be used
to simulate actual consumption.4 The amount by which estimates of actual
consumption exceed estimates of taxed sales in a state would then
represent the net cigarettes smuggled into that state. In addition to
examining the Washington State results, we developed another set of
estimates by using survey data provided by the Centers for Disease
Control and Prevention. Using survey data at the state level on the
prevalence of smoking and cigarettes smoked per day, we developed
estimates of actual taxable consumption in each state.5 Then, for each
state, we compared the estimates of taxable actual consumption to
reported taxed sales to arrive at estimates of cigarette smuggling.

On a national level, both the Washington State study and our analysis
produced roughly similar results, suggesting substantial smuggling from
states with low tax rates to states with high tax rates. For example, from
both studies, the estimates of tax revenue losses in states with the highest
tax rates such as Massachusetts and Washington ranged between
$52 million and $115 million annually. Similarly, estimates of tax revenues
lost for New York, a state with slightly lower tax rates but which has a
large population, still exceeded $90 million annually. Exporting states,
such as Kentucky, North Carolina, and Virginia showed only modest
revenue gains because their tax rates are so low that extra sales to buyers
in the high-tax states do not generate significant tax revenue.




4
 This approach was pioneered by the Advisory Commission on Intergovernmental Relations in
Cigarette Tax Evasion: A Second Look, ACIR, Washington, D.C., March 1985, and recently updated in A
Tax Study: Cigarette Consumption in Washington State, Washington State Department of Health,
January 1997.
5
 Our estimates of actual taxable consumption exclude smokers on military bases and Indian
reservations, where purchases of cigarettes are exempt from state excise taxes. Also, this approach
requires adjusting the survey on the basis of estimates of actual consumption in order to correct
somewhat for the known bias in the survey data toward underreporting consumption.



Page 3                                                                           GAO/T-RCED-98-50
                     Because there are disadvantages with each estimation method, the results
                     of the studies should be viewed as providing ball-park estimates. The
                     estimates may also be imprecise for a number of other reasons. Estimates
                     of revenues lost6 may be (1) overstated because they do not account for
                     the fact that smokers would buy fewer cigarettes if they were unable to
                     avoid the state cigarette tax (and therefore pay more for their cigarettes on
                     average), or (2) understated because they do not account for federal and
                     state tax revenues avoided because of international smuggling.


                     According to the Canadian government, for several years Canada
Large Increases in   increased the price of cigarettes through federal and provincial excise
Canadian Cigarette   taxes, which resulted in a steady decline in the number of Canadians who
Taxes Led to         smoke. However, these efforts had an unintended consequence—a sharp
                     increase in smuggling activity resulting in revenue losses exceeding
Widespread           $2 billion (in Canadian dollars) for the federal and provincial governments
Smuggling Into       in 1993 alone, according to the Canadian government. From 1984 through
                     1993, federal taxes on a pack of 20 cigarettes increased from 42 cents to
Canada               $1.93 in Canadian dollars. Provincial taxes, levied in addition to the federal
                     taxes, increased significantly as well. For example, from 1984 through
                     1993, Québec’s cigarette taxes rose from 46 cents to $1.78 per pack, and
                     Ontario’s rose from 63 cents to $1.66 per pack (in Canadian dollars). As a
                     result, the average real price of a pack of cigarettes in Canada—in 1994
                     Canadian dollars—increased from $2.64 in 1984 to $5.65 in 1993.

                     According to a 1994 study for the National Coalition Against Crime and
                     Tobacco Contraband, because of these price increases, Canadians found
                     lower-priced alternatives on the black market. During most of this period,
                     cigarettes made in Canada were exported tax-free to the United States.
                     Organized criminal groups purchased Canadian cigarettes that had been
                     exported to the United States and smuggled them back into Canada. This
                     resulted in more than an 11-fold increase in United States cigarette
                     imports from Canada from 1990 to 1993 (see fig. 1). The 1994 study found
                     that an Indian reserve that straddles the U.S.-Canadian border between
                     Cornwall, Ontario, and Massena, New York, had become the primary
                     conduit for smuggling cigarettes into Canada. Once in Canada, the
                     cigarettes were passed through elaborate networks for distribution to
                     vendors throughout the country. By evading the Canadian federal and
                     provincial taxes, smugglers were able to earn huge profits from
                     contraband cigarettes. According to the Canadian government, profits for

                     6
                      For some states, revenue from state sales taxes, in addition to cigarette taxes, may also decline
                     because of cross-border purchases and contraband sales.



                     Page 4                                                                             GAO/T-RCED-98-50
                                        smuggled cigarettes were an estimated $500 per case,7 or $500,000 per
                                        truckload, in Canadian dollars.8


Figure 1: U.S. Cigarette Imports From
Canada, 1984 Through 1996

                                            Million packs (20 cigarettes per pack)
                                            600



                                            500



                                            400



                                            300



                                            200



                                            100



                                              0
                                                  1984   1985   1986   1987   1988    1989    1990   1991   1992   1993   1994   1995   1996
                                                                                              Year

                                        Source: GAO analysis of U.S. Department of Agriculture’s data




                                        In 1993, approximately 2.1 million Canadians consumed an estimated
                                        90 million to 100 million cartons of contraband cigarettes with a legal
                                        retail value of about $4.5 billion in Canadian dollars. That year, the
                                        problem was greatest in the province of Québec, where, the Canadian
                                        government estimated, contraband cigarettes made up over 60 percent of
                                        the market. In other parts of the country, according to the government,
                                        between 15 and 40 percent of the cigarettes sold were contraband.

