Center Scholar Testifies on Cigarette Taxes

(Editor’s note: The following is written testimony submitted to the North Dakota Legislature by Todd M. Nesbit, Ph.D., assistant professor of economics at the College of Charleston and an adjunct scholar with the Mackinac Center.)

We thank you for the invitation to submit this testimony regarding tax-induced cigarette smuggling. I have studied the cross-border economic phenomena and the secondary and unintended effects of various excise taxes over the course of my career and have specifically examined over the past four years the extent of cigarette smuggling resulting from cigarette taxation. Cigarette smuggling takes on two forms: commercial and casual. Commercial smuggling involves organized criminals who counterfeit and distribute state tax-paid stamps, the physical cigarettes and packaging, or both. Casual smuggling occurs when the ultimate consumer drives across state, international or other legal boundaries in an effort to avoid paying higher taxes (and therefore higher prices).

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In 2010 I published with my co-author, Michael LaFaive, a policy report titled “Cigarette Taxes and Smuggling 2010” in which we estimate tax-induced cigarette smuggling for 47 of the contiguous states based on data covering 1990 through 2009. North Carolina is excluded from the sample since we model the state as the primary source of commercial cigarettes, as is common in studies of commercial smuggling. We develop an econometric model of cigarette smuggling, taking into account data on legal cigarette sales, smoking prevalence, tax rates, state border population, presence of Native American reservations, and international borders. Our results indicate that, as a percent of in-state consumption, Arizona (51.8 percent), New York (47.5 percent), Rhode Island (40.5 percent), New Mexico (37.2 percent) and California (36.3 percent) are the top five net importers of illicit cigarettes in 2009. On the other side of the distribution, Virginia (56.3 percent), Delaware (28.6 percent), West Virginia (13.0 percent), Missouri (11.7 percent), and Wyoming (10.5 percent) are the largest net exporters (other than North Carolina) of smuggled cigarettes as a percent of in-state consumption.

As of 2009, North Dakota’s cigarette tax rate of 44 cents ranked the ninth lowest in the sample. Despite this relatively low tax rate, we estimate that just over 1.5 percent of all cigarette consumption in the state comes from sources outside of the state, ranking the state as the 33rd largest net importer of smuggled cigarettes. This figure is for net smuggling and already accounts for the estimated 1 million packs of cigarettes (2.8 percent of in-state consumption) purchased from North Dakota retailers by Canadians shopping across the border.

To provide an example of how the extent of smuggling in North Dakota would change in response to a tax increase, we examine a $1 increase, raising the state excise tax to $1.44 per pack, which is also the national state average tax rate. Total net smuggling into the state would increase from just over 580,000 packs annually to more than 6,300,000 packs. As a percent of consumption, this represents an increase from 1.5 percent to 17 percent. We estimate that commercial smuggling into the state under this tax increase would rise from 1 percent of consumption to more than 10 percent. Casual smuggling into the state would increase from roughly 3 percent of consumption to about 9 percent. Given the dramatic rise in smuggling, the impact of the $1 tax increase, a 227 percent increase, on tax revenue for the state, while still positive, is muted to some extent. We estimate that the 227 percent tax increase would raise revenue by an estimated 176 percent.

Proponents of cigarette tax increases typically justify such tax increases based on some combination of the following:

  • Cigarette taxation is a low-cost means to increasing revenue for the government, particularly given the inelastic demand for the product.
  • Cigarette taxes discourage the consumption of cigarettes, thereby promoting the health of the citizens in the state.
  • Given that proportionately more low income individuals consume cigarettes, often at the expense of the needs of their families, cigarette taxes incentivize the head-of-household in low income households to make better decisions concerning the family’s expenditures by discouraging the consumption of cigarettes.
  • The results of our studies conflict with each these claims. First, given that commercial cigarette smuggling is a crime and has been shown to be closely linked to other major crimes, expenditures on law enforcement must rise to combat the increased criminal activity. Other major costs affiliated with organized commercial smuggling include property damage, bodily injury and death of innocent citizens. Thus, the costs of raising this revenue should not be viewed as negligible by any means.

    Second, while increased cigarette taxes do encourage some people to reduce their consumption of cigarettes, the figures stated by proponents of such tax increases are over-stated as they attribute all of the reduced legal sales to a reduction in consumption, ignoring smuggling altogether. However, as our results indicate, smuggling is extensive and a large share of the change in legal in-state sales is due to smuggling and cross-border sales, not consumption reductions. Thus, choice architects supporting the use of cigarette taxes to aid the less education and poor in making better decisions regarding their health and welfare of their families will be disappointed in the actual outcomes. The taxes, we argue, largely discourage the legal purchase of cigarettes within the state and do very little to actual consumption and thus exert little positive influence on health and family welfare. Even worse, the tax increases actually harm the very people they are intended to help by creating an environment in which people spend less time with their families as they travel to bordering states rather than down the street to purchase cigarettes and in which they are introduced to illegal markets.

    The better solution to help the less educated and poor is to educate them on the health effects of smoking and allow them to make an educated decision on their own.  However, as noted above, others argue for higher cigarette taxes on grounds of bridging the state budget shortfalls. Given that smuggling mitigates the revenue gains from increased taxation and leads to a greater need for police expenditures, the better solution to state budget problems is not to turn to increased taxation but to spending reductions instead.

    As is the case with many taxes, increases in the cigarette tax cause a wide array of unintended secondary effects which, when properly considered, I argue outweigh the benefits from the tax increase. As such, cigarette tax increases should be resisted.