In the past year, enacted and proposed changes to state and federal cigarette excise tax laws and federal regulations have grabbed headlines. They should. All of them have or will create greater tax evasion and other troubles for federal and state governments.
For 13 years, the Mackinac Center for Public Policy has measured (in partnership with the Washington, D.C.-based Tax Foundation) the degree to which cigarettes are acquired as a function of tax evasion and avoidance. We call this “smuggling,” and in addition to creating state estimates, we have also identified a role that international traffic plays from and to Mexico and Canada.
Traffic of illicit products from inside and outside the United States may be more pronounced in coming years as some states work to ban menthol cigarettes and the federal government moves to do the same. This popular product makes up more than 30% of the legal marketplace, and it will not simply go way if outlawed. In addition, in April, a federal excise tax hike of an additional $1.01 per pack was proposed in Congress. Both changes would exacerbate smuggling, much of which will eventually be detectable in the data.
Currently, our estimates continue to demonstrate a great deal of smuggling in the United States. Through 2019, we estimate that New York state was America’s number one state for cigarette smuggling, with a rate of 52%. That is, more than half of all cigarettes consumed there are smuggled. New York is followed by California (43%), Washington (43%), Arizona (37%) and New Mexico (37%). The Mackinac Center’s home state of Michigan has a smuggling rate of 19%, which is 14th highest among the states. Nearby Illinois (16th highest) just saw an arrest in Kankakee early this month involving 40,000 untaxed cigarettes.
To give the reader an idea about just how large an illicit cigarette market can become, consider that the Empire State alone consumed 266 million smuggled packs in 2019. Absent this, the state’s treasury would have received almost $1.2 billion more in cigarette tax revenue than it did. The sources of these cigarettes might be lower taxed states such as Virginia, Native American reservations, or other countries, whether through online sales, the postal service or diversions through foreign trade zones and bonded warehouses.
In addition to tracking the flow of cigarettes smuggled into states, we measure outflows, too. There is no bigger source state, as a percentage of total consumption, than New Hampshire. We estimate that for every 100 cigarettes consumed in the Live Free or Die State, an additional 71 are smuggled out to higher taxed states, such as Massachusetts.
New Hampshire’s cigarette excise tax stood at $1.78 per pack while the Massachusetts tax was $3.51 in 2019. That tax gap is helping drive smuggling and is being exacerbated by the Bay State ban on menthol flavored cigarettes. (All smuggling import and export states can be found in Graphic 1 following this essay.)
The Mackinac Center’s statistical model measures smuggling two years after it happens due to data limitations, so the impact from the Massachusetts menthol ban has not yet shown up in our model. Early reports, however, indicate that the decline in cigarette sales there isn’t due so much to people quitting as it is their buying in nearby states.
As of June 2021, the Massachusetts ban has been in place for just over a year. While we don’t have data for the full fiscal year, by the end of April 2021, excise tax revenue in the state had declined by over 25% or about $120 million. This figure does not include sales tax revenue. At the same time, some of Massachusetts’ neighbors have enjoyed double-digit increases in tax revenue. This is especially true in New Hampshire where, according to census figures, excise tax revenues have grown since the ban was imposed.
On June 17, the Massachusetts Office of the Attorney General issued a press release announcing that a New Hampshire man (and others, apparently) had just been arrested on charges of trafficking illicit products including flavored tobacco, vaping supplies and marijuana. Police also confiscated more than $500,000 in cash and vehicles. According to the announcement, the “majority of [the untaxed tobacco and electronic nicotine delivery systems] were counterfeit and flavored.”
While a federal ban on flavors would obviously limit interstate smuggling, it is highly likely that international smuggling would simply take over, given the market share of menthol cigarettes and profit opportunity for international smugglers.
A ban on menthols isn’t the only possible opportunity for smugglers. In April, legislation was introduced in Congress that would double the current federal excise tax on cigarettes from $1.01 per pack to $2.02. Between the menthol ban and the FET hike, the federal government may very well be ringing the dinner bell for international crime syndicates.
The Mackinac Center’s statistical model measures, at the state level, the difference between reported smoking rates and legal paid sales. The difference between the two must be explained, and we and others lay it at the feet of smuggling. The model contains an international component in that we measure purported smuggling into the United States and out to Canada. For instance, our model reports that almost 22% of Arizona’s illicit market comes from Mexico.
This component of our model, however, has long given us pause. We believe that a percentage of the illicit cigarette traffic that is attributed to Mexico may actually be passing through bonded warehouses or perhaps foreign trade zones, both avenues for legal trade. Both are locations that store and process international products, including cigarettes, that have not yet been taxed and which may get diverted to other locales.
The owner of bonded warehouses in Texas pleaded guilty in 2020 to trying to illegally move untaxed cigarettes into Mexico after importing them from other countries. A federal investigation found more than 422 million contraband cigarettes at his warehouses in Hidalgo and McAllen Texas. That was for export, though. Bonded warehouses also facilitate illicit trafficking within the United States.
One high profile 2018 bust involved a bonded warehouse and foreign trade zone in California, at the Port of Los Angeles. In that case, men took cigarettes meant for export and diverted them to local retail stores. The previous October a similar case resulted in a guilty plea by one man for illegally diverting from bonded warehouses 143 million cigarettes to Los Angeles retailers between 2012 and 2015.
Illicit shipments into California and elsewhere are not uncommon, either. The United States is chockablock with large ports of entry.
On March 20, 2018, customs officials in Miami announced that they had seized six million counterfeit cigarettes from at least one bonded warehouse. Ten days later, in a different case, Pedro Ivan Flores was sentenced to prison for his role in bringing counterfeit smokes into Florida through Port Everglades in Ft. Lauderdale. In late 2020, and in a sign of the times, federal officials confiscated 86,000 counterfeit vaping products at the Port of Lehigh Valley in Pennsylvania. Another 33,000 units of counterfeit flavored e-cigarettes were confiscated last January at the Dallas-Ft. Worth International Airport, having just arrived from China.
It strains credulity to suggest that there won’t be more stories like these to report if the federal government raises its cigarette excise tax by $1.01 per pack and bans menthol cigarettes across the country. There are large organized crime syndicates operating across the globe that would be only too happy to increase their profits by delivering more illicit products to the United States.
This additional activity would join the already rampant cigarette tax evasion and avoidance taking place across the country, which is primarily among states.
Federal officials would be wise to rethink an excise-tax hike and menthol ban, lest the result be a surge in illicit activity from abroad.
In addition to normal model, we ran a modified version in an attempt to better measure the amount of cigarette trafficking from long-haul, organized smuggling. The regular model uses North Carolina as a prototypical source state for smuggled smokes. Our new modified version uses an average of cigarette tax rates from all tobacco states instead of just North Carolina.
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