Authors Michael LaFaive and Todd Nesbit update their 2008 cigarette taxes and smuggling study titled “Cigarette Taxes and Smuggling: A Statistical and Historical Review.” The update includes new statistical data to reflect the 27 state-level tax increases that occurred between January 2007 and the end of 2009 in Michigan’s 48 contiguous states.

Executive Summary

Between January 2007 and 2009, 21 of the 48 contiguous states — including tobacco state North Carolina — raised their cigarette taxes, producing a total of 27 tax hikes. In 2010, tobacco state South Carolina and five other states did the same.

This study updates the Mackinac Center’s 2008 publication “Cigarette Taxes and Smuggling: A Statistical Analysis and Historical Review” to reflect state and federal cigarette tax hikes through fiscal 2009. The original study used data through fiscal 2006.

Our new estimates indicate that in 2009, the state of Michigan ranked 10th in the nation[*] in smuggled cigarettes as a percentage of total in-state cigarette consumption — 26 percent. The five smuggling destination states with the highest cigarette smuggling rates were Arizona (51.8 percent of the state’s total consumption); New York (47.5 percent); Rhode Island (40.5 percent); New Mexico (37.2 percent); and California (36.3 percent).

According to our calculations, Arizona’s inbound smuggling rate was not in the top five in 2006, yet we estimate that Arizona now has the nation’s highest inbound cigarette smuggling rate, with over half of all cigarette consumption coming from smuggled sources. This is probably a function of the state’s 2006 excise tax hike, the 2009 federal excise tax hike and Arizona’s proximity to Mexico.

The study also breaks smuggling rates into two primary types of smuggling: “casual” and “commercial.”[†] Casual smuggling typically involves individuals crossing borders to obtain their cigarettes for personal use. It may also involve purchases made over the Internet. Commercial smuggling involves larger, typically long-haul efforts, such as transporting cigarettes from North Carolina (a typical source state) to Michigan or elsewhere.

In the casual smuggling category, Michigan’s smuggling rate ranks 5th in the nation, at 11.6 percent of total in-state cigarette consumption. Only New York (19.9 percent), Rhode Island (18.2 percent), Washington (14.5 percent) and Montana (13.2 percent) residents crossed into neighboring jurisdictions for lower-taxed cigarettes more often than those of the Great Lakes State. Remarkably, New York state earned the number one spot even before hiking state taxes by $1.60 per pack in 2010. Anecdotal evidence suggests that this recent hike has been a boon to Pennsylvania retailers just across the Empire State’s border.

The states with the top inbound commercial cigarette smuggling rates are New Jersey (29.1 percent); New York (28.5 percent); Vermont (24.2 percent); Massachusetts (23.3 percent); and Connecticut (20.9 percent).

Five smuggling destination states moved up by double digits between 2006 and 2009 in our state rankings of net smuggling rates: Texas, from 16th to 6th; Mississippi, from 37th to 22nd; South Dakota, from 28th to 12th; Maryland, from 24th to 9th; and Iowa, from 33rd to 15th. These large smuggling rate increases relative to those of other states can likely be attributed to the five states’ substantial state excise tax increases over the past three years. Texas increased its per-pack cigarette tax from 41 cents to 141 cents in 2007; Mississippi, from 18 cents to 68 cents in 2009; South Dakota, from 53 cents to 153 cents in 2007; Maryland, from 100 cents to 200 cents in 2008; and Iowa, from 36 cents to 136 cents in 2007.

Despite the notable cigarette tax hikes in recent years, other proposals are being floated around the country. In 2009, Michigan Gov. Jennifer Granholm suggested raising cigarette taxes to $2.25 per pack, up from $2.00 per pack. That proposal never came to fruition, but we estimate that had it become law, illicit cigarette trafficking would have leapt to 28.3 percent of Michigan’s total cigarette consumption. In Illinois, according to our calculations, a proposed $1.00-per-pack cigarette tax hike would cause cigarette smuggling to increase from a modest 5.9 percent of total in-state consumption to 24.3 percent.

