Abstract: The objective of this paper is to analyze the correlation between state cigarette taxes and cigarette smuggling. It has been shown that when a state has a lower cigarette tax than a bordering state, it will see a gain in revenue at the expense of the border state due to smugglers buying cigarettes from the low-tax state and reselling them in the higher tax, neighboring state. However, if the state with the higher cigarette tax fits the three conditions of the Demosthenous Test, then it can still see a gain in revenue despite the tax differential. The three conditions of the Demosthenous Test are Condition 1: The focus state, State X must border a state with a higher tax (State Z) while also bordering a lower tax state (State Y). Condition 2: State Y must border another state with a tax even higher than state X (State W). Condition 3: Smugglers in State X must not have economically feasible competition in gaining a high percentage of the market share in smuggling (assuming Y’s and X’s smuggle to bordering state with highest tax) to State Z.
The main arguments for taxes on cigarettes are that it raises revenue and improves health. By increasing the tax consumers pay to purchase cigarettes, it stands to reason that states will profit directly from the the added tax revenue and indirectly from increases in its constituents’ healthcare, coupled with lower healthcare costs. States that levy a tax on cigarettes claim that by increasing the burden to buy cigarettes, they consequently make the carcinogenic habit financially inaccessible or less attractive to people, especially the youth. Since cigarette smoking is highly addictive and causes cancer, it makes sense that hiking cigarette taxes is a great solution, but this is flawed logic. Like any in-demand product made less accessible, cigarettes become a high commodity to smugglers. Similar to the black market of illicit drugs, smugglers make an easy profit when buying cigarettes in states with low excise taxes, then reselling them in states with a higher tax. High cigarette tax differentials among states lead to smuggling, especially when the states are in the near vicinity to each other. In addition to smugglers, law-abiding citizens will often travel out-of-state to buy cigarettes in bulk when their home state has a prohibitive tax, especially if these citizens live close to the state border (say a 15-20-minute drive). Cigarettes are highly addictive, and thus are a highly inelastic commodity similar to gasoline. With inelastic products like cigarettes, as the price increases, the quantity demanded doesn’t decrease significantly, which make them highly susceptible to smuggling. Therefore, for a state to have a cigarette tax that maximizes revenue from said tax, it must either have 1: a tax that is lower or equal to its neighbors, or 2: Fit the Conditions of the Demosthenous Test.
Each state's cigarette tax is levied in addition to the federal tax rate of $1.0066 per 20-pack of cigarettes and range widely from just $0.17 to $4 (Cook). New York State and Connecticut are tied for first in the country for the highest cigarette tax at $4.35 per 20-pack (Lafaive). Non-coincidentally, New York also ranks number one in the country with 55.8 % of cigarette packs sold being smuggled (Lafaive). It is estimated that cigarette smuggling has cost the state $1,520, 343,639 in revenue last year alone (Lafaive). New York borders five states, all of which, with the exception of Connecticut, have lower excise taxes on cigarettes. The cigarette taxes in Vermont ($3.08), Massachusetts ($3.51), New Jersey ($2.70), and Pennsylvania ($1.60) are so much lower in comparison to New York that it is easy to turn a profit by smuggling enough product (Cooks). Vermont, Massachusetts, and, even, Maine ($2.00) have serious problems with cigarettes being smuggled in from lower-taxed neighboring states. They rank 31st, 12th, and 28th respectively for states with most packs smuggled in from out-of-state (Lafaive). Vermont, Massachusetts and Maine are met, mostly, by runners most likely smuggling from the bordering live free or die state, New Hampshire, where the excise tax levied on cigarettes is just $1.78 (Lafaive). In fact, in 2016, an estimated 85.69% of all cigarette packs sold in New Hampshire were smuggled out and resold in other states (Lafaive). The smuggling of cigarettes is not just a Northeast coast issue. In the Northwest, Washington has a cigarette tax of $3.025 per pack and is 7th in the country for packs smuggled in from bordering states Oregon and Idaho, where cigarettes are taxed $1.33 and $0.57, respectively (Lafaive). The loss to Washington state coffers is estimated to be approximately $292,311,450 (Lafaive). Conversely, the price differential has caused Idaho to see a gain of $7,672,287 in state tax revenue as a result of smugglers buying their lower-cost cigarettes and, then, smuggling them into other states where they are resold for a profit (Lafaive). The fiscal losses suffered by states which levy high excise taxes on cigarettes is real and due, in part, to illicit smuggling activity from border states. The losses incurred from high cigarette tax states can be a financial windfall for neighboring states which levy low excise taxes on cigarettes, as in Idaho’s case.
