Tobacco use has been described as a “complex system” that can be thought of in terms of “[t]he product, the person, and the tobacco producer,” all of whom “operate in an environment of national-, state-, and community-level factors” (National Cancer Institute, 2007, pp. 13, 19). This chapter describes part of that complex system by exploring some of the key features of the illicit tobacco market. These features include the cigarette supply chain (with overlapping legal and illegal components) and major illicit procurement schemes, the role of price and nonprice factors in driving illicit trade, and the profitability associated with the illicit market. The chapter concludes with the committee’s recommendations for research and data.
Because there is both a legal and an illegal market for cigarettes, it is important to consider the intersections between legal and illegal supply chains, including where and at what scale leakages occur along the legal supply chain of cigarettes. The supply chain of illegal cigarettes is defined by how raw materials are transformed into cigarettes, how—through subsequent phases of packaging, transportation, and storage—these cigarettes are distributed to consumers, and how some, or all, of the phases in the supply chain involve some violation of laws.
The Legal Supply Chain
The schemes that characterize the illegal cigarette trade can be categorized with regard to the point in the supply chain at which the line between legal and illegal conduct is crossed. For this purpose, the legal supply chain of cigarettes can be broken down into five phases: preproduction, production, taxation/in-transit, wholesale, and retail.
Preproduction involves the cultivation, harvesting, and cutting of tobacco and the production of other intermediate products, such as paper and filter tips. Illegal schemes in this phase of the supply chain are rare given the absence of strict regulations in most jurisdictions: that is, given few laws, there are few ways to break them.1 In the United States, the cultivation of tobacco and the production of other materials necessary for the manufacture of cigarettes, such as filter tips and cigarette paper, are not subject to licensing or other regulatory oversight aimed at curbing the illegal production of cigarettes.
Production involves the manufacturing of cigarettes, typically including packaging in packs of 20 sticks and in cartons of 10 packs (200 sticks). In the United States, manufacturers are required to obtain a license from the Alcohol and Tobacco Tax and Trade Bureau (TTB) of the U.S. Department of the Treasury prior to engaging in business operations.
Taxation involves the payment of taxes and other fees2 on cigarettes. How this is done varies from jurisdiction to jurisdiction. In the United States, cigarette manufacturers must pay federal excise tax on cigarettes destined for the domestic market when the cigarettes leave the production facility. Cigarettes destined for export—known as “in-transit” cigarettes—are exempt from taxes until they are introduced into a market; in-transit cigarettes may be stored or transported for extended periods of time.
The wholesale phase involves the storage of bulk consignments of taxed cigarettes by wholesale dealers and the eventual distribution to retail dealers. State and local taxes (in addition to the federal excise tax) are commonly paid by wholesale dealers, who have to obtain and affix tax stamps on each pack (U.S. Government Accountability Office, 2011, p. 9).
The retail phase involves the retail sale of cigarettes to consumers. Illicit cigarettes may be sold in public places by street vendors; in semiprivate places, such as stores and bars; in private locations, such as private clubs or apartment buildings; and over the Internet. Although systematic evidence is lacking as to whether consumers of illicit tobacco are aware of the illegal nature of their purchases, anecdotal accounts suggest that consumers may
1 Australia, where tobacco cultivation has been heavily regulated, is an exception. The Australian experience is discussed in Box 5-2, in Chapter 5.
2 See the discussion of the Master Settlement Agreement (MSA) in Box 1-3, in Chapter 1.
not be completely ignorant about the legality of their behavior (von Lampe et al., 2014).
Although, as is discussed below, counterfeit cigarettes and “fake brand products” are a minor issue in the United States, the evidence suggests that consumers of illicit tobacco in low-income communities are fully aware that they are engaging in illicit behavior (see Chapter 3).
The Main Illegal Procurement Schemes
Four main schemes have characterized the illegal cigarette trade globally over the past two to three decades: bootlegging, large-scale smuggling, “illicit whites” (cigarettes that are legally produced under unique brand names or no brand name), and illegal production. Each of these schemes is linked to particular phases in the legal supply chain of cigarettes. As shown in Figure 2-1, the green represents the legal portion of the supply chain, and the red represents the illegal portion. In some cases, as discussed below, the green and red paths overlap because there is some variation in where exactly in the supply chain the diversion from legal to illegal takes place.
Bootlegging, which is also sometimes known as small-scale smuggling, refers to the legal purchase of cigarettes in one jurisdiction and their con-
FIGURE 2-1 Phases of the cigarette supply chain.
NOTE: Green indicates a legal path, and red indicates an illegal path.
sumption or resale in another jurisdiction without the payment of applicable taxes or duties (Merriman et al., 2000, p. 366). Bootlegging, in its simplest form, involves the purchase of relatively small amounts of cigarettes from regular retail stores (in the retail phase of the legal supply chain). More sophisticated bootleggers buy cigarettes in bulk from legal wholesalers (in the wholesale phase of the legal supply chain). For example, in Virginia, bootleggers often use “smurfing schemes” in which individuals legally purchase cartons of cigarettes from retail or wholesale stores, and after a sufficiently large quantity of cigarettes has been collected the cartons are transported to high-tax jurisdictions. Accordingly, depending on the volume of business, bootlegging can range from “mom and pop” operations handling a few packs or cartons embedded in private cross-border movement to operations handling truckloads of cigarettes.
The illegal cigarette trade in the United States has traditionally been centered on domestic bootlegging, which is largely a result of different tax rates across U.S. jurisdictions. Bootlegging occurs primarily across state lines, with low-tax states such as Virginia and the Carolinas being the main sources. As discussed below, Native American tribal reservations have also been an important source of bootlegged cigarettes, especially in New York, which typically involves the use of minivans and cars by bootleggers to pick up the cigarettes and bring them to retail sellers in New York City (Guevara and Willson, 2008). A change in the legal framework in 2011, which made the sale of tax-free cigarettes to non-tribal members illegal, has shifted the supply back to interstate bootlegging (Kurti et al., 2012; Davis et al., 2013).
Large-scale smuggling occurs when cigarettes are sold without the payment of any taxes or duties, even in the country of their origin (Merriman et al., 2000, p. 366). Large-scale smuggling involves diversion of untaxed in-transit cigarettes to the illegal market. In these cases, tax-exempt cigarettes are obtained in bulk under the pretense of export trade directly from manufacturers or from wholesalers that supply international markets. It is important to note that “large-scale smuggling” refers not to the scale of the evasion activity, but to the systematic means by which it occurs: the committee uses this term because of its widespread usage and acceptance in discussions of the illicit tobacco trade. Although large-scale smuggling is also sometimes referred to as “wholesale smuggling,” this evasion activity does not occur only at the wholesale phase of the supply chain.
