The Commonwealth of Virginia is considering forcing retailers to get licenses to sell tobacco products, attempting to increase the difficulty of reselling Virginia-purchased tobacco in other states.
Currently, Virginia laws do not restrict to whom wholesalers may sell their products, and excise taxes are applied only during retail transactions. The Commonwealth State is one of 14 states without laws requiring cigarette retailers to obtain licenses before selling the products, and it has very low excise taxes on tobacco.
The Virginia State Crime Commission, whose stated goal is determining “the causes of crime” and recommending “ways to reduce and prevent it,” recommended requiring tobacco retail licenses.
Under the Crime Commission’s proposal, wholesalers would be allowed to conduct business only with state-authorized sellers.
High-Tax Neighbors Complain
Neighboring states in the mid-Atlantic region blame Virginia’s low excise taxes and lack of economic regulations for lost tobacco excise tax revenue in their states, as individuals choose to purchase tobacco in Virginia and resell it elsewhere, such as Maryland and Pennsylvania.
According to the commission’s report, filed with the state legislature in 2014, high excise taxes in “mid-Atlantic and New England states directly north of Virginia” create an “opportunity for traffickers to make huge profits” by transporting “cigarettes from Virginia to higher tax states.”
The tax differences are significant. For every 10 packs of cigarettes purchased in Virginia, consumers pay $3.00 in taxes. Pennsylvania consumers pay $16.00 in taxes for the same quantity, and Massachusetts consumers pay $35.10 in sin taxes.
Economic research suggests excise tax avoidance is a rational response to poorly implemented policies. Nachum Gabler, a former research assistant with the Fraser Institute’s Centre for Canadian-American Relations, says there are better options for states that want to reduce the economic impact of underground sales.
“Buying contraband tobacco is a rational consumer response, given individual budget constraints, tastes, and preferences and weighing the risks and rewards associated with buying tobacco,” Gabler said. “Tobacco smuggling is a rational enterprise to meet that consumer demand and earn a profit, after weighing the risks and rewards associated with selling tobacco.”
In 2010, Gabler and Fraser Institute Director of Risk, Environment, and Energy Policy Diane Katz authored a comprehensive study on the outcomes of Canadian excise tax policies enacted by provinces during the 1990s and 2000s.
“The contraband tobacco market is entirely driven by an economic calculus,” he said.
Excise tax policies create price differentials between states, Gabler noted, causing people to decide to purchase cigarettes originating in other states because other states’ prices are closer to their preferred price.
In their 2010 study, Gabler and Katz determined consumers do not perceive a difference between contraband and “lawful” tobacco, causing purchasers to discriminate primarily on price.
“Contraband cigarettes are perceived to be a near-perfect substitute for lawfully purchased cigarettes. As such, contraband tobacco use neutralizes the deterrent effect of higher taxes. Moreover, the tobacco tax revenues sought by politicians shrink when the contraband market enables smokers to evade taxation,” the researchers wrote. “Combating the contraband trade is particularly difficult given the tax environments of neighboring jurisdictions. A price differential between domestic and smuggled cigarettes increases opportunities for black market profits.”
Finding the Sweet Spot
Gabler says state policymakers in Virginia, and elsewhere, should examine the results of the Canadian government’s attempts to combat the underground economy during the 1990s and 2000s.
“Governments can fail to appreciate the lessons learned from their own earlier experiences,” he said. “To me, it’s an example of Mark Twain’s observation about ‘history rhyming’—ultimately, at the taxpayer’s expense.”
“The current contraband smuggling issue is a repeat of an earlier Canadian episode that transpired between the mid-1980s to 1994. Tobacco smuggling was rampant back then, taxes were too high, and interdiction couldn’t eliminate the criminal activity,” Gabler said. “The government cut taxes, knowing that they’d be taking the wind out of the smugglers’ sails, reducing the profitability of black marketeering and reducing the incentive for smokers to buy contraband tobacco.
“They implemented deep excise tax cuts, and—presto—smuggling almost disappears, figuratively speaking, overnight,” he explained.
Solution: Cut Tax Rate
The key to reducing tobacco tax evasion, Gabler says, is lowering the economic incentive to evade the tax, by reducing the tax rates being evaded.
“To eliminate tobacco tax evasion, all jurisdictions in close geographic proximity should harmonize their excise tax rates at a reasonable level, commensurate with the optimal tax rate, which should reflect the average consumer’s preference disposition and disposable income level,” Gabler suggested. “That would be the only way to end cross-jurisdictional smuggling, in my opinion.… No tax-induced price differential to capitalize on, no incentive to buy tax evaded tobacco, no tobacco smuggling problem.”
Police enforcement and interdiction of transportation are similarly ineffective at keeping excise tax dollars at home, he says.
“Interdiction is not effective at all. It’s hard to say with certainty, but as is the case with the prohibition of other controlled substances, like narcotics or alcohol during the Prohibition Era, the law enforcement approach has been a failure,” he explained. “Nonetheless, scarce police resources are being squandered in an unwinnable law enforcement campaign.
“The limited instances of successful interdiction have no discernable impact on supply,” he explained. “Illicit producers can make up for any confiscated product, and the offenders are prosecuted and incarcerated for what—selling cigarettes?”
Matt Hurley ([email protected]) writes from Cincinnati, Ohio.
“Contraband Tobacco in Canada: Tax Policies and Black Market Incentives,” Nachum Gabler and Diane Katz, Fraser Institute, http://heartland.org/policy-documents/contraband-tobacco-canada-tax-policies-and-black-market-incentives/