Cigarette Smuggling: A Real Drag on State Revenues

The economic principle of comparative advantage was first defined nearly two centuries ago, and examples still pop up regularly today, some in surprising places. Take, for example, the rapid increase in cigarette smuggling between various U.S. states in recent years.

Places that can produce a product more cheaply or efficiently than others can profit by trading their output with places where that product is hard to get. But when the advantage results from a high level of taxation on a product in one state versus a low level in another, the incentive for profit can quickly cause people to turn from legitimate commerce to illegal smuggling.

The Correlation Between Tax Rates and Smuggling

A March report from the Tax Foundation, notes that cigarette smuggling rates typically rise in states that have adopted large tax increases on the product. And no U.S. state better fits that description than New York. Between 2006 and 2012, both tax and smuggling rates in the state rose significantly: the tax rate up by 190 percent, and the smuggling rate up by 59 percent. Nearly 60 percent of the state’s cigarette market comprises smuggled products, making New York the highest net importer of smuggled cigarettes in the country. New York’s cigarette tax, at $4.35 per pack, is also the highest, and New York City tacks on an additional $1.50 per pack.

New York’s Crackdown

Smugglers sometimes use forged tax stamps to get by official scrutiny, but in many cases they simply sell cartons, packs, or loose cigarettes on the street to customers who care more about getting a lower price than they do about obeying the law. However, officials are beginning to crack down on this practice.

No state loses more money to smuggling than New York. In addition to increasing penalties for smuggling, the state is taking supply-side measures by pressuring other states to raise their taxes, reducing the incentive to smuggle by leveling the playing field across state lines, or otherwise to pass laws to make the practice of smuggling more difficult.

Virginia and Other States Respond

In response, Virginia, which has the second-lowest cigarette tax in the country at 30 cents a pack, and is the fourth-highest smuggling source, has passed a new state law, effective July 1, which charges those who possess and plan to distribute more than 25 tax-paid cigarette cartons (5,000 cigarettes) with a misdemeanor. Civil penalties will range from up to $5,000 for a first offense to $50,000 for three or more offenses.

The Tax Foundation says that other state policies have included increased enforcement on interstate roads, differential tax rates near low-tax jurisdictions, and banning common carrier delivery. Nevertheless, there is still the issue of illegal response to high cigarette tax rates.

Similar to the banning of alcohol sales during the Prohibition period from 1919 to 1933, which is generally believed to have strengthened the growth of organized crime syndicates, the rate of taxation on cigarettes, while not as widespread in its effects, has created an incentive for criminal activity. As long as the opportunity for illegal gain is substantial, an increase in legal penalties may not be enough to significantly affect the practice.

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