                                        7
                                         A case of Canadian cigarettes contains 50 cartons.
                                        8
                                         Prime Minister Jean Chrétien, Government Action Plan on Smuggling, House of Commons,
                                        February 8, 1994.


                                        Page 5                                                                        GAO/T-RCED-98-50
    While citing the effectiveness of past efforts to reduce smoking by
    increasing cigarette taxes, Prime Minister Chrétien stated in February 1994
    that the widespread availability of relatively inexpensive contraband
    cigarettes was negating government controls on the distribution, sale, and
    consumption of cigarettes. According to the Canadian Prime Minister, as
    the portion of the Canadian market supplied by smuggled tobacco
    increased, the average price paid for cigarettes dropped. Access to cheap
    contraband tobacco undermined the government’s health policy objectives
    of reducing tobacco consumption, particularly among youth.

    In February 1994, Prime Minister Chrétien addressed the smuggling
    problem by proposing, among other actions,

•   strengthening enforcement at targeted smuggling areas, particularly along
    the U.S.-Canadian border;
•   reducing the federal cigarette tax by $5 per carton in all provinces,
    effective February 9, 1994, and matching any provincial tax reduction over
    $5, to a maximum federal reduction of $10 (in Canadian dollars);
•   imposing an export tax of $8 per carton (in Canadian dollars) to be paid by
    tobacco manufacturers;
•   imposing a 3-year federal surtax on tobacco manufacturers’ profits to fund
    a major public education program and other health measures;
•   requiring manufacturers to clearly mark individual cigarettes to
    differentiate cigarettes manufactured for domestic and export use; and
•   further restricting access to cigarettes by minors.

    From February 9 through April 15, 1994, federal and provincial taxes were
    significantly lowered in the five provinces where international smuggling
    was particularly troublesome, including Québec and Ontario. For example,
    combined taxes in Québec fell by $2.10 per pack, and taxes in Ontario fell
    by $1.92 per pack in Canadian dollars.9 Although taxes in these provinces
    have increased slightly since, once the initial tax cuts took effect, the
    contraband cigarette market dried up, according to the 1994 study for the
    National Coalition Against Crime and Tobacco Contraband. Consistent
    with the study’s findings, U.S. cigarette imports from Canada dropped
    about 96 percent from 1993 through 1996 (see fig. 1).


    Thank you again for the opportunity to appear before you today. We would
    be pleased to respond to any questions you may have.


    9
     Based on 20 cigarettes per pack.



    Page 6                                                     GAO/T-RCED-98-50
Table 1: State Cigarette Tax Rates Per
Pack of 20 Cigarettes, as of July 1,                                       State
1997 (In cents)                                                         cigarette
                                         State                           tax rate
                                         Alabama                            16.5
                                         Alaska                             29.0
                                         Arizona                            58.0
                                         Arkansas                           31.5
                                         California                         37.0
                                         Colorado                           20.0
                                         Connecticut                        50.0
                                         Delaware                           24.0
                                         District of Columbia               65.0
                                         Florida                            33.9
                                         Georgia                            12.0
                                         Hawaii                             60.0
                                         Idaho                              28.0
                                         Illinois                           44.0
                                         Indiana                            15.5
                                         Iowa                               36.0
                                         Kansas                             24.0
                                         Kentucky                             3.0
                                         Louisiana                          20.0
                                         Maine                              37.0
                                         Maryland                           36.0
                                         Massachusetts                      76.0
                                         Michigan                           75.0
                                         Minnesota                          48.0
                                         Mississippi                        18.0
                                         Missouri                           17.0
                                         Montana                            18.0
                                         Nebraska                           34.0
                                         Nevada                             35.0
                                         New Hampshire                      37.0
                                         New Jersey                         40.0
                                         New Mexico                         21.0
                                         New York                           56.0
                                         North Carolina                       5.0
                                         North Dakota                       44.0
                                         Ohio                               24.0
                                                                      (continued)



                                         Page 7                 GAO/T-RCED-98-50
                                       State
                                    cigarette
           State                     tax rate
           Oklahoma                     23.0
           Oregon                       68.0
           Pennsylvania                 31.0
           Rhode Island                 71.0
           South Carolina                7.0
           South Dakota                 33.0
           Tennessee                    13.0
           Texas                        41.0
           Utah                         51.5
           Vermont                      44.0
           Virginia                      2.5
           Washington                   82.5
           West Virginia                17.0
           Wisconsin                    44.0
           Wyoming                      12.0

           Source: ATF.




(150738)   Page 8           GAO/T-RCED-98-50
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