The 1990's: California's Tax Evasion Escalates Dramatically With Internet Sales and Proposition 10

For a little more than a decade, the ruling in the Chemehuevi case had seemingly solved the Indian tax-exemption problem. This began to change in the mid-1990s, however, when the tribes both in and outside California began selling cigarettes over the Internet, as did vendors in foreign countries. Suddenly, travel was no longer necessary as the Internet revolution put brand-name cigarettes within reach of every customer with Web access for as little as $1.25 per pack.

As with sales on military bases and Indian reservations, this convenient new way to shop for tax-exempt cigarettes put a major dent in the state's taxed cigarette sales. California had enough trouble doing legal battle with Indian tribes; they struggled even more in their attempts to enforce tax laws against vendors in foreign countries.

The California Board of Equalization responded with a public relations campaign to remind smokers that if they purchased cigarettes online where taxes weren't collected, they were still required by law to send the tax payment to Sacramento.[197] Beginning in 1999, BOE went further, deciding it would not let out-of-state vendors operate with impunity. The agency threatened online vendors with legal action under the federal Jenkins Act if they didn't turn over their California customer lists. Only a fraction of Internet retailers did so, and when the BOE sent their customers overdue tax bills, some for thousands of dollars, only a few actually paid.[198]

The BOE also created a computer model of the cigarette market. This was a custom software program that could use survey data about smokers and historical sales data from the tobacco manufacturers, wholesalers and retailers to produce estimates of supply, demand and tax evasion. In 1999, the BOE's first computer estimates showed that 11 years earlier, the 1988 tax hike had boosted smuggling substantially. The estimates were approximate, but even under conservative estimates, the numbers were staggering. During the 1990 fiscal year (July 1, 1989 - June 30, 1990), between 183 million and 377 million packs of cigarettes had illegally entered California. That is about four tractor-trailers full each day, and in revenue terms, the state lost between $64 million and $132 million in one year. 

Soon other states raised their cigarette taxes, making them more attractive to smugglers than California was. By fiscal 1993, the BOE estimated that tax evasion had dropped 13.2 percent in three years. California's 2-cent per-pack tax increase on Jan. 1, 1994, temporarily reversed this trend slightly, but by 1998, BOE estimates showed that cigarette tax evasion had fallen 26.2 percent since 1990. Even with smuggling on the decline, the estimated volumes were still considerable: Between 135 million and 278 million packs of cigarettes were estimated to have illegally entered California in fiscal year 1998, representing between $50 million and $103 million in potential excise tax revenue.[199]

The moderate decline in illicit smuggling that lasted 10 years between 1988 and 1998 ended when California voters raised the cigarette tax by 50 cents per pack, from 37 cents to 87 cents, by approving Proposition 10 in November 1998. That same month, California signed the national Master Settlement Agreement, which raised cigarette prices by about 45 cents per pack. That created yet another slice of potential profit that smugglers could realize when bringing cigarettes in from abroad. Not only could they avoid 87 cents per pack in state taxes, but they could also avoid the 45-cent MSA payment and the 24-cent federal tax.[200]

That meant smugglers could possibly earn hundreds of thousands in evaded taxes on every shipping container of cigarettes smuggled into the state. And indeed, the BOE model showed evasion surging 12 percent after 1998. Police and BOE inspectors came across more and more cigarettes smuggled from abroad, and the U.S. General Accounting Office found that seizures of counterfeit cigarettes at the ports of Los Angeles and Long Beach increased dramatically in the years following the tax hike.[201]

[197] "California Excise Tax and Use Tax Due on Cigarettes Purchased from Outside California," California Board of Equalization, News Release #4-G, January 18, 2000.

[198] Troy Wolverton and Greg Sandoval, "Taxes Threaten Booming Sales of Cigarettes Online," CNET, February 18, 2000.

[199] "Preliminary Estimates of Cigarette Tax Evasion," California Board of Equalization, June 1999, 4.

[200] Ibid.

[201] Cigarette Smuggling, (Washington, D.C.: United States General Accounting Office, 2004). Also see Lisa Friedman, "Smoking Gun at Ports?" The Daily News (Los Angeles), July 3, 2004.