The major difference between bootlegging and large-scale smuggling is the cost of procuring the cigarettes. In large-scale smuggling, no taxes or fees are paid on the cigarettes, which are usually obtained directly from the manufacturer at low factory rates. Large-scale smuggling, as the term
suggests, also typically involves purchases in bulk, by the truck or container load of several million cigarettes.
The diversion to the illegal market can take place at different phases in the supply chain. In one scheme, cigarettes are first properly exported and then illegally reimported and inserted into illegal distribution channels. In another scheme, false documents are used to indicate export, and the in-transit cigarettes are put directly into the domestic illegal market. Large-scale smuggling typically entails the use of businesses that appear as receivers of exported cigarettes and as senders and receivers of the shipments within which smuggled cigarettes are hidden. These businesses may be specifically set up by smugglers as a front for illegal activity, or they may be existing businesses that are also used for legitimate commercial activity.
Although legally produced U.S. cigarettes in transit to markets abroad could be diverted to the illegal market in the United States through export-reimport schemes, the committee did not find any evidence that such schemes play a major role in the domestic illegal market in the United States. The three major manufacturers in the U.S. tobacco industry—Philip Morris USA, R.J. Reynolds, and Lorillard—–have also sold or separated from their international businesses and now focus on the U.S. market (U.S. Government Accountability Office, 2011, p. 5). Moreover, in a presentation to the committee, representatives of the U.S. Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF) referred only to the past involvement of U.S. tobacco manufacturers in the diversion of cigarettes to European black markets. The case that came closest to the scenario of large-scale smuggling was that of a fourth-tier manufacturer falsifying shipping papers indicating that cigarettes were going to a Native American reservation to avoid the escrow deposits required of nonparticipating manufacturer as part of the Master Settlement Agreement (MSA),3 when in fact the cigarettes were shipped to states where MSA payments were due.
As shown in Figure 2-1 (above), in the case of large-scale smuggling the licit and illicit portions of the supply chain can overlap. Untaxed (in-transit) cigarettes could be legally exported and be moved to a free-trade zone where they are then falsely labeled as a different type of good and smuggled to a destination country. In such a scheme, the first part of what happens in the in-transit phase is legal.
While domestic illegal production (discussed below) and large-scale smuggling of U.S.-made cigarettes do not currently represent major sources of illegal cigarettes, the United States has been and continues to be a destination country for illegal cigarettes from abroad. Those cigarettes have involved counterfeit versions of U.S. brands, genuine or counterfeit international brands, and unlicensed or unbranded cigarettes. In all of these
3 See Box 1-3, in Chapter 1 for discussion of the MSA.
cases, contraband cigarettes, similar to other contraband (like illegal drugs), may enter the United States under the guise of international commerce or international noncommercial traffic, or they may be brought across the border clandestinely (outside of regular border crossings). In small amounts, contraband cigarettes may also be transported by mail or parcel service (von Lampe, 2011). Counterfeit cigarettes, particularly of foreign origin, have attracted recent attention due to intelligence collected and seizures conducted by ATF and the U.S. Immigration and Customs Enforcement (ICE) (totaling 24 seizures in fiscal 2013 and 124 in fiscal 2012),4 as well as the discovery of several high-profile counterfeit smuggling rings among 87 people arrested in 2005 for smuggling hundreds of millions of sticks into the United States (U.S. General Accounting Office, 2004; T. Chen, 2008; U.S. Department of Homeland Security, 2013). Still, these illegal cigarettes do not seem to have a major impact on the illegal cigarette market in the United States, especially in comparison with the situation in Europe and other parts of the world (von Lampe et al., 2014).5
Given that global cigarette smuggling relies heavily on maritime container traffic, cargo security is particularly relevant in this respect (World Customs Organization, 2013). For example, under the Container Security Initiative (CSI), launched in 2002 in response to the 9/11 attacks, U.S. Customs and Border Protection staff are stationed at foreign seaports and work with local authorities to scrutinize containers bound for the United States (see Chapter 6). In 2013, there were 58 ports in 32 countries included in the CSI, which collectively accounted for more than 80 percent of the container shipments entering the United States (U.S. Government Accountability Office, 2013, pp. 9-10). This program is supported by the 24-Hour Manifest Rule, which requires that cargo manifest data be electronically filed with U.S. customs at least 24 hours before cargo destined for the United States is loaded onto a vessel at a foreign port (Cook, 2012, p. 172).
There are several possible explanations for why, in comparison with other destination countries for contraband cigarettes, the United States appears to be less affected by large-scale smuggling of brand cigarettes and by counterfeit cigarettes and illicit whites. First, although tobacco-specific border control efforts appear to be limited (see Chapter 6), general border
4 ICE enforcement efforts are discussed in Chapter 6.
5 For example, industry estimates cited in the media have placed the share of counterfeit cigarettes sold in New York City at about 2 percent (Crudele, 2010). According to another estimate by a cigarette manufacturer, which compares the prevalence of counterfeit cigarettes by world regions, the overall share of counterfeit cigarettes is about 2 percent in the Western Hemisphere, about 4 percent in the Asia-Pacific region, 7 percent in Africa and the Middle East, 12 percent in Western Europe, 49 percent in Eastern Europe, and 80 percent in China (British American Tobacco, 2010, p. 18).
control efforts to stymie illegal trade may deter the illicit tobacco trade,6 especially because tobacco is bulky and therefore more easily detected than some other contraband.7 Second, alternative paths for illicit trade inside the United States (e.g., bootlegging) require less complex organization and less investment than large-scale smuggling. As discussed below, other countries do not have the large tax differentials in relatively small geographic areas that exist in the United States, making domestic smuggling of legally produced, brand-name cigarettes unprofitable in other countries. As a consequence, imported contraband and counterfeits have a larger share of the illicit market abroad than they do in the United States.
