California's Experience With Cigarette Taxation

California's casual smugglers are increasingly aware that they are breaking the law, but casual smuggling remains commonplace. In 2008, California's cigarette tax rate is almost as high as the pre-tax cost of a pack of cigarettes.

The sources of tax-exempt or low-tax cigarettes in California are military bases, Indian reservations, other U.S. states and foreign nations, especially China and Mexico. Except for military bases, all these locations are filled with vendors who take orders over the Internet and deliver, all of which is illegal unless the customers pay California tax, which they rarely do.

Many states taxed cigarettes throughout the 1940s and 1950s, but California held off until the summer of 1959, when it enacted a 3-cent tax.[183] All cigarettes sold in California were required — and still are required — to bear a tax stamp meant to prove payment.

Although a tax of 3 cents per pack seems like nothing compared with today's prices and taxes, the average retail price of a pack at that time was only 25 cents, including the federal tax. So as a percentage of the item's price, the new tax was by no means negligible. Adjusting for inflation, 3 cents in 1959 was equivalent to 20 cents today.

Was the tax large enough to inspire tax evasion? Sales certainly jumped on military bases, where cigarettes remained exempt from state and local taxes.[184] But the evidence of large-scale smuggling or other tobacco-related crime during the early 1960s is slight. Tax collections on legal sales stayed strong, well above the national average.[185] Evidently, buyers at military bases were casual smugglers, not commercial smugglers trying to get rich reselling low-tax cigarettes.

In 1967, however, California enacted a major cigarette tax hike, more than tripling its tax to 10 cents per pack, the equivalent of 60 cents today. Tax-free sales boomed at military bases, saving customers approximately a dollar per carton (about $6.00 today).[186] Smokers without privileges on base often asked friends and relatives to improperly purchase cigarettes for them.[187]

This sales volume on base was painful to the state and embarrassing to the military. Legally taxed sales dropped 7 percent, while statistics showed military personnel buying a preposterous quantity of cigarettes — 725 packs a year per active duty serviceperson,[188] compared to just 123 packs per civilian statewide.[189]

An ACIR study confirmed that no legal explanation — extra purchases by retirees or immediate families of active duty personnel — could possibly account for the military personnel's purchase volume.[190] Evidently, active duty personnel were making purchases on base for resale off base.

In response to these problems, California legislators held off from further tax hikes. They could see the surge of smuggling and violent crime in New York at that time, and they wanted no part of it.[191] A 1977 ACIR report was rich in New York-based examples. Chapter three of the report, entitled "Cigarette Smuggling and Organized Crime," cites a 1975 media investigation detailing how just four crime families, employing more than "500 enforcers, peddlers and distributors[,] smuggle an estimated 480 million packs into the state each year."[192]

[183] "Digest of Tobacco Taxes," in Proceedings of the 34th Annual Meetings of the National Tobacco Tax Association (Chicago: Federation of Tax Administrators, 1960), 41.

[184] J.D. Dotson, "Military Sales in California," in Presentations at the 1984 Annual Meetings of the Tobacco Tax Section of the National Association of Tax Administrators (Washington, DC: Federation of Tax Administrators, 1984), 16.

[185] Author's calculation using data from The Tax Burden on Tobacco and Census Bureau.

[186] Karen Jowers, "Butt Out: Tobacco Sales Plummet As Prices Rise," Army Times, October 20, 2003.

[187] John Shannon, "The ACIR Study on State Excise Taxation of Sales to the Military," in Proceedings of the 49th Annual Meetings of the National Tobacco Tax Association (Chicago: Federation of Tax Administrators, 1975), 16.

[188] Author's calculation using data from The Tax Burden on Tobacco.

[189] Author's calculation using data from State Taxation of Military Income and Store Sales (Washington, DC: Advisory Commission on Intergovernmental Relations, 1976), U.S. Census Bureau, and The Tax Burden on Tobacco.

[190] State Taxation of Military Income and Store Sales, 13-16.

[191] For a discussion of cigarette tax evasion in the United States during the mid-1970s, see Cigarette Bootlegging: A State and Federal Responsibility, and Patrick Fleenor, Cigarette Taxes, Black Markets, and Crime, Cato Institute Policy Analysis No. 468, February 6, 2003.

[192] Cigarette Bootlegging Responsibility, 21.