Reason Foundation & Canadian Taxpayers Federation

The Effect of Cigarette Tax Rates on Illicit Trade: Lessons Learned in Canada

U.S. President Barack Obama is proposing to raise the federal cigarette tax by nearly $1.00 per pack, hoping to bring in additional tax revenue to help fund universal preschool. Likewise, earlier this year legislators in Massachusetts, Minnesota and New Hampshire put forth—and passed—proposals to increase their state’s cigarette tax. Such proposals to increase cigarette or tobacco taxes are a politically expedient way to add to state or federal coffers while ostensibly reducing consumption. Since 2000, U.S. states have increased state cigarette tax rates more than 100 times and, generally, smoking prevalence in the U.S. has continued to decline, but is this decline caused by the increase in taxes? If so, what would happen to tobacco consumption if tax rates on cigarettes are cut?

An understandably instinctive answer is that consumption would rise, as the price of cigarettes would presumably fall with the tax cut. However, this instinctive answer assumes that smokers purchase all of their cigarettes through legal means where the sale is taxed. In reality, this is not necessarily the case.

Taxes have been shown to increase the size of black markets and to cause economic activity to move underground as price-sensitive individuals look for creative ways to evade taxation. Studies have shown that in the tobacco industry, consumers’ willingness to switch from smoking legally purchased cigarettes and tobacco to contraband products increases with tax hikes. Econometric analysis conducted by Jean-Francois Ouellet, Associate Professor of Marketing at HEC Montreal, and his co-authors Mariachiara Restuccia, Alexandre Tellier and Caroline Lacroix, found that each additional dollar in final applicable taxes raises the propensity to resort to consuming contraband cigarettes by 5.1 percent.

This is consistent with the literature pertaining to counterfeit products—that for a product yielding the same benefit, consumers will typically consider a lowerpriced option despite the fact that it is illegal. And where there is consumer demand for cheaper products, despite legality, there is profit incentive for players to provide those products on the black market.

High cigarette taxes lead to inflated prices, which allow smugglers to profit from bringing cigarettes out of lower-taxed areas and re-selling them into highertaxed jurisdictions. For instance, in the United States, cigarette prices differ from state to state depending on the states’ cigarette tax regimes. Therefore, cigarettes sold in states with low tax rates can be bought and re-sold on the black market in states with high tax rates, yielding a profit for the seller. High taxes also increase the incentive for producing illegal cigarettes completely outside the tax regime. In this case, cigarettes are produced in illegal, unregulated factories and sold on the black market.

The sum effect of these factors suggests that it is possible that rather than reducing cigarette consumption, high taxes might shift some consumption from the legal to the black market—that is, to smuggled and/or illegally produced cigarettes. The corollary of this is that tax cuts could drive out illicit trade without increasing overall cigarette consumption.

Due to its dramatically varied cigarette taxation rates over the past two decades, Canada has witnessed first-hand the effects that taxes can have on illegal tobacco sales. It therefore provides an excellent case study of the effects of both increasing and decreasing such taxes. This policy brief begins with some background on tobacco taxes in Canadian history. It then analyzes how various changes in the law, both tax increases and cuts, have affected illicit trade, informing policy-makers on likely effects of taxation.

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