A third factor could be the preferences of U.S. consumers for certain kinds of tobacco and cigarettes. American consumers tend to be accustomed to “American blend” cigarettes, which differ quite substantially in their chemosensory characteristics from blends used in many international markets. American cigarettes blend flue-cured bright with burley and oriental tobacco varieties to produce the desired basic flavor grade. Extenders, such as reconstituted tobacco sheet and expanded tobacco and stems, are typically combined with the blend to reduce costs. Flavor and sugar additives and humectants are introduced in the form of “casing,” which is sprayed onto the tobacco blend in a fine mist. The addition of sugar is important to replace that lost during the air curing process. Further toasting of the burley tobacco produces the “Maillard-Browning” reaction that forms amino-sugar compounds, which contribute desirable flavor characteristics. In contrast, the majority of cigarettes produced in Canada, the United Kingdom, and Australia use a 100 percent flue-cured Virginia tobacco blend (World Health Organization, 2008). Even with the availability in the United States of many major foreign cigarette brands (usually from specialist tobacco retailers), foreign brands have failed to achieve any notable share of the domestic U.S. cigarette market. The historic preference of U.S. consumers for American blend cigarettes may be as important for overall levels of consumer demand as price differences and attempts to avoid or evade taxes. To understand this issue better, research would be needed that directly tests the appeal and acceptability of a representative selection of non-American blend cigarettes, chosen from major international markets, among U.S. consumers.
However, the illicit tobacco market in the United States could change significantly if new product regulations increase demand for cigarettes with
6 The committee is not aware of any systematic comparative studies of border controls that measure the effectiveness of U.S. controls compared with, for example, controls in the European Union.
7 The bulkiness of cigarettes also means that transportation, storage facilities, and staff required for handling large numbers of cigarettes can create costs that drug dealers, for example, may not face, at least not to the same extent (von Lampe, 2007).
prohibited features. In particular, an illegal market for cigarettes that have restricted characteristics could develop. Such a market could include illicit whites, genuine cigarettes diverted from other countries, or unlicensed or unbranded cigarettes. (For discussion of potential tobacco product regulation and the U.S. illicit market, see Chapter 8.)
Illicit whites, also called cheap whites, are legally produced cigarettes with unique brand names or no brand name, typically sold either in standard packs of 20 cigarettes or in bags with a larger number (e.g., 200) of loose cigarettes. They are destined primarily or exclusively for illicit distribution: typically no efforts are made to market these cigarettes through legal distribution channels (Joossens and Raw, 2012, p. 231).
The overall market structure for illicit whites is similar to large-scale smuggling in several respects. In both cases, legally produced untaxed cigarettes8 are made available for illegal distribution in large consignments at low costs. And in both cases there is some degree of connivance on the part of manufacturers. However, in the case of illicit whites, the manufacturers are more or less integrated into the illegal cigarette trade.
Historically, illicit whites are an alternative to the production of counterfeit brand cigarettes. Illicit whites, like counterfeits, are produced in large numbers in different countries. For example, the most common illicit white brand, “Jin Ling,” is manufactured in Kaliningrad, Russia, as well as in the Ukraine and Moldova. Other important bases of illicit white manufacturers are Cyprus and the United Arab Emirates. The most popular illicit white brands tend to be counterfeited over time (World Customs Organization, 2013, p. 20).
Research based on littered pack surveys, while not measuring the total prevalence of counterfeit cigarettes (see Chapter 4), indicates that illicit whites have no presence at all on the U.S. market. Even Native American brands, which could theoretically play a role similar to illicit whites in Europe, are only of marginal importance (Kurti et al., 2012; Chernick and Merriman, 2013). In addition to the factors discussed above (the role of border security, opportunities for bootlegging, consumer preferences, etc.), the prevalence of illicit whites may be related to the historical prominence of an illegal cigarette distribution infrastructure. Once there is an illegal distribution network in place, switching from one kind of illegal cigarettes
8 In addition to being produced for export with no local taxes paid, illicit whites can, in principle, be sold domestically in the country of production with all relevant local taxes paid. Because the committee is interested in illicit whites as a global phenomenon, the report focuses on the former.
to another on the supply side is fairly easy. For example, historical experience shows that Jin Lings in Germany and in the United Kingdom replaced other kinds of illegal cigarettes within a short time frame. The importance of established distribution networks for allowing changes in supply is a more general phenomenon (see Joossens and Raw, 1998, p. 67; Shleynov et al., 2008).
As discussed below, some Native American tribes produce their own cigarettes. These brands produced on tribal land have the potential to play the same role as illicit whites, as they could in principle be sold in bulk to smugglers for distribution outside of tribal lands. However, there is no evidence that this has occurred. Like major brand cigarettes, cheap whites are produced in geographically fixed facilities that involve substantial capital investment. However, since the operations are legal in their country of origin, deterring illegal conduct by targeting production is unlikely to be productive absent legal changes and cooperation by the countries in which the cigarettes are produced.
Illegal production involves the manufacturing of cigarettes in violation of the law. The two main forms are unlicensed or underreported production of unique brand or nonbrand cigarettes and the production of counterfeit cigarettes. In the case of undeclared production, legal manufacturers violate obligations to fully disclose to authorities the amounts of cigarettes they produce, thereby avoiding taxation on some portion of their output (Joossens and Raw, 2012, p. 231).9 In October 2012, for example, the president of a Virginia cigarette manufacturer was sentenced to 60 months in prison for underreporting production and underreporting cigarettes that were sold in several states; similarly, a Kentucky manufacturer forfeited $8 million to the federal government for underreporting production and sales to avoid paying taxes (Virginia State Crime Commission, 2013a, p. 11).10 In a presentation to the committee, a representative from ATF indicated that illegal activities of this kind could be attributed to lower-end,
9 Illegal production of cigarettes by unlicensed manufacturers in the United States has occurred on tribal lands when cigarette manufacturers operate without a U.S. federal license in violation of the Contraband Cigarette Trafficking Act. For details, see http://www.atf.gov/files/press/releases/2011/07/070511-ny-atf-and-ttb-accept-125-million-cigarette-settlement.pdf [January 2015] and https://www.atf.gov/press/releases/2010/04/041210-ny-cigarette-manufacturer-admits-violations.html [January 2015].
10 For details, see http://www.kentucky.com/2010/06/30/1329526/kentucky-father-and-son-plead.html [January 2015].
“fourth-tier” manufacturers.11 In the United States, tobacco producers engage in geographically fixed, visible, and regulated operations, factors that make detecting and disrupting illegal activity relatively easy if law enforcement efforts are focused on doing so.