Smuggling is not the only unintended consequence of high cigarette taxes. Tax-induced smuggling can also lead to violence against people, police and property, and encourage sizable and brazen theft. The authors recommend reducing state and local cigarette taxes as a way to thwart smuggling and other unintended consequences.

Introduction

Cigarette excise taxes have been a constant topic of discussion in state capitols around the nation during the past two years.

It is not hard to imagine why. In December 2007, America slipped into the “Great Recession,” and state tax revenues plummeted across the nation.

Faced with a choice between cutting expenditures and raising taxes, some legislators proposed cigarette tax increases. The hikes were also promoted to the public as a way to improve public health. From 2007 through 2009, 21 of the 48 contiguous states — including tobacco state North Carolina — raised cigarette taxes, producing a total of 27 tax hikes. In 2010, tobacco state South Carolina raised cigarette taxes, as did five other states.[*]

But cigarette tax hikes can produce unintended consequences.

In December 2008, we published, together with a third co-author, a comprehensive 90-page study titled “Cigarette Taxes and Smuggling: A Statistical and Historical Review.”[†] The study, issued by the Mackinac Center for Public Policy, included a statistical model designed to estimate interstate and international smuggling in the United States, while also discussing cigarette tax-related violence, theft and financing of terrorism. This study updates those estimates and complements the original work.

Summary of Earlier Findings

The economic model in our 2008 analysis was used to estimate smuggling rates for 47 of the 50 states, producing annual averages from 1990 through 2006 and single-year estimates for 2006. At the time, 2006 was the last year for which complete data were available.

We broke the smuggling data into categories, reporting the amounts of “casual” and “commercial” smuggling. Casual smuggling involves cross-border shopping, typically by individuals for their own consumption. Commercial smuggling typically employs large trucks that travel greater distances than, say, an adjacent state to acquire cigarettes. We also provided estimates for smuggling imports from Mexico and smuggling exports to Canada.

Our previous study included detailed histories and analyses of Michigan, California and New Jersey. The Mackinac Center is a Michigan-based think tank, and we focused on New Jersey and California to underscore the degree to which cigarette taxes have led to similar problems in different parts of the country with long smuggling histories.[*]

In April 2009, we updated our original estimates to include the new federal excise cigarette tax rate,[†] which had just been raised by 61.66 cents per pack, from 39 cents to 100.66 cents, effective April 1.[1] Our revised estimates for 1990 through 2006 indicated that Michigan’s average annual total smuggling was 19.1 percent of the state’s total cigarette market. That is, 19.1 percent of all cigarettes, legal and illegal, consumed each year in Michigan were obtained by illicit means. The total smuggling rate for New Jersey during that same 17-year period was a more modest 15.0 percent, while California clocked in at 29.5 percent. One reason for California’s high rate was its shared border with Mexico, a significant source of contraband cigarettes.[‡], [2]

The three states’ estimated total smuggling rates generally grew from 1990 through 2006, with the rates in 2006 being higher than the average rates for the period. According to our 2009 calculations for 2006, 31.0 percent of all cigarettes consumed in Michigan were smuggled that year. In New Jersey, the figure was 38.4 percent, and in California, it was 34.6 percent (see Graphic 1). Remarkably, California did not have the highest smuggling import rates in the nation. This honor went to tiny Rhode Island at 43.2 percent. (Note that the rates in Graphic 1 are negative if the cigarettes are smuggled into the state and positive if they are smuggled out.)

