INSIGHTS: CIGARETTE TAXES AND CIGARETTE SMUGGLING BY STATE
Guest Columnist Ulrik Boesen, Senior Policy Analyst, Excise Taxes at the Tax Foundation. Reprinted with permission
- Excessive tax rates on cigarettes in some states induce substantial black and gray market movement of tobacco products into high-tax states from low-tax states or foreign sources.
- New York has the highest inbound smuggling activity, with an estimated 53.2 percent of cigarettes consumed in the state deriving from smuggled sources in 2018. New York is followed by California (47.7 percent of consumption smuggled), Washington (40.1 percent), New Mexico (36 percent), and Minnesota (35.8 percent).
- New Hampshire has the highest level of outbound smuggling at 66.8 percent of consumption, likely due to its relatively low tax rates and proximity to high-tax states in the northeastern United States. Following New Hampshire is Idaho (27.4 percent outbound smuggling), Wyoming (23.1 percent), Virginia (22.8 percent), and North Dakota (20 percent).
- Rhode Island, following a cigarette tax increase from $3.75 to $4.25 in the Summer of 2017, has seen a significant increase in smuggling into the state, moving it from a ranking of 18th to 8th highest inflow of cigarettes in the U.S.
- Cigarette tax rates increased in 39 states and the District of Columbia between 2006 and 2017.
- Lawmakers interested in taxing and regulating electronic cigarettes should understand the policy trade-offs related to high taxation or bans of nicotine products. With distribution networks already well-developed, criminal gangs are poised to expand into vapor products.
Tobacco Tax Differentials across States Cause Significant Smuggling
The crafting of tax policy can never be divorced from an understanding of the law of unintended consequences, but it is too often disregarded or misunderstood in political debate, and sometimes policies, however well-intentioned, have unintended consequences that outweigh their benefits.
One notable consequence of high state cigarette excise tax rates has been increased smuggling as people procure discounted packs from low-tax states and sell them in high-tax states. Growing cigarette tax differentials have made cigarette smuggling both a national problem and, in some cases, a lucrative criminal enterprise.
Each year, scholars at the Mackinac Center for Public Policy, a Michigan think tank, use a statistical analysis of available data to estimate smuggling rates for each state. Their most recent report uses 2018 data and finds that smuggling rates generally rise in states after they adopt cigarette tax increases. Smuggling rates have dropped in some states, often where neighboring states have higher cigarette tax rates. Table 1 shows the data for each state, comparing 2018 and 2006 smuggling rates and tax changes.
New York is the highest net importer of smuggled cigarettes, totaling 53.2 percent of total cigarette consumption in the state. New York also has one of the highest state cigarette taxes ($4.35 per pack), not counting the additional local New York City cigarette tax ($1.50 per pack). Smuggling in New York has risen sharply since 2006 (+49 percent), as has the tax rate (+190 percent). In October 2019, three people were charged in connection with smuggling cigarettes on the Staten Island Ferry. They were in possession of 30,000 untaxed cigarettes and $63,000 in cash, and they are just the tip of the spear. The inbound flow of cigarettes, not appropriately taxed by New York, is estimated to cost the state $1.2 billion.
Smuggling in Rhode Island has increased sharply since the last data release. The state increased the cigarette excise tax from $3.75 to $4.25, which resulted in increased inflow of almost 70 percent. As a result, Rhode Island jumped 10 places on our ranking. Over the same period, inbound smuggling decreased in nearby Massachusetts, from 25 percent to 21.5 percent, suggesting that Rhode Island’s tax increase impacted interstate smuggling. This effect can also be seen in Delaware. In 2017, Delaware had outbound flow of 40.6 percent but, after a tax increase of $0.50 per pack, this outflow had decreased to 11.5 percent in 2018. In 2017, Pennsylvania had inbound flow of 14.4 percent, but following a tax increase in the Keystone State, the state inbound smuggling increased to 24.3 percent.
Other peer-reviewed studies provide support for these findings. A 2018 study in Public Finance Review examined littered packs of cigarettes across 132 communities in 38 states, finding that 21 percent of packs did not have proper local stamps.
As noted by LaFaive and Nesbit, primary authors of the Mackinac Center study, smuggling comes in different forms: “casual” smuggling, where smaller quantities of cigarettes are purchased in one area and then transported for personal consumption, and “commercial” smuggling, which is large-scale criminal activity that can involve counterfeit state tax stamps, counterfeit versions of legitimate brands, hijacked trucks, or officials turning a blind eye.
The Mackinac Center has cited numerous examples over the many editions of this report, including stories of a Maryland police officer running illicit cigarettes while on duty, a Virginia man hiring a contract killer over a cigarette smuggling dispute, and prison guards caught smuggling cigarettes into prisons.