For counterfeited cigarettes, the production is illegal because brand labels are used without the permission of the trademark owner. The annual number of counterfeit cigarettes produced globally is estimated at several billion, and China is considered the main source country (Shen et al., 2010; World Customs Organization, 2013, p. 24). The production of counterfeit cigarettes is not currently prevalent in the United States.
The counterfeit cigarettes that have been seized by U.S. authorities have been traced to foreign countries, including China, North Korea, and Paraguay. Elsewhere, there has been a partial shift of counterfeit production from traditional source countries, such as China, to consumer countries: since the mid-2000s, illegal cigarette production sites that are manufacturing counterfeit brand cigarettes have been discovered in the Czech Republic, Germany, and the United Kingdom (von Lampe, 2006, p. 240; World Customs Organization, 2013, pp. 17-18).
The history of the illicit tobacco trade in China provides one example of conditions that enable illegal manufacturing to arise (von Lampe et al., 2012). In the 1970s, illicitly traded tobacco in China largely came from the diversion of products from state-controlled factories or illegal production beyond the state-set quotas. With the creation of the World Trade Organization (WTO) in 1995 and its oversight of global trade, tariffs on imported cigarettes fell from 65 percent to 25 percent, and the anticipation of increased competition from transnational tobacco companies prompted a restructuring and consolidation of the Chinese domestic tobacco industry. This change resulted in the availability of surplus resources, including skilled staff and production facilities, which could be diverted to illegal production.
Like all cigarette production, counterfeit manufacturing requires infrastructure, inputs, and capital investment: see Box 2-1. As a result, counterfeit manufacturing is usually carried out by stable, organized, sophisticated, and well-networked enterprises, as in the case of Chinese counterfeit cigarettes produced in Fuijan and Guangdong provinces (Shen et al., 2010). The level of organization necessary to make counterfeiting profitable may make counterfeiters more resistant to low-level and intermittent enforcement
11 Cigarettes are divided into four different price categories or tiers: first-tier or premium brands are produced by major manufacturers; second-tier and third-tier brands are produced by major manufacturers but sold at a substantial discount in comparison with first-tier cigarettes; and fourth-tier brands sell at prices below third-tier brands and are produced by smaller manufacturers. See http://apps.americanbar.org/antitrust/at-committees/at-pdiscr/pdf/discussion-list/07/03-05-07.pdf [March 2015].
Material and Inputs Necessary for Illegal Cigarette Production
The specific raw materials that illegal manufacturers need to produce cigarettes include tobacco, acetate tow for filter tips, and cigarette papers. In addition, depending on the level of sophistication of the production, illegal manufacturers need machinery to produce and to package the cigarettes.
Raw Tobacco Given the lack of a regulatory framework, domestically grown tobacco seems to be easily accessible to illegal manufacturers and could be acquired through normal, inconspicuous market transactions. In Canada, domestically grown raw leaf tobacco is considered an important source of illegal cigarettes (Luk et al., 2007, p. 9). In the United States, however, no similar cases have come to the attention of the committee that would suggest there is a trend in this direction.
Acetate Tow Acetate tow is made from cellulose acetate. Most of the acetate tow manufactured globally is made by only a few major corporations, and it is difficult to produce. Although cellulose acetate has several industrial uses, acetate tow is used in very few products, and more than 80 percent of world production is reportedly used in the manufacture of cigarettes. For these reasons, acetate tow could be controlled to make illegal manufacturing of cigarettes more difficult.
Cigarette Papers Papers used in the production of individual cigarettes, such as acetate tow, are a highly specialized product. They are designed to control factors such as density, porosity, and burn rate (Framework Convention Alliance, 2010). Like cellulose acetate, cigarette papers have a unique harmonized tariff code (Framework Convention Alliance, 2010), and they are supplied by a small number of producers (Law Enforcement Alliance of America, 2014). Given this production characteristic, a licensing system would be relatively easy to establish. However, as is true for acetate tow, the production of cigarette papers is not subject to any form of regulation aimed at preventing the illegal manufacturing of cigarettes, either in the United States or elsewhere.
Cigarette Manufacturing Machinery As is the case for the raw products required for the manufacturing of cigarettes, the machinery needed for industrialscale production of cigarettes is not subject to any legal restrictions. However, some tobacco companies do take actions that have the effect of limiting access to such machinery. British American Tobacco, for example, destroys machinery if there is no authorized buyer, and Imperial Tobacco likewise destroys old production equipment.
efforts. However, integrated vertical criminal organizations that sell counterfeit tobacco could be subject to methods of detection and enforcement often used to disrupt drug enterprises, such as efforts focused on distributors and retailers that trace retail counterfeit cigarettes up the supply chain to production facilities.
Stable infrastructure also makes illegal cigarette production easier to detect, which, in turn, suggests that local law enforcement commitment could be a significant factor in attempts to stop illegal manufacturing. National governments can play an important role in influencing the priorities of local governments. High levels of corruption at either the national or local level, then, can interfere with identifying and disrupting illegal production facilities abroad. And if law enforcement targets fixed facilities, manufacturers will seek smaller, more mobile alternatives. Recently, for example, truck-based production facilities have been discovered in Paraguay and China (von Lampe et al., 2012). Mobile facilities are more difficult to detect than fixed facilities, but they are also more limited in production volume. Given that there are significant economies of scale in cigarette production, shifting suppliers from fixed facilities to mobile facilities will cause substantial increases in the cost of illicit production.
Unlike the situation for the vast majority of other commodities, taxes can comprise a substantial proportion of the retail price of cigarettes. In the United States, federal and state cigarette excise taxes on average account for about 44 percent of cigarette prices (Orzechowski and Walker, 2014), not including the MSA payments. In 2013, the average price per cigarette pack in the United States was $5.76, and the average tax per pack was $2.56 (Orzechowski and Walker, 2014). There is wide variation among countries in the kind and amount of taxes applied to tobacco products. Globally, total taxes on the most sold brand of cigarettes varied from 2.5 percent of the price in Afghanistan to 83.9 percent of the price in Slovakia (World Health Organization, 2013b).