Graphic 1: State Cigarette Smuggling as a Percentage of Total State Cigarette Consumption (Legal and Illegal), 2006 (Calculated in 2009)

A Short Description of the Model

Several years and many cigarette tax hikes have passed since we first obtained the data necessary to publish our original estimates of smuggling rates. To update our research with three additional years of data, we recently reran the model we constructed in 2008. That model was built only after an extensive review of the academic literature yielded strong evidence that substantial cigarette smuggling exists. These studies included, but were not limited to:

• “How Far to the Border?: The Extent and Impact of Cross-Border Cigarette Smuggling,” by Michael Lovenheim and published in the National Tax Journal in March 2008. Lovenheim found that “between 13 and 25 percent of [U.S.] consumers purchase cigarettes in border localities.”[*], [3]


• “Excise Tax Avoidance: The Case of State Cigarette Taxes,” a May 2008 working paper by Philip DeCicca, Donald Kenkel and Feng Liu. This study used 2003 survey data to estimate the percentage of smokers in each of the 50 states and the District of Columbia who were casual cigarette smugglers. In a 2010 update of the study, the authors estimated that in 2003, 6.2 percent of Michigan’s smokers engaged in casual cigarette smuggling.[†]


• “Cigarette Tax Avoidance and Evasion,” by Mark Stehr and published in the Journal of Health Economics in March 2005. Stehr found that “up to 85 percent of the tax paid sales response”[4] was due to tax avoidance, rather than actual reductions in tobacco use.[‡]

The simplest way to describe our model is that it compares legal, per-capita sales of cigarettes to survey data on the percentage of smokers in each state. The difference between legal sales and reported rates of smoking provides a basis for estimating a state’s smuggling rate.[§] If the difference is positive, it indicates that the state is exporting cigarettes to other locations, making the state a “source state” for smuggled cigarettes. If the difference is negative, it indicates the state is importing cigarettes from elsewhere, making the state a “destination state” for smuggled cigarettes. A fuller treatment of the model’s construction — including a description of important variables — is provided in the Appendix.

The model contains a variable to measure the degree of international smuggling between the United States and Mexico or Canada. In these estimates, shipments are assumed to go only one way: from Mexico to the United States, or from the United States to high-tax Canada — not the other way around.

While the model includes two other countries in its calculations, it excludes two American states — Alaska and Hawaii — from smuggling measurements. These two states present unique challenges to modeling smuggling because they are not contiguous to the continental United States. North Carolina is also excluded from the model, since it is the model’s base source stage for commercially smuggled cigarettes, and other states’ taxes are measured against its own.[¶]

New Smuggling Estimates

Our estimates indicate that in 2009, the five destination states with the highest inbound cigarette smuggling rates were Arizona, where it represented 51.8 percent of the state’s total consumption; New York, where it represented 47.5 percent; Rhode Island, with 40.5 percent; New Mexico, with 37.2 percent; and California, with 36.3 percent. (See Graphic 2.) Arizona was not in the top five when we updated the 2006 numbers in 2009, yet we estimate that Arizona now has the nation’s highest inbound cigarette smuggling rate, with over half of all of the state’s cigarette consumption coming from smuggled sources.

This is noteworthy. In 2007, Arizona had already increased its state excise tax on cigarettes from 118 cents per pack to 200 cents,[5] but in 2009, the U.S. government increased the federal cigarette excise tax from 39 cents per pack to 100.66 cents.[6] Together, these tax changes resulted in a full 143.66-cent-per-pack increase, raising the incentive to smuggle cigarettes from Mexico to Arizona.[*]

Since our 2009 revision, five destination states have moved up by double digits in the state rankings of net smuggling rates: Texas, from 16th to 6th; Maryland, from 24th to 9th; South Dakota, from 28th to 12th; Iowa, from 33rd to 15th; and Mississippi, from 37th to 22nd. These large smuggling rate increases relative to those of other states can likely be attributed to the five states’ substantial state excise tax increases during the past three years. Texas increased its per-pack cigarette tax from 41 cents to 141 cents in 2007;[7] Mississippi, from 18 cents to 68 cents in 2009;[8] South Dakota, from 53 cents to 153 cents in 2007;[9] Maryland, from 100 cents to 200 cents in 2008;[10] and Iowa, from 36 cents to 136 cents in 2007.[11]

Similarly, four states declined by double digits in state rankings of net smuggling rates: Illinois, from 17th to 30th; Pennsylvania, from 21st to 31st; Massachusetts, from 13th to 32nd; and Nevada, from 29th to 41st. While many other states since 2006 have approved increases in their cigarette excise taxes, none of these four states had changed their cigarette tax rate by the close of fiscal 2009.[†] As neighboring states increased their tax rates, the average cross-border tax differential of these four states consequently declined, leading to a decrease in net smuggling into the state or even an increase in net smuggling out of the state.

