The Price of Prohibition: Illicit Tobacco Trade

I recently discussed Tacit Incremental Prohibition – Tobacco Elimination, or TIP-TOE (here). A new report from the United States Government Accountability Office (GAO) provides important lessons about how prohibitive policies have created a thriving illicit tobacco industry (read the report here).

The report highlights New York City, where the cost of a pack of name-brand cigarettes is a prohibitive $13.00. Here is a breakout of where that money goes:

Cigarettes at $13 Per Pack: Where the Money Goes
Who	How Much ($)	Percent (%)
Manufacturers	4.91	38
Tobacco Farmers	0.06	< 1
States (Master Settlement)	0.56	4
Local Govt. (Sales Tax)	0.61	5
Local Govt. (Excise Tax)	1.50	12
State Govt. (Excise Tax)	4.35	33
Federal Govt	1.01	8

Manufacturers, who produce, package, ship and market the cigarettes, get 38% of the purchase price. Everyone else, including local, state and federal governments, get the lion’s share. New York taxes are so high, compared to those in other states, that they have spawned a major, lucrative illicit cigarette industry. GAO breaks out the key elements:

1. Smuggling genuine and counterfeit cigarettes from foreign countries to the U.S. For example, in January the Customs and Border Protection announced that more than 22,000 cartons of counterfeit Marlboros were intercepted at the Los Angeles/Long Beach seaport complex after being shipped from China (story here).

2. Unlicensed manufacturers, located in northern New York on land controlled by the St. Regis Mohawk tribe, can produce a carton of cigarettes that sells for $20 in New York. This region is also the source for the contraband cigarettes that comprise half of all consumption in Ontario and 40% in Quebec (article here). A recent article describes the impact of illicit cigarette sales throughout Canada (here).

3. Diverting cigarettes during distribution and retail to avoid local and state taxes. “According to federal and state law enforcement officials, there are many different types of diversion schemes at the wholesale and distribution level of the supply chain. [Alcohol, Tobacco and Firearms] officials stated that criminal organizations may purchase state excise tax-paid cigarettes from wholesalers in a state with low state excise taxes, like Virginia, and illegally transport those cigarettes for resale in a state with higher excise taxes, like New York, to capitalize on state excise tax differentials.” The GAO reports that just one carton (10 packs) of cigarettes travelling from Richmond, VA to New York City will avoid $55.50 in taxes.

We can only guess at the huge scale of economic activity related to contraband cigarettes. Every so often, authorities announce a large seizure, such as one on March 8 at the Ontario-Quebec border involving six million cigarettes (here).

Excessively high taxes are irrational and counter-productive. New York should follow Kentucky’s rational risk-based tobacco tax policy, enacted in 2005, which bases excise taxes for cigarettes and smokeless tobacco products on differential risks. It recognizes that “[t]he relative taxes on tobacco products…reflect the growing data from scientific studies suggesting that although smokeless tobacco poses some risks, those health risks are significantly less than the risks posed by [cigarettes]…Taxing tobacco products according to relative risk is a rational tax policy and may well serve the public health goal of reducing smoking-related mortality and morbidity and lowering health care costs associated with tobacco-related disease.”