There are three categories of taxes that are levied on tobacco products—excise taxes, sales (or consumption) taxes, and import duties. Excise taxes are a product-specific tax that can be applied on a per unit basis (e.g., 5 cents a pack) or as an “ad valorem” excise tax (e.g., 5 percent of the retail price).12 Sales taxes are generally applied broadly on goods and services as a percentage of the retail price; value-added taxes (VAT) are applied to
12 The point in the supply chain at which the ad valorem tax is applied varies from jurisdiction to jurisdiction. In the United States, state excise taxes are typically applied at the wholesale (distributor) level.
the value added by the supplier (including capital and labor costs). Excise taxes and VAT on tobacco products vary considerably across the world (World Health Organization, 2013b); in most jurisdictions, taxes on “other tobacco products” are low relative to cigarette taxes, so that excise taxes account for a lower share of prices for these products. (See Box 2-2 for a discussion of other tobacco products.) Import duties are taxes levied on products imported into a country that are intended for domestic consumption; most countries impose duties on imported tobacco products, collected
Taxation of Other Tobacco Products
“Other tobacco products,” which include cigars, small cigars, smokeless tobacco (snuff or chewing tobacco), pipe tobacco, and rollyourown tobacco, are broadly defined in the Internal Revenue Code (26 U.S.C. §5702). Small and large cigars are differentiated by weight, and rollyourown tobacco and pipe tobacco are differentiated by their intended use and defined by characteristics that are based on their appearance, packaging, and labeling.
Like excise taxes on cigarettes, disparities in the taxation of other tobacco products exist between the states. As with taxes at the federal level, some states use weightbased taxes, ad valorem taxes, or a combination of both. Pennsylvania does not tax any other tobacco products, while Minnesota taxes all of them (as well as ecigarettes) at 95 percent of the wholesale price (Campaign for TobaccoFree Kids, 2014b).
Taxes also vary across products at the federal level. Federal excise tax rates for cigarettes, rollyourown tobacco, pipe tobacco, smokeless tobacco, small cigars, and large cigars increased in 2009 with the passage of the Children’s Health Insurance Program Reauthorization Act. The act equalized federal excise tax rates for cigarettes, rollyourown tobacco, and small cigars. Although federal excise taxes on pipe tobacco and large cigars also increased, these products are still taxed at significantly lower rates than rollyourown tobacco and small cigars. The discrepancies in these tax rates have created opportunities for tax avoidance and have led to significant market shifts by manufacturers and consumers toward the lowertaxed products. For example, manufacturers of rollyourown tobacco products made minor changes to the packaging of their products—without changing the appearance of the actual tobacco product produced—in order to have the product labeled as pipe tobacco, saving more than $20 per pound in excise taxes due. A similar market shift occurred for cigars. Small cigar manufacturers began producing heavier cigars that would qualify for the lowertax rate for large cigars by adding weight to a filter or packing the tobacco tighter. The U.S. Government Accountability Office (2014) has estimated that from April 2009 to February 2014, $2.6 billion to $3.7 billion in federal revenues was lost as a result of these market shifts.
from the importer when the product enters the country and typically based on the cost (the price paid by the importer, including insurance and freight costs).
In the United States, cigarettes are subject to excise taxes, levied on a per unit basis. Unlike the United Kingdom and most countries in the European Union, where the same cigarette tax is applied throughout the entire county, cigarette taxation in the United States is highly decentralized. Because of the homogeneity in tax rates within most countries, there is little incentive for within-country smuggling in comparison with the United States. Overall, interstate tax differentials in the United States are greater than cross-country differences in the European Union,13 while the average tax burden on cigarettes in the United States is significantly lower than in the European Union (von Lampe et al., 2014, p. 270).
In Canada, as in the United States, there are significant disparities in provincial taxes (Non-Smokers’ Rights Association, 2014). Although the difference between the lowest price per carton and highest prices (after all taxes are taken into account) is large—Can $85.39 in Quebec and Can $125.80 in Manitoba—it does not appear to provide an incentive for bootlegging between provinces. This may be due to the considerable geographic distances between population centers in different Canadian provinces. Moreover, smuggling cigarettes from Native reserves, where all taxes can be evaded, is highly profitable, further limiting incentives to bootleg between provinces.
Cigarette taxes became an attractive revenue source for the states in the wake of the 1964 report of the U.S. Surgeon General linking smoking with cancer, and cigarette tax evasion began to pose serious problems for state administrators in the late 1960s as tax rate differentials among the states began to widen (Advisory Commission on Intergovernmental Relations, 1985, p. 1). State cigarette excise taxes now range from $0.17 in Missouri to $4.35 in New York. Significant local taxes add further variability, with local taxes as high as $3.00 in Cook County, Illinois, and $1.50 in New York City. The average state cigarette tax increased from 43.1 cents per pack at the end of 2001 to 153.1 cents by the end of 2013.
The tax differential between “tobacco states” (Georgia, Kentucky, North Carolina, South Carolina, Tennessee, and Virginia14) and non-tobacco states also increased during this period. At the end of 2001, the average cigarette tax was 7.1 cents in tobacco states and 48.3 cents in
13 However, because of significant differences in production/distribution costs and in income, intercountry price differentials in the European Union are still larger than interstate price differentials in the United States (see, e.g., Blecher et al., 2014).
14 These states account for more than 90 percent of all cigarette tobacco leaf grown in the United States and contain more than 90 percent of all the U.S. tobacco farms that grow cigarette tobacco (Campaign for Tobacco-Free Kids, 2014c).
non-tobacco states; by the end of 2013, the average cigarette tax was 48.5 cents in tobacco states and 167.0 cents in non-tobacco states (Campaign for Tobacco-Free Kids, 2014c).15 In this section, we explore the role of price factors in driving the domestic and global illicit tobacco trade.16 We highlight select key studies and emphasize, to the extent possible, evasion rather than avoidance.17
Baltagi and Levin (1986, 1992) estimated dynamic demand for cigarettes using pooled state-tax-paid cigarette sales data from 46 states from 1963 to 1988. The authors modeled a “bootlegging” effect by allowing for a “neighboring price elasticity,”18 which they found to be substantively small but statistically significant: a 10 percent price increase in a neighboring state tax was found to cause, on average, a 0.8 percent increase in taxed sales in the short run and a 0.21 percent increase in the long run.