At the far end of the spectrum, five source states had estimated net total smuggling exports that exceeded 10 percent of total state consumption: Virginia, Delaware, West Virginia, Missouri and Wyoming. (North Carolina would certainly be on this list as well, were it not excluded from the model due to its treatment as the base source of commercial smuggling.) Delaware and Virginia in particular stand out; smuggling out of Delaware is estimated at more than 28 percent of its in-state consumption, while smuggling out of Virginia is estimated at more than 56 percent of its in-state consumption. These high estimated rates are not surprising. Delaware’s state excise tax of 115 cents per pack[‡] is safely below the rates of its neighboring states, with Maryland at 200 cents per pack, New Jersey at 257.5 cents per pack and Pennsylvania at 135 cents per pack. Similarly, Virginia’s cigarette excise tax of 30 cents per pack is safely below the tax rates of its neighbors.

Graphic 2: State Cigarette Smuggling as a Percentage of Total State Cigarette Consumption (Legal and Illegal), 2009

Notes: Estimates computed based on regression results presented in columns 3 and 4 of Graphic 12 (see the Appendix). The smuggling percentage is negative when the state is a net importer of smuggled cigarettes, and the percentage is positive when the state is a net exporter of smuggled cigarettes. The sum of commercial, casual and Canada/Mexico smuggling does not equal the totals presented in the final column due to the nonlinear nature of the model. North Carolina, Hawaii and Alaska are not included.

The state of Michigan has the 10th highest 2009 smuggling rate among 47 contiguous states. As Graphic 3 suggests, the smuggling rate for Michigan mirrors its tax rate. (Note that the numbers on the right-side axis indicate rates of smuggling imports and thus are the negative of the smuggling rates reported in other graphics.)

Graphic 3: Michigan Cigarette Tax Rates and Estimated Total Smuggling Import Rates, 1990-2009

Casual Smuggling

States with the highest rates of overall smuggling do not necessarily have the highest rates of casual, commercial or international smuggling. In the category of casual smuggling, which involves smaller purchases, usually for personal use, the top five destination smuggling rates are in New York, 19.9 percent; Rhode Island, 18.2 percent; Washington, 14.5 percent; Montana, 13.2 percent; and Michigan, 11.6 percent.

The estimated casual smuggling rates are directly related to the excise taxes in neighboring states. In our 2008 study, we obtained private cigarette sales data, categorized by ZIP code, from a large Midwestern wholesaler. We were then able to see how distributor sales to Michigan’s border counties changed after Indiana and Wisconsin hiked their cigarette taxes by 44 cents per pack and 100 cents per pack, respectively.[12] These hikes meant that Indiana and Wisconsin’s cigarette prices, which had been considerably lower than high-tax Michigan’s prices, were only somewhat lower. Just as economic theory would suggest, the distributor’s cigarette sales to Michigan’s Indiana and Wisconsin border counties increased by 53.2 percent and 8 percent, respectively.[13] Residents of Michigan’s border counties now had less incentive to drive to Wisconsin and Indiana for cigarettes, and many began buying their smokes close to home.

