Michigan Cigarette Policy Ignores Lessons of History

Cigarette smuggling is big business in Michigan and the reason why should be no surprise. Our state is unique in many ways, but being immune to things such as economics and human nature is not one of them.

Michigan’s neighbor to the north can teach us a lesson or two about this. In 1994, Canadian Prime Minister Jean Chretien threw in the towel after years of his government’s futile attempts to crush the illegal trade in cigarettes, caused by confiscatory taxes that priced Canadian smokes at $33 a carton. He admitted that taxes created "an almost impossible problem." Two of every three cigarettes smoked in the province of Quebec were contraband, and the central government was losing an estimated $4.5 billion in revenue. Chretien’s solution was to call for slashing the taxes so that the price per carton would fall by half.

Since Michigan tripled its cigarette tax from 25 cents to 75 cents per pack in 1994, smuggling has soared, especially along the state’s borders with Indiana and Illinois. State officials say it is costing Michigan $17 million a year in lost tax revenue. The governor and some legislators want to make manufacturers put tax stamps on cigarette packs sold here to more easily identify those that are smuggled in, but there is good reason to believe that this additional intervention may do little more than paper over the problem.

The goals of Michigan’s huge cigarette tax hike were to discourage cigarette smoking, especially among children, and to raise revenue for public schools. The trouble is, excise taxes create smuggling and the bigger the tax, the greater the incentive to smuggle. The tax adds a markup to the price. As long as the smuggler’s markup is smaller, he’ll have a market. When the tax is small, smuggling is not worth the effort. But the bigger the tax, the more profitable the illicit trade becomes. Because our tax makes cigarettes much costlier in Michigan than they are elsewhere, the incentive to smuggle is powerful. Michigan is hemorrhaging revenue for the same reason Canada did with its sky-high cigarette tax.

One reason for studying history is that it teaches what works and what does not. Two centuries ago, before Great Britain had an income tax, the British levied excise taxes on everything from liquor and wine to building materials, windows, candles, sugar, tobacco, silk, spices and tea. As British economic historian T. S. Ashton noted, "high duties gave rise to smuggling. The profits of the clandestine trade depended on the existence of a marked difference between prices in England and those abroad." Smuggling was big business, involving thousands of people. By the 1780s, about £3 million worth of contraband goods were coming in annually, or about 25 percent of the value of legal imports.

Tea smuggling, especially, was a nightmare. By the 1770s tea drinking had spread from the rich to the general population. But the tax rate on imported tea was an incredible 119 percent. A huge market plus a very high excise tax created an extremely powerful incentive to smuggle. Sound familiar?

The consequences were bad for the British treasury. Revenue losses were huge. Undersold by the smugglers, the East India Company, which held a government-granted monopoly on legal tea imports, was facing ruin. According to estimates by the Company’s accountant in 1784, roughly two-thirds of the tea drunk in Britain was smuggled in.

Prime Minister William Pitt was receptive to the advice of free traders like Adam Smith and in 1784, he slashed the tea tax rate to 12.5 percent. Legal tea prices collapsed. With the profit taken out of it, smuggling collapsed too. Next year, legal tea imports more than tripled. Soon, Britain’s tea smuggling troubles were over.

For Michigan, the lessons from the British and Canadian experiences are clear. Our cigarette tax is defeating its purpose. Rather than impose tax stamps, we would do better to slash the tax that encouraged smuggling in the first place.

The philosopher George Santayana is famous for his warning, "Those who ignore history are condemned to repeat it." Were he alive today, he would cite Michigan’s cigarette tax as a perfect example of exactly what he meant.