Policy responses in recent years have included banning common carrier delivery of cigarettes, greater law enforcement activity on interstate roads, differential tax rates near low-tax jurisdictions, and cracking down on tribal reservations that sell tax-free cigarettes. However, the underlying problem remains: high cigarette taxes amount to a “price prohibition” on the legal product in many U.S. states.
International Smuggling and Counterfeiting Puts Consumers at Risk
While buying cigarettes in low-tax states and selling in high-tax states is widespread in the United States, other methods for evading federal, state, and local taxes are popular. One way that criminals grow their profits is by avoiding the legal market completely. They produce counterfeit cigarettes with the look and feel of legitimate brands and sell them with counterfeit tax stamps. Many of these products are smuggled from China, with one source estimating that Chinese counterfeiters produce 400 billion cigarettes per year to meet international demand.
Global focus on counterfeit cigarettes has forced the criminals to innovate. A growing global problem is the so-called illicit whites or cheap whites. These products are produced legally in low-tax jurisdictions, but often intended for smuggling.
Smuggled and counterfeit cigarettes are dangerous products as they do not live up to the quality control standards imposed on legitimate brand cigarettes. Pappas et al. (2007) find that counterfeit cigarettes can have as much as seven times the lead of authentic brands, and close to three times as much thallium, a toxic heavy metal. Other sources report finding insect eggs, dead flies, mold, and human feces in counterfeit cigarettes.
During prohibition of alcohol in the United States during the 1920s, increased enforcement did not manage to significantly decrease the prevalence of bootlegging because the profit margins were so large, and the distribution networks sophisticated. The same is true for today’s cigarette smugglers.
In June 2019, Canadian authorities arrested nine people who reportedly smuggled over one million pounds of tobacco (valued at CA $110 million). According to police, the group was involved in both theft and arms trafficking. Also that year, European authorities arrested 22 people across five countries representing an organized crime ring suspected of large-scale cigarette trafficking, drug trafficking, assassinations, and money laundering which had netted an estimated $750 million over two years. This year in Spain, authorities busted an underground illegal cigarette factory. The organized crime network behind the operation is suspected of large-scale cigarette trafficking with profits estimated at $647,000 per week.
Global illicit trade in tobacco is a growing problem, but is considered low-risk, high-reward. Billions of dollars are made each year, and the trade involves corruption, money laundering, and terrorism. According to the Financial Action Task Force (FATF): “Large-scale organized smuggling likely accounts for the vast majority of cigarettes smuggled globally.” These operations hurt governments, who lose out on revenue; consumers, because the products often don’t adhere to health standards; legal businesses, which cannot compete with illicit products; and the general respect of the law.
A Cautionary Tale
Most vapor product users also smoke or previously smoked cigarettes. With this in mind, we can imagine the behaviors of vapers to mirror those of smokers. Over the last few years, both federal and state lawmakers have called for flavor bans and cigarette-level taxation of vapor products. As the data from cigarettes clearly show, the risk of creating a new black market or fueling an existing one with operators willing and able to supply nicotine products to consumers is significant. In addition, several states have either implemented or are considering implementing flavor bans on cigarettes. These bans risk further escalating tax avoidance, tax evasion, and illicit sales in the U.S.
There are already reports of nicotine-containing liquid coming into the U.S. from questionable sources. In addition to tax evasion—costing states billions in lost tax revenue—black market e-liquid and cigarettes can be extremely unsafe. Last year, stories about serious pulmonary diseases have prompted the Food and Drug Administration (FDA) to publish a warning about black market THC-containing liquid (the psychoactive compound in marijuana).  Reports of illicit products containing dangerous chemicals resulting in serious medical conditions also arose in 2019. Providing vapers with a well-regulated legal market will limit the distribution of illegal products.
In addition to the dangers to consumers, the legal market would also suffer, as untaxed and unregulated products would have significant competitive advantages over high-priced legal products. This would impact not only the large number of small business owners operating over 10,000 vape shops around the country, but also convenience stores and gas stations relying heavily on vapers as well as tobacco sales.
Policymakers should not lose sight of the law of unintended consequences as they set rates and regulatory regimes for tobacco and vapor products alike.
Click here for footnotes and full pdf version.
ON THE ECONOMY: 2021 JDA PREDICTIONS
John Dunham, Managing Partner, John Dunham & Associates
Greetings, my friends. We are all interested in the future, for that is where you and I are going to spend the rest of our lives. So began one of the great cult movie classics of all time, Ed Wood’s Plan 9 From Outer Space. The narrator of the film was a former radio announcer known as the Amazing Criswell. Criswell was famous for his bizarre predictions including a claim that the earth would be struck by a ray from space that would cause all metal to adopt the qualities of rubber, leading to horrific accidents at amusement parks. He also suggested that the end of the planet would happen on August 18, 1999. While Criswell never claimed to be a real psychic, and his bizarre prognostications were for entertainment only, many of those who make forecasts are not always so humble.