Still, it is not just the states with high cigarette taxes that are subject to smugglers and fiscal losses. Texas has the 23rd lowest cigarette tax in the country at $1.41 per pack, yet it ranks 3rd in the country for packs smuggled in, with about 24.63% packs being the result of smuggled product (Cook, Lafaive). Three states bordering Texas have lower cigarette taxes, including Arkansas ($1.15), Oklahoma ($1.03), and Louisiana ($1.08), which is just a $0.38-$0.26 price differential - yet it has grave effects on state revenue (Cook). Even Louisiana, with the 16th lowest cigarette tax rate in the country, is 13th in the country for packs smuggled in, with an estimated 13.2 % of packs being sold through smuggling (Lafaive). The smuggling in Louisiana is surprising because the only state bordering it with a lower cigarette tax rate is Mississippi, with a tax of $0.68 (Cook). Even Mississippi loses over $5 million a year in smuggling from Alabama and Tennessee where the taxes are relatively similar at $0.68 and $0.62 per pack respectively (Lafaive). So, even states with some of the nation’s lowest excise taxes rate are susceptible to cigarette smuggling and can face revenue losses in the hundreds of millions of dollars. Such deficits show that even a state with a low cigarette tax can still lose when it borders a state with an even lower tax and has a high tax border where it isn’t economically feasible to smuggle to.
Some are starting to realize the problem with cigarette taxes and taking corrective action, as we can see from South Dakota. South Dakota currently has a cigarette tax that is the 26th highest in country at $1.53 per 20-pack (Cook). The people of South Dakota just voted down a ballot measure known as Initiated Measure 25. This bill would have increased the cigarette tax, while also increasing the wholesale tobacco products tax from 35 to 55 percent (Jackley). Under the current cigarette tax, South Dakota allocates the first $30 million in tobacco tax revenue each year to the general fund and the next five million dollars to tobacco use prevention (Jackley). All revenue beyond the first $35 million is, also, currently allocated to the general fund by default. Initiated Measure 25, however, would have allocated the first $20 million in excess of the $35 million in revenue to improving the states technical institutions and providing scholarships to technical school students (Jackley). In 2017, the revenue generated from the state's tobacco tax was $60.38 million, with the state estimating the 2018 revenue being $60.03 million under the same laws (South Dakota). Looking back to 2016, South Dakota had the 20th highest cigarette smuggling rate in the country at 13.79 percent, and they also had the 29th highest rate in the country for smuggled cigarette packs (Lafaive). During this time, the cigarette tax in South Dakota was only $1.29 per pack and it is estimated that the smuggling resulting from this tax cost the state $9,373,962, which is the 28th biggest state revenue loss from cigarette smuggling in the country (Lafaive). There are six states that border South Dakota, only two of which Minnesota ($3.04) and Montana ($1.70) have higher cigarette taxes (Cook). If Initiative Measure 25 passed, South Dakota's cigarette tax would rise to $2.53, which would not only mean that Minnesota would be the only state bordering South Dakota to have a higher cigarette tax, but also that South Dakota would go from having the 26th highest cigarette tax in the nation to having the 12th highest. See Figure 1 below for an illustration. With a prohibitive cigarette tax, South Dakota would also be subject to further smuggling because of the economic feasance of smuggling in cigarettes from Montana as well.
Essentially, since it would be cheaper to buy cigarettes in five of South Dakota’s border states, smuggling would prospectively increase while state revenues would decline.
The higher cigarette tax levied in South Dakota would equate to extra profits for the black market as they would simply smuggle in more product for profit. Both law-abiding and law-breaking consumers would be disgruntled because of the hike in prices, either paid to the state or to the cigarette runners. In total, South Dakota would likely take in less revenue from the tax than estimated, and possibly even less than they did with the lower tax – making it counterintuitive. Therefore, the most effective way to combat cigarette smuggling is for lawmakers to lower the cigarette tax rate in their state to the same level (or below) the state(s) that border it, as it would create an impossible environment for smugglers. When a state matches or lowers its own cigarette tax as compared to border states, then there is no profit margin for smugglers.
