Tobacco tax hike could backfire

Should they turn their gaze northward, state legislators looking to increase tobacco taxes by as much as $1 per pack will discover a cautionary tale.
One recent report out of Canada suggests that 48 percent of cigarettes consumed in Ontario, for example, come from smuggling — a rate that has increased and decreased with excise tax rates.
Our own research indicates that, if the $1-per-pack tax increase is adopted in Washington, the state’s cigarette smuggling rate will leap to more than 50 percent of the total market, along with other very expensive unintended consequences.
As recently as 1980, cigarette tax rates in Canada were in the same range as in most U.S. states. In a book published in 2000, “Tobacco Control in Developing Countries,” several economists describe how this changed beginning in the early 1980s. By 1994, Canadian federal and provincial cigarette taxes had been increased to “more than five times the U.S. average.”
As a result, smuggling accounted for 30 percent of the market by 1993. To combat this, Canada’s federal government (and some provinces) slashed cigarette tax rates in 1994. As predicted, legal sales rose dramatically and “the overall smuggling problem all but disappeared.”
The economics lesson didn’t stick, however. By 1998, Canada’s politicians were once again increasing cigarette taxes, widening the gap between their rates and most American taxing jurisdictions. As a result, Canada began experiencing renewed and rampant cigarette smuggling.
In March 2009, the Center for Public Integrity described Canada as having “a runaway black market,” complete with brazen heists from tobacco farmers, mobster- and gang-related crime, and even violence against police.
Of course, these unintended consequences are not limited to Canada. Examples of theft, violence and organized crime involvement in the illicit cigarette trade are reported with great frequency here in the United States, too.
In December 2008 we published a study with colleague Patrick Fleenor, titled “titled “Cigarette Taxes and Smuggling: A Statistical Analysis and Historical Review,” designed to measure the smuggling rates of 47 contiguous states. We recently updated the model to include changes to the Federal Excise Tax.
Based on that model, we believe that hiking taxes $1 per pack will lead to a leap in the total smuggling rate in Washington from 39.3 percent to 51.5 percent. That is, 51.5 percent of the cigarettes smoked in the state of Washington will be contraband.
We also expect legal paid sales to drop by at least 20 percent over 12 months following the tax hike, but as a direct result of smuggling, not from people quitting smoking. Research shows that as much as 85 percent of the after tax-increase change in cigarette sales is a function of tax avoidance — as opposed to smoking avoidance. The smuggling will occur in two major forms: casual and commercial.
Casual smuggling typically involves individual bargain hunters shopping for themselves or perhaps a friend over the state border or perhaps on the Internet.
Commercial smuggling involves large-scale organizations that ship semi-tractor trailers and vans long distances and maintain complex distribution systems.
Our estimates indicate that nearly 30 percent of the smuggling will come from these commercial haulers. It’s worth noting that some of the trailers are actually hijacked from underneath legitimate truckers themselves.
Anyone familiar with the history of alcohol prohibition knows that much of the booze consumed in the states then was brought in illegally from Canada. Today’s policymakers are engaging in a form of “prohibition by price” — making cigarettes effectively illegal by raising their costs — so we’re reliving many of the unintended consequences of that era.
Consider some parallels: violence against police, corruption of law enforcement, the sale of adulterated products manufacturerd by illegal producers (“bathtub smokes,” anyone?), smuggling, theft, hijacking, expansion of organized crime syndicates and even the sale of “loosies” – cigarettes illegally sold one stick at a time. (During Prohibition, men would sell single shots of whiskey to factory workers leaving manufacturing plants in the Detroit area.)
If state lawmakers wish to hike cigarette taxes, they must do so with the knowledge that the new rate is likely to generate a fraction of the new revenues they suspect and much more in the way of crime.
Today’s cigarette smuggling issues — on both sides of the U.S.-Canadian border — are the product of an addiction: Politicians addicted to the tax revenue generated by the sale of a legal product that people want.
Michael D. LaFaive is director of the Morey Fiscal Policy Initiative at the Mackinac Center for Public Policy, a research and educational institute headquartered in Midland, Mich. Todd Nesbit is a Penn State economist and Mackinac Center adjunct scholar.