In a similar study, Saba and colleagues (1995) examined cigarettes sales from 1960 to 1986 using data from 48 states. The authors found that although border shopping accounted for less than 2 percent of sales in most states, it accounted for a substantial portion of sales when many people resided in high-tax jurisdictions in proximity to low-tax ones. Moreover, estimates of the price elasticity for total cigarette demand that take border crossing flows into account “exceed by a wide margin” estimates that do not account for cross-border shopping. In other words, total cigarette consumption is higher in high-tax jurisdictions that border low-tax jurisdictions than in high-tax jurisdictions that border high-tax jurisdictions. This suggests that “[n]aively instituted state policies, at the very least, will clearly have the effect of exporting taxpayers” (Saba et al., 1995, pp. 197, 201).
Thursby and Thursby (2000) developed a smuggling measure based on cigarette tax rate differentials with North Carolina (at that time thought to be the primary source of cigarettes smuggled by truck).19 The level of enforcement was posited as being a function of, among other things, whether the state was a member of the Interstate Revenue Research Center or the Eastern Seaboard Interstate Cigarette Tax Enforcement Group, the severity of the felony penalty for smuggling, and the rebate offered to wholesalers
15 The federal excise tax on cigarettes increased from $0.34 in 2000 to $1.01 in 2009 (U.S. Government Accountability Office, 2011); as this report was being written, the tax remained at $1.01 (Campaign for Tobacco-Free Kids, 2014a).
16 Because tobacco excise taxes generally represent the largest proportion of tobacco prices and uniquely differentiate tobacco product prices from prices of other goods and services, our discussion focuses on excise taxes.
17 Studies that appear to deal solely or predominantly with tax avoidance are discussed in Chapter 3.
18 The bootlegging specification did not account for bootlegging done over long distances by truck (Baltagi and Levin, 1986, p. 149). The bootlegging effect also does not differentiate between tax evasion and tax avoidance.
19 The authors’ results did not change when Kentucky or Virginia tax rates were used.
for each legal sale. Using annual data from 1972 to 1990 for 39 states, the authors found that declines in the real level of state tax differentials explained more of the decline in smuggling activity during the early 1980s than the Contraband Cigarette Trafficking Act (CCTA) of 1978.20 This finding conflicted with that of the Advisory Commission on Intergovernmental Relations (1985, p. 4), which found that “[t]he decline in cigarette tax evasion activities is due mainly to the enactment of the Federal Cigarette Contraband Act of 1978.” However, the commission acknowledged that “[i]t is also possible that the reduction in smuggling is partly due to the declining real value of interstate price differences that began in the mid-1970s and continued until 1981” (p. 4).
Using state-level cross-sectional data from 2002, Goel (2008) similarly found that nonprice inducements—such as the level of state corruption (measured as the average federal public corruption convictions per 100,000 population) and police presence (the number of police per 1,000 inhabitants—did not have a significant influence on bootlegging, even as a 10 percent increase in the minimum cigarette price in adjoining states increased a state’s cigarette sales by around 10 percent.21 It should be noted, however, that this study does not address the issue about the rate and nature of enforcement that might be needed to create a threshold of deterrence, or econometric identification issues in measuring the relationship between law enforcement and crime that are now standard in the economic and criminology literature (Nagin, 2013).
Looking globally, Merriman and colleagues (2000) analyzed cross-border shopping and bootlegging in Europe using data from 1989 to 1995 from 23 countries. They estimated a demand curve for cigarettes and simulated the impact of two specific policy changes: a 10 percent price increase in just one country and a 10 percent price increase in all countries. The impacts varied across high-price countries such as Germany and low-price countries such as Poland. In low-price countries, small to moderate increases in price had relatively little effect on bootlegging, but the simulation suggested that bootlegging may be a problem in relatively high-price countries if increases in cigarette taxes and policies are not coordinated.
Increases in federal tobacco taxes in the United States would, in principle, reduce incentives for bootlegging and individual tax avoidance, given that relative price differences across jurisdictions would fall. However, unless the federal tax increase is substantial (so that federal taxes account for a much larger proportion of the taxes on cigarettes than state-level taxes
20 The CCTA made commercial cigarette smuggling a federal offense and charged ATF with augmenting the enforcement efforts of state and local officials.
21 As with Baltagi and Levin (1986, 1992), Goel’s (2008) bootlegging effect reflects overall cross-border sales and does not distinguish between tax evasion and tax avoidance.
than is currently the case), the narrowing of price differentials would likely be modest, and it is unlikely that the profitability of bootlegging would be much affected. At the same time, federal tax increases would raise the incentives for other forms of illicit trade to emerge or increase, everything else being constant. However, in other forms of illicit trade, significant increases seem unlikely given that existing policies and enforcement efforts appear, to date, to have largely deterred large-scale smuggling.
Tax and price differentials, as discussed above, are important determinants of the illicit trade in the United States, which mostly consists of bootlegging. Tax and price differentials are also major drivers of bootlegging between countries in Europe, with third countries sometimes used as conduits to create a façade of legitimacy and to make the smuggling and money trails less transparent. However, when it comes to the overall illicit global cigarette trade—encompassing both large-scale smuggling and bootlegging—tax differentials do not tell the whole story. Although high-tax margins may provide an initial incentive to smuggle, other factors—such as the ease and cost of operating in a country and the strength of border controls—are also important (Merriman et al., 2000; Joossens et al., 2010, pp. 1,642, 1,646). Large-scale smuggling also requires good local distribution networks through which smuggled cigarettes can be easily and quickly sold. Such a network most often involves extensive street selling, which is more common in low- and middle-income countries than in high-income countries (Joossens et al., 2000).
In a regression analysis using survey data from the Pricing Policies and Control of Tobacco in Europe (PPACTE) project, which were collected in 18 countries between January and July 2010,22 Joossens and colleagues (2014a) found no significant associations between cigarette prices and the prevalence of illicit cigarettes. The authors also found that illicit purchases were more common in countries that had a land or sea border with Belarus, Moldova, Russia, or Ukraine, which are major suppliers of cheap and illicit cigarettes.