In our final Monthly Manifesto of the year, we like to examine the predictions that were made through 2020. However, the government response to COVID-19 all around the world make any comparisons difficult. Any economist or pundit that predicted a 33 percent decrease in GDP in the second quarter, and likely a 4 percent annual decrease, is way out in left field. In 2017, Harry Dent, the publisher of a financial newsletter forecast that an economic and market catastrophe would strike in early 2020. Of course, Dent predicts a market collapse every year, and a slew of other economists, including yours truly, predicted a downturn by the end of 2020 or early 2021.
So this year, we are putting our guffaws about last year’s predictions to the side, and looking instead at historical predictions for the year 2020. Let’s start with our homes. In 1966, Arthur C. Clarke, who co-wrote the screenplay for 2001: A Space Odyssey, suggested that by now our homes would be able to relocate themselves, such as by flying or teleporting. I moved to Florida this year, but believe me, it was not as easy as teleporting. Speaking of flying, Popular Mechanics was pretty sure back in 1951 that every family would have at least one helicopter in their garage by now. But who needs a helicopter? In 2014, Michael J. O’Farrell, an expert in the technology industry predicted that by 2020, telepathy and teleportation would be possible if not widespread.
One of my personal favorites. Back in 1911, Professor Walter F. Wilcox of Cornell University predicted that there would be no more children in the United States under 5 years of age in the year 2020. The only hope of seeing babies in the United States after 2020, according to Professor Wilcox was through the importation of them … from France.
Some earlier predictions have come true. In a recent blog post (Sound of Silence) we examined predictions made by Peter Turchin based on generational data. In 2010, he predicted that America would suffer a period of major social upheaval beginning around 2020. Futurist Ray Kurzweil predicted in 1999 that computers would become invisible (they have, since they are in practically everything and we never see them), and that our every move would be tracked (Hi Google).
As we say every year, we should all be wary of predictions, and particularly of the computer models that all of us rely on to make them. The fact is, as economist John Kenneth Galbraith has been quoted as saying, “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” Then again, the Simpsons may have shone a light on 2020 back in 1993 (its 4th season), in an episode titled Marge in Chains, it predicted a global flu pandemic known as the Osaka Flu. The same episode contained widespread civil unrest and rioting in Springfield resulting from Marge’s unfair arrest. Welcome to 2020.
With all that has happened, we are not even going to look back at our predictions for 2020, only to say that they were massively optimistic. Rather, lets focus on 2021, a year which is also likely to be difficult to call simply due to the fact that the government is still imposing severe economic restrictions in response to COVID-19. That said, as I write this, Congress is pushing through another debt-funded relief bill which will undoubtedly have some positive impacts, at least in the short term. In fact, we had been predicting that a relatively strong 4th quarter would end up leading to a return to negative GDP in the first. The COVID relief legislation changed that forecast dramatically.
So how do we see 2021 working out? Considering that the economy is still in a downturn to rival the worst part of the 2008-2009 recession, even strong growth will not put us past even, so we expect to see the recession lasting well into next year, and potentially into 2022. Timing all depends on when, or if, people will feel comfortable enough to congregate again, and if the government will let them. The 2021 forecasts are based on the world finally deciding to ignore COVID in June of 2021.
With this caveat we expect to see the economy running at an underlying 2 percent growth rate beginning in 2021, similar to that under the Obama Administration. Add to that, an additional percent of growth in the first quarter spurred by the COVID relief bill, and an uptick in the 3rd quarter spurred by an ending of the government-imposed shutdowns, and the overall economy should grow at a relatively strong 3.2 percent rate over the course of the year.
Growth (as the BEA measures it) will be dominated by consumer spending, with business investment likely to lag for some time, particularly if a new regulatory push begins with the onset of the new Administration. Our forecast is for overall real consumption expenditures to grow by 4.1 percent over the course of the year, with a major bump forecast for the third quarter as people come out of isolation to visit the surviving restaurants and hospitality venues.
One of the strange statistical anomalies that has occurred in the COVID-19 economy is that the unemployment rate has been falling even as the number of jobless Americans remains virtually unchanged. There are two factors influencing our unemployment forecasts for 2021. First, the recently passed COVID relief bill will add an additional $300 per week to state unemployment benefits and will lengthen the time that individuals can receive benefits. This will affect the unemployment rate statistically, as more jobless people are counted as unemployed. It may also encourage many of the 6.7 million individuals who are now working part-time to quit and take advantage of fairly lucrative unemployment benefits.