Of course, large-scale casual smuggling tends to occur when a neighboring state has relatively low cigarette tax rates. Among these source states, Virginia tops the chart with the staggering estimate that 55.4 percent of its total in-state cigarette consumption is casually smuggled out of the state. Virginia’s cigarette tax rate is only 30 cents per pack, while Maryland’s is $2.00 per pack and the District of Columbia’s is $2.50 per pack.[*]

Graphic 4: Top Five Casual Smuggling Import and Export States by Percentage of Total State Cigarette Consumption (Legal and Illegal), 2009

Notes: Estimates computed based on regression results presented in columns 3 and 4 of Graphic 12 (see the Appendix). The smuggling percentage is negative when the state is a net importer of smuggled cigarettes, and the percentage is positive when the state is a net exporter of smuggled cigarettes. The sum of commercial, casual and Canada/Mexico smuggling does not equal the totals presented in the final column due to the nonlinear nature of the model. North Carolina, Hawaii and Alaska are not included.

As we noted in our 2008 study, casual smuggling also occurs over the Internet. Some overseas websites actually advertise the fact that they are not allowed to share their customers’ purchase and contact data with taxing authorities outside their own nation.[14]

In 2010, President Barack Obama signed the Prevent All Cigarette Trafficking Act, which prohibits the United States Postal Service from delivering cigarettes through the mail, among other restrictions.[15] This is not the only law on the books designed to thwart cigarette sales over the Internet,[†] but it is the newest. For instance, the Jenkins Act of 1949 mandates that American companies report sales information, including the quantity and the purchasers’ names, to states into which they have shipped their products. States have used this law to track their residents’ out-of-state cigarette purchases and to demand the state cigarette taxes owed to their treasuries.[16]

Cigarette sales from foreign websites that sell cigarettes are not subject to the Jenkins Act. It remains to be seen how the new federal Prevent All Cigarette Trafficking Act will affect these sales. The site Nativeblend.net is already advertising that it can help smokers beat the PACT Act with its private delivery system. Graphic 5 shows a screen shot from the Nativeblend.net website, which practically taunts federal authorities with its willingness to assist smokers in evading taxes.

Graphic 5: Nativeblend.net Website on “How to BEAT the PACT Act”

Casual Web-Based Smuggling in Michigan

According to a spokesman for the Michigan Department of Treasury, more than 23,000 Michigan residents are known to have bought cigarettes online between February 2005 and August 2008. Their total tax liability to the state is computed at more than $36 million.[17] In a November 2010 e-mail, the Treasury spokesman claims that Michigan residents’ Internet purchases of cigarettes have dropped precipitously in recent years:

The contact and revenue data/information I had sent previously was accurate. As noted in a recent e-mail, … the department experienced a nearly 70% drop-off in sales data between 2007 and 2008. We have experienced another 25% drop-off in sales data since.

Treasury has sent out approximately 200 subpoenas (citing the Jenkins Act) over the last year or so, however there has been very little compliance. Vendors are often located out of state, in foreign countries, or on Native American lands, which makes enforcement difficult.

It appears that some of the sellers that had been cooperating (per the Jenkins Act) likely had customers turn elsewhere, as some sellers have advertised that they would not share customer lists with taxing authorities.[18]

Commercial Smuggling

Commercial smuggling, which involves large-scale, long-distance transport, also plays a major role in cigarette trafficking. Because it requires significant organizational abilities, the distribution networks of organized crime syndicates have long been involved in the smuggling of cigarettes.[*]

We estimate that the destination states with the top five rates of inbound, commercially smuggled cigarettes are New Jersey, at 29.1 percent of the state’s total consumption; New York, at 28.5 percent; Vermont, at 24.2 percent; Massachusetts, at 23.3 percent; and Connecticut, at 20.9 percent. Our calculations also suggest that two of these five states have experienced significant increases in their rates of commercial smuggling. We estimate that between 2006 and 2009, New York’s commercial smuggling rate leapt nearly 9 percentage points, from 19.7 to 28.5 percent, while Vermont’s leapt 10 percentage points, from 14.2 percent to 24.2.