In an econometric analysis using the “corruption perception index” from Transparency International as a measure of the ease with which cigarettes could be imported and distributed, Merriman and colleagues (2000, p. 376) found that “each 1-point increase in a country’s transparency index
22 The PPACTE survey is able to distinguish between tax evasion and tax avoidance, identifying tax-evaded cigarette packs as those that were bought “from ‘individuals selling cigarettes independently at local markets, delivery service, door-to-door, just in the street, or, for UK and Spain, cheap cigarettes sold from legitimate retailers’” (Joossens et al., 2014a, p. e18).
is associated with a 2%-point decrease in experts’ estimates of cigarette smuggling.”23 Yürekli and Sayginsoy (2010) conducted a similar analysis using World Bank corruption indicators, which they used as a proxy for the quality of anti-smuggling law enforcement. Estimating a static global demand model using data for 110 countries in 1999 and then simulating the effect of increasing the average price of a pack of cigarettes by increased taxes, the authors found that the level of global cigarette smuggling is higher in places with high taxes and low-quality law enforcement (i.e., high levels of corruption), but that global smuggling activities are lower when higher cigarette taxes were accompanied by improved enforcement.24
Of course, causal policy conclusions cannot be drawn from cross-national correlational studies, but these findings suggests that the relationship between taxes and international smuggling may be a function of the law enforcement environment.
Anecdotal reports about the high profitability of cigarette smuggling are easy to find (Guevara and Willson, 2008; Alderman 2012). However, by and large, they are not actual estimates of profit in the strict economic sense, which take into account the opportunity cost of the smuggler’s time; the perceived expected costs of engaging in this sort of criminal offense, which in turn include the social costs of being stigmatized as a smuggler; and the legal risks associated with being apprehended by law enforcement. Rather, they refer to a crude measure of the potential of monetary returns to be had by purchasing cigarettes in a low-tax state and selling them in a high-tax state. This distinction is important because economic profits, rather than simple monetary return, are typically better predictors of people’s behavior.
Although the legal risk associated with trafficking in illicit cigarettes is probably quite low (see Chapter 6), this fact begs the question: setting legal risk aside, which includes the probability of being apprehended by law enforcement and potential exposure to violence, exactly how much money could plausibly be made smuggling cigarettes across state borders in the United States? Comparing the relative simple monetary returns associated with different trafficking routes to what is known about actual trafficking routes can provide a sense of the perceived economic costs of
23 The authors’ smuggling measure is based on expert estimates from Joossens (1998) and Market Tracking International Ltd. (1996, 1997a, 1997b).
24 The authors’ measure for organized smuggling is based on intercountry price disparities and a smuggler risk perception function, which is derived from an analysis of an extensive set of interviews with incarcerated drug dealers by Anthony (2004).
cigarette smuggling. If most smuggling traffic does not occur along the most (potentially) high-return routes, then it can be assumed that unobserved nonmonetary costs, such as law enforcement efforts or consumer demand for illicit goods, are also larger along those routes than other routes.
In order to provide some quantitative estimate of the maximum potential accounting profit associated with tobacco smuggling in the United States, the committee constructed a simple distance matrix. This matrix is based on two sources of data: cigarette excise taxes as of December 2013, compiled by the Campaign for Tobacco-Free Kids, and the driving distance between various population-weighted county centers in different states, as measured by the Oak Ridge National Laboratory. The committee’s analysis also accounted for some clearly defined business costs, such as vehicle wear and tear and a minimum estimate of a driver’s wages, based on the minimum wage in the originating state.
We estimated the relative revenue associated with buying cigarettes in a low-tax jurisdiction and selling them in a high-tax jurisdiction by identifying the largest difference in per-pack taxes levied at the retail level across states, including all local taxes (tracked by the Center for Tobacco-Free Kids). This approach obviously involves a simplifying assumption, as the actual sales price of a pack of cigarettes will vary across different stores and markets, depending on the market structure, the price elasticity of supply, and the price elasticity of demand in different counties. It is also probably not the case that all smugglers purchase their cigarettes at retail prices; as discussed above, cigarettes can be diverted into the illicit market at various earlier phases.
We then calculated the cost of driving from the origin to the destination county based on the physical mileage, average national gas prices in April 2014 ($3.683/gallon), and the average highway miles per gallon (mpg) of a Ford Expedition (15 mpg). Using data from ATF seizures, we assumed that a Ford Expedition can hold 2,410 packs of cigarettes, and a Dodge Grand Caravan can hold 8,200 packs. We also assumed about $0.50 of depreciation per mile traveled for the vehicle and that one driver was paid the state or federal minimum wage (whichever was lower) for a round-trip journey. We then identified the county-to-county smuggling route for each state pair that yielded the highest potential monetary return. Consistent with law enforcement reports, New York and Illinois are the most profitable destinations for smuggled cigarettes, and so our analysis focuses on the return to smuggling various goods to and from those states.
Tables 2-1 and 2-2 present the top 10 most “profitable” routes to Illinois and New York, respectively, excluding legal and social costs and assuming that smuggled cigarettes enter the illicit market after retail purchase. Law enforcement reports identify the Virginia to New York I-95 corridor as being the most active route for cigarette smuggling. Technically, the
TABLE 2-1 Top 10 Retail Cigarette Smuggling Routes to Illinois, Based on Tax Differentials and Estimated Transportation Costs, Compared with Returns for Alcohol and Cocaine Smuggling
|Rank||Source State||Source State to Illinois||Illinois to Source State|
|Cigarettes||Alcohol||Cocaine||Pure Cocaine||Alcohol||Cocaine||Pure Cocaine|
NOTES: The analysis assumes that the vehicle used travels 15 miles per gallon of gas. One shipment is equal to 2,410 packs of cigarettes, 200 cases of alcohol, or 1 kilogram of cocaine. The analysis assumes the driver is paid the state minimum wage of the originating state. For other assumptions used in the analysis, see text.
TABLE 2-2 Top 10 Retail Cigarette Smuggling Routes to New York, Based on Tax Differentials and Estimated Transportation Costs, Compared with Returns for Alcohol and Cocaine Smuggling
|Rank||Source State||Source State to New York||New York to Source State|
|Cigarettes||Alcohol||Cocaine||Pure Cocaine||Alcohol||Cocaine||Pure Cocaine|
NOTES: The analysis assumes that the vehicle used travels 15 miles per gallon of gas. One shipment is equal to 2,410 packs of cigarettes, 200 cases of alcohol, or 1 kilogram of cocaine. The analysis assumes that the driver is paid the state minimum wage of the originating state. For other assumptions used in the analysis, see text.
analysis suggests that if tax differentials and transportation costs were the only concern of smugglers, cigarettes purchased in Missouri should be at least as common in Chicago and New York City as cigarettes from Virginia. Louisiana and North Dakota also appear to be attractive sources for illicit cigarettes, yielding returns within a few hundred dollars of the southeastern “tobacco states” of Georgia, North Carolina, and South Carolina. Notably, due to local taxes, purchasing the same number of cigarettes in a low-tax county in Illinois and reselling them in Chicago yields roughly $10,000, which is only $2,000 less than the return from smuggling cigarettes from Indiana.