The levying of higher cigarette taxes does not have to mean a death blow to state revenues if lawmakers take economics and geography into consideration. A state with a higher cigarette tax than a neighbor can still turn a profit if it fits all three conditions of the Demosthenous Test. The three conditions of the Demosthenous Test are Condition 1: Our focus state, State X must border a state with a higher tax (State Z) while also bordering a lower tax state (State Y). Condition 2: State Y must border another state with a tax even higher than state X (State W). Condition 3: Smugglers in State X must not have economically feasible competition in gaining a high percentage of the Market share in smuggling (assuming Y’s and X’s smuggle to bordering state with highest tax) to State Z. An example of this is Alabama as seen in Figure 2. Our focus state, Alabama, (State X) has a cigarette tax of $0.67 cents per pack but borders Georgia, (State Y) which, by comparison, has the 3rd lowest tax in the country at $0.37 per pack (Cook). However, Georgia also borders Florida, (State W) which has a significantly higher cigarette tax at $1.33.9 per pack (Cook). Because of this, most smugglers would run cigarettes into Florida, as opposed to Alabama, where they can realize a higher profit margin due to the 96.9 cent difference instead of a 30.5 cent difference. Meanwhile Alabama will be able to make any revenue that is lost through smugglers buying their cigarettes to sell in Mississippi where the tax rate is $0.50 more and maybe through the border to Louisiana as well. Alabama also has a second State Y that it borders, Tennessee, whose cigarette tax is $0.62 (Cook). Tennessee however also borders Arkansas (State W) where smugglers can make more profit due to the Arkansas tax rate being $1.15 per pack (Cook). Thus, Alabama fits condition 3 of the Demosthenous Test as it will be able to gain a large percentage of the cigarette smuggling market share in Mississippi (State Z) due to Tennessee Smugglers focusing on Arkansas. While some packs will still be smuggled into Alabama from Georgia and Tennessee, the incentive is higher to smuggle into Florida and Arkansas. Therefore, Alabama will be able to make that revenue back via smugglers buying their cigarettes to sell in Mississippi where the tax rate is $0.50 more and maybe through the boarder to Louisiana as well. Hence, this explains how Alabama was still able to gain an estimated profit of $4,723,552.00 from cigarette taxes despite levying a rate that is almost twice that of Georgia (Lafaive).
A good example of why we need the third condition of the model is Arkansas. Arkansas, despite having the first two conditions hold true, fails the third condition as although it can seek to minimize the State Y affects from Arkansas ($1.15) and Missouri ($0.17) it has significant competition from Louisiana and Oklahoma with smuggling into Texas (State Z) as they both have lower cigarette tax rates tax rates and make up a far bigger portion of the border (This is portion condition is only for accounting for citizens who go over state lines to buy cigarettes for personal use not to smuggle) (Cooks). Tennessee and Kentucky also border Missouri, but thanks to the existence of State Z’s (Arkansas and a little of Alabama as the Z for Tennessee as well as Illinois [$1.98], and Indiana [$0.99.5], and Ohio [$1.60]) and Missouri focusing on multiple state W’s (Illinois, Arkansas, Oklahoma, Iowa [$1.36], Nebraska [$0.64], and Kansas [1.29]) They hold all three necessary conditions that allowed them to make an estimated profit of $6,641,206 and $17,966,159.00 respectively (Lafaive). Indiana however is a State X as in 2016, it was able to turn a profit of $59,963,028 from the cigarette tax, by smugglers selling their cigarettes in Ohio and Illinois, while Kentucky (State Y) smugglers focused primarily on Ohio and Illinois (Lafaive).
Massachusetts, Vermont and Rhode Island all fail the third condition because they all compete for New York (RI and MA also compete for Connecticut) and thus lose revenue. Wyoming holds all three conditions and is thus able to make large profits from smuggling into large areas of bordering states (Idaho in this case is the State Y and its state Z’s are parts of Utah, Colorado, Nebraska, South Dakota, and Montana). Pennsylvania ($2.60) is another example of a State X that can still turn a profit by having all three conditions hold true. In this case West Virginia and its $0.55 tax act as the state Y and New York and New Jersey act as a sufficient state Z (Lafaive).
Due to these statistics I can conclude that even though a state may have a higher cigarette tax than a border state it can still be an effective source of revenue if it fits the three conditions of the Demosthenous Test.
Cook, Colin. “How High Are Cigarette Tax Rates in Your State?” Tax Foundation, Tax Foundation, 26 July 2018, taxfoundation.org/state-cigarette-tax-rates-2018/
Jackley, Marty J. Attorney General's Statements for Two Initiated Measures. South Dakota Office of the Attorney General, 1 Aug. 2017, sdsos.gov/elections-voting/assets/2018_IM_55percent_AGOpinion.pdf
Lafaive, Michael D, et al. “Cigarette Taxes and Smuggling.” Mackinac Center: Advancing Liberty and Opportunity, www.mackinac.org/smokes
South Dakota Bureau of Finance and Management. REVENUE FORECASTS. South Dakota Bureau of Finance and Management, bfm.sd.gov/econ/RevenueEstimatesFeb2017.pdf