Graphic 6: Top Five Commercial Smuggling Import and Export States by Percentage of Total State Cigarette Consumption (Legal and Illegal), 2009

Notes: Estimates computed based on regression results presented in columns 3 and 4 of Graphic 12 (see the Appendix). The smuggling percentage is negative when the state is a net importer of smuggled cigarettes, and the percentage is positive when the state is a net exporter of smuggled cigarettes. The sum of commercial, casual and Canada/Mexico smuggling does not equal the totals presented in the final column due to the nonlinear nature of the model. North Carolina, Hawaii and Alaska are not included.

These increases in the model’s commercial smuggling estimates reflect large cigarette excise tax increases in both states. In Vermont, taxes were hiked in July 2008 and July 2009 by 20 cents and 25 cents per pack, respectively, and the tax now totals $2.24 per pack.[19] In New York, taxes were raised in 2008 by $1.25 per pack, resulting in a tax of $2.75 per pack.[†], [20]

New York’s sky-high tax rates also help explain why Pennsylvania is a net export state with regard to casual smuggling. Pennsylvania’s cigarette tax rate is $1.60 per pack,[21] and we estimate that in 2009, 9.1 percent of Pennsylvania’s entire in-state cigarette consumption was casually smuggled out of the state. Anecdotal evidence suggests that the rate would leap upwards should we update our model with 2010 data.[‡]

Mexico and Canada

In the model, we limited estimates of international smuggling to Canada and Mexico, because they are the major countries contiguous to the U.S. mainland.[*] As in our previous analyses, Mexico played a considerable role in the estimated smuggling rates of four states: Arizona, New Mexico, California and Texas. Indeed, almost 24 percent of New Mexico’s in-state cigarette consumption is estimated to have originated in Mexico.[†]

Canada plays a different role in American cigarette smuggling. Canadians are frequently acquiring their cigarettes in the United States — even, our model suggests, from relatively high-tax states.

According to our estimates, in 2009, 10 states “exported” smuggled cigarettes to Canada: Vermont, at 5.2 percent of its consumption; New York, at 4.9 percent; Maine, at 4.3 percent; Washington, at 4.1 percent; Michigan, at 3.5 percent; Idaho, at 3.1 percent; Minnesota, at 3.0 percent; Montana, at 2.8 percent; New Hampshire, at 2.3 percent; and North Dakota, at 2.1 percent. Our estimates for each state’s smuggling exports to Canada in 2009 are higher than our previous estimates for their exports in 2006.

Graphic 7: Top Four States in Smuggling From Mexico and Top Five States in Smuggling to Canada by Percentage of Total State Cigarette Consumption (Legal and Illegal), 2009

Notes: Texas, New Mexico, Arizona and California were the only states calculated to have cigarette smuggling imports from Mexico. Estimates computed based on regression results presented in columns 3 and 4 of Graphic 12 (see the Appendix). The smuggling percentage is negative when the state is a net importer of smuggled cigarettes, and the percentage is positive when the state is a net exporter of smuggled cigarettes. The sum of commercial, casual and Canada/Mexico smuggling does not equal the totals presented in the final column due to the nonlinear nature of the model. North Carolina, Hawaii and Alaska are not included.

Our revised 2006 data study showed that only three states in the union — Maine, New York and Washington — had export rates to Canada exceeding 2 percent of the states’ cigarette consumption, and the rates barely exceeded that 2 percent threshold. Our estimates for 2009 suggest the smallest nonzero export rate is just above 2 percent.

The higher smuggling estimates for 2009 are driven by increases in Canada’s federal cigarette tax in 2008.[22] In addition, the province of Prince Edward Island increased its cigarette tax in 2008 and 2009,[23] while Nova Scotia increased its cigarette tax in 2009.[24] The U.S.-Canada tax differential has been further heightened by the two countries’ currency exchange rates, which have generally made the cost of American goods fall relative to the cost of Canadian goods in recent years.[25]