Of course, whether or not the roughly $13,500 that can be earned driving an SUV of cigarettes across state lines constitutes an attractive and profitable activity depends on the return from smuggling cigarettes relative to some other product. For comparison, we include in Tables 2-1 and 2-2 the same return from transporting two other goods along the same routes: 634 gallons of alcohol (roughly 200 cases) and 1 kilogram of (pure or cut) cocaine. State excise taxes on spirits, per gallon, as of January 2013, were taken from the Tax Foundation, and the sales price for 1 kilogram of pure (or of unknown purity) cocaine is based on the mean price paid by federal undercover agents in 2007, as reported in the Drug Enforcement Agency’s publicly available System to Retrieve Information from Drug Enforcement (STRIDE) dataset.25
In comparison with cigarettes, smuggling alcohol across state lines does not appear to be profitable. The overall lower return from smuggling alcohol relative to cigarettes is primarily driven by the assumption that a smaller amount of alcohol can be transported at a time: on a per-unit basis (a gallon of alcohol or a carton of cigarettes), cross-state tax differentials for the two goods are roughly comparable, ranging from $0 to $35 for 1 gallon of alcohol and from $1.70 to $61 for a carton of cigarettes. If one assumes that smugglers moved roughly the same number of units of alcohol as they could packs of cigarettes, the net return would be approximately the same as the return to smuggling cigarettes.26 On average, transporting alcohol along the most profitable tobacco routes is associated with less than $9,000 in profit, and as little as $50 for the route between Kentucky and
25 The validity of STRIDE data has been the subject of controversy. Horowitz (2001) expanded on criticism by the National Research Council (2001), which showed inconsistencies in various series generated by STRIDE through 2000. Responses to Horowitz can be found in Caulkins (2001a) and Rhodes and Kling (2001). A number of studies have found that STRIDE data have been consistent with other measures of market conditions: see, for example, Caulkins (2001b) on its predictive value for emergency room admissions.
26 Interestingly, there is apparently only a weak correlation between tobacco and alcohol taxes. Depending on the state, in some cases it is more profitable to buy alcohol in Illinois or New York and resell it in a low-cigarette tax state, the reverse route of tobacco.
New York. Smuggling the same amount of alcohol to Washington State, which levies the highest taxes on alcohol, would yield a profit of $16,000 if the alcohol came from Illinois and $17,000 if it came from New York. These profit estimates almost certainly do not reflect the reality of the illicit tobacco (or alcohol) market in the United States, particularly the extent to which smugglers are compensated for the legal risks that they face or the price discounts that consumers of illicit cigarettes expect.
In order to provide a better sense of how legal risk affects the prices at which goods are bought and sold, the committee also considered the return to smuggling cocaine along the same routes. The actual street prices paid for cocaine incorporate the legal risk of being apprehended, as well as demand and supply costs, none of which is included in the above calculations of profitability, which are based solely on tax differentials for cigarettes or alcohol.
Opportunities exist at all phases of the cigarette supply chain for diversion to the illicit market: preproduction, production, taxation/in-transit, wholesale, and retail. Every illicit procurement scheme, from bootlegging and large-scale smuggling to the production of illicit whites and counterfeiting, is linked to a particular phase in the supply chain.
In the United States, the illicit tobacco market has traditionally consisted of bootlegging from Native American reservations and low-tax states, such as Virginia, to high-tax states, such as New York. Large-scale smuggling, including the diversion of untaxed in-transit cigarettes to the black market, has not been a significant part of the U.S. illicit market, nor is there any evidence that unlicensed and underreported production, counterfeiting, or illicit whites are a significant source of the illicit market. In contrast, these paths have played a significant role in shaping illicit tobacco markets abroad.
There are several possible explanations for why the United States appears to be less affected by large-scale smuggling of brand cigarettes and by counterfeit cigarettes and illicit whites than other countries: (1) general border control efforts may deter the illicit tobacco trade, especially because tobacco is bulky and therefore more easily detected than some other contraband; (2) U.S. consumers may prefer certain kinds of tobacco and cigarettes that differ quite substantially in their chemosensory characteristics from blends used in many international markets; and (3) alternative paths for illicit trade inside the United States—namely, bootlegging—requires less complex organization and less investment than large-scale smuggling.
The dominance of bootlegging in the United States reflects the fact that, in comparison with other countries, there is great heterogeneity in
the amount of taxes that are levied by different jurisdictions in the United States. Consequently, bootlegging from low-tax jurisdictions to high-tax jurisdictions has been an attractive profit source. However, tax differentials cannot be the only factor that affects bootlegging in the United States, as law enforcement reports consistently identify specific smuggling routes (e.g., the I-95 corridor from Virginia and other southeastern states to New York City), even though there are other sources of low-tax cigarettes that would appear to generate roughly the same profit. The relative absence in New York City of bootlegged cigarettes from Missouri or North Dakota may be due to several factors: the tax differentials may not fully reflect the actual monetary costs and revenues in the illicit market, existing law enforcement activities may impose a substantially large cost on smugglers, or there are high entry costs (e.g., only being able to distribute through ones social networks) that inhibit bootlegging over some theoretically profitable routes. Similarly, evidence from other countries suggests that overall levels of smuggling are affected by factors—such as weak governance and political corruption, the ease and cost of operating in a country, and the availability of retail distribution networks—that affect the total cost of smuggling at least as much as, if not more than, “sticker price” factors.
RECOMMENDATION 2-1 Better information about the illicit tobacco market is needed to more accurately measure accounting profits of tobacco smugglers. For example, data could be systematically collected on the prices at which untaxed cigarettes are sold on the wholesale and retail levels, perhaps similar to the way in which the U.S. Drug Enforcement Agency collects information on heroin prices in large cities through its Domestic Monitoring Program, a component of the System to Retrieve Information from Drug Evidence (STRIDE) Program.
RECOMMENDATION 2-2 Research is needed on the extent to which consumer preferences explain why the United States appears to be less affected than other countries by large-scale smuggling of brand cigarettes and by counterfeit cigarettes and illicit whites. Research that directly tests the appeal and acceptability among U.S. consumers of a representative selection of non-American blend cigarettes, chosen from major international markets and Indian reservation producers, would shed light on this issue.