The other factor that will impact unemployment numbers is fear. As I said before, fear is keeping people from frequenting hospitality industry businesses, from traveling, and from going out in general. If, as we expect, the level of fear begins to drop in the third quarter, there will be a dramatic reduction in unemployment, and firms that have survived over a year of lock-downs come back on line. As such, our numbers worsen for the first two quarters of the year and rebound sharply after that.
The relationship between a range of economic factors helps to determine how prices will change – what is known as inflation. There are many different models of how inflation works. Some economists see it as solely related to monetary factors – so if the amount of money in the economy grows faster than economic output, there will be price inflation. Honestly, this is how our inflation models have been developed, and they have been woefully inaccurate for some time.
In fact, the stock of money in the economy has boomed, growing fourfold since the beginning of this century, while GDP has only doubled. Meanwhile, inflation has been trending downward. Obviously, something is interrupting the relationship between the money supply and prices.
Simply put, the money going into the system is not being spent on goods and services, but rather is being used financially, pushing up asset prices rather than consumer prices. Corporate bond issues have risen by a factor of almost 2.8 during the 21st century so far, and bank assets are up by 264 percent. Meanwhile, the velocity of money (which is a measure of actual spending) has been cut in half. This means that all of the money being printed is not going into the real economy, so demand for goods and services is not rising all that rapidly. So even with all of the borrowing on the part of the Federal Government and the Federal Reserve, prices have remained fairly stable.
At some point, the big rock candy mountain of debt will come tumbling down. It may be next year. It may be 10 years from now. At that point there will likely be a huge spike in inflation. Until then, it should remain fairly low, even with loose fiscal and monetary policies. We therefore expect that inflation will likely just hit the Federal Reserve’s 2.0 percent target rate in 2021.
We are changing up our forecasts a bit this year and removing both the 2-year note and 30-year bond and replacing those with the 10-year note and a forecast of domestic spot (WTI) oil prices. First to interest rates.
Inflation is the driving force for interest rates, and last year, as we had expected inflation to tilt upward, we expected to see the Federal Reserve normalizing interest rate policies and the target Federal Funds rate moving up as high as 2.75 percent. Obviously COVID-19 put the kibosh on this, and the rate stayed stuck at near zero. The Fed has broadcast that it has no intentions of raising interest rates in our lifetime, so most forecasts have it holding at 0.25 percent for at least the next year if not longer. This is probably unlikely, particularly if the economy grows by more than 3 percent next year. This will undoubtedly push inflation above the target rate, which will give the Fed some cover to raise the target rate at least 2 or maybe 3 times in 2021.
That said, we forecast a target rate of 0.75 percent by the end of the year. This is a far cry from the 2.0 percent we forecast last year, but it does at least take short term interest rates above zero.
Meanwhile, while the Federal Reserve controls short-term rates, longer term interest rates are set by the market. This is why the yield on the 10-year Treasury Note has risen over the course of the last few months, even as the Federal Funds Rate has remained at virtually zero. So far, since bottoming out after COVID-19 struck, the yield on the 10-year Note has nearly doubled, though it is still far below historical norms. If market interest rates continue to climb at the current pace, yields would reach 1.5 percent by the end of 2021, and if inflation spikes a bit as the economy reopens, this could increase dramatically and be back to pre-COVID levels by the end of the year.
Finally, since we are forecasting this for a number of clients, we wanted to add oil prices to our annual Manifesto forecast. Currently the spot price of oil as measured in Cushing Oklahoma, (the West Texas Intermediate or WTI Spot Price) is $47 per barrel. It was about $50 per barrel pre-COVID. Prices are up by about 20 percent since the beginning of November, even though petroleum stocks are at near record levels. OPEC has agreed to cut production beginning in January and that has led the Energy Information Administration (EIA) to forecast average prices of about $45 per barrel over the course of next year. This may be a bit pessimistic if the economy does begin to recover in the 4th quarter. We expect to see oil prices soften at the beginning of the year and then come back strongly toward OPEC’s $50 price goal toward the end of 2021, with an average price of about $46.50 over the course of the year. This too may be pessimistic if the incoming Biden Administration holds true on its promises to curtail energy development on public lands, and to reestablish some stringent regulations that environmentalists have been calling for.
In sum, depending on what happens with COVID-19 and the government response to it, we believe that 2021 will be a fairly good year for the economy. By the end of the year, the overall numbers will be approaching pre-depression levels, although unemployment will likely remain elevated. Depending on how rapidly the new Administration is able to implement some of its less fortunate economic promises, it is likely that the economy will slump back to Obama era grown and unemployment levels after 2021, and somewhere during the next 5 to 6 years, it is likely that there will be an economic reckoning, as interest rates begin to rise, and governments, corporations and individuals alike find it difficult to meet their debt payments. This will bring on the next downturn.
Based on these general findings, our most recent forecasts for 2021 are presented in the following chart.