Other sources estimate high cigarette smuggling rates into Canada. For instance, a 2008 report from GfK Research Dynamics authored for the National Study for the Canadian Tobacco Manufacturers’ Council indicates that illegal cigarettes made up 32.7 percent of that nation’s cigarette market share, up from 22 percent the year before.[26] The same 2008 report also argued that the illicit market for cigarettes was almost 49 percent in Ontario,[27] where more than one-third of all Canadians live.[28] Citing the Royal Canadian Mounted Police, the National Coalition Against Contraband Tobacco writes that 90 percent of the contraband cigarettes originate in the United States.[29]

Trends in Estimated Smuggling Rates

Our estimates suggest that cigarette smuggling rates across the country have wafted downward a bit. Consider Michigan as an example. In our January 2009 revision of 2006 state smuggling rates, we estimated Michigan’s total net smuggling rate at just over 31 percent of Michigan’s total cigarette consumption. That is, for every 10 cigarettes smoked, three appear to have been contraband. In contrast, our current estimate for Michigan’s net smuggling rate in 2009 is just 26 percent.

There may be several reasons for this decline. First, in 2009, North Carolina raised its cigarette taxes by 10 cents per pack. Because North Carolina is our prototypical source state (as it is in much of the economic literature on cigarette smuggling), this tax hike reduced the interstate tax differentials, and our estimates of commercial — and thus total — smuggling rates declined.

Second, as we mentioned above, Canada increased its taxes in 2008 and thus spurred outbound trafficking from states such as Michigan. According to our calculations, Michigan exports to Canada between 2006 and 2009 increased by nearly 1.7 percentage points, to 3.5 percent. Such smuggling exports would lower the total net inbound smuggling estimates for Michigan, as it did other states exporting to Canada.

Overall Smuggling Volumes for 2009

So far, we have examined cigarette smuggling in terms of smuggling rates — i.e., smuggling as a percentage of a state’s consumption of cigarettes, both legal and illegal. But a state with a relatively high smuggling rate may not experience a large volume of smuggled cigarettes relative to other states if the state does not consume many cigarettes in the first place. Similarly, a state with a relatively low smuggling rate may experience relatively large smuggling volumes if the volume of cigarettes it consumes is high.

For instance, as shown in Graphic 8, Michigan has the 10th highest smuggling rate in the nation, but it is fifth highest in sheer volume of illegal contraband flowing into the state. Michigan is a relatively populous state, and its residents consume a large volume of cigarettes.

Graphic 8: Estimated Smuggling Volumes and Smuggling Rates, 2009

The same goes for other big states. California has the fifth highest cigarette smuggling import rate in the nation, according to our model, but it is first in estimated contraband volume, with more than 451 million packs of cigarettes smuggled into the state. Even more striking is Florida: It has only the 29th highest smuggling import rate in the nation (just 6.36 percent of state consumption), but it is 9th in estimated overall smuggling volume, with our calculations suggesting that nearly 70 million packs were brought illegally into the state in 2009. Similar differences occur for Ohio, which is 23rd in smuggling import rate, but 11th in smuggling import volume; Illinois, which is 30th in rate, but 17th in volume; and Pennsylvania, which is 31st in rate, but 18th in volume.

Conversely, tiny Rhode Island, with a population exceeding just 1 million, has the third highest overall smuggling import rate in the nation, but is 19th among the states in estimated smuggling import volume. Similar disparities occur for New Mexico, which is fourth in estimated smuggling import rate, but 16th in estimated smuggling import volume; Montana, which is 13th in smuggling rate, but 26th in smuggling volume; and South Dakota, which is 12th in rate, but 27th in volume.

Unintended Consequences of Cigarette Tax Increases

We do not doubt that most lawmakers who push for cigarette tax hikes sincerely believe it is the best way to solve a particular policy problem. Some may be concerned about public health and wish to dissuade smokers from smoking. Others may want to balance a state budget without spending cuts.

But the effects of well-intentioned cigarette excise taxes are not completely positive. Negative consequences include smuggling, “channeling,” counterfeiting and violence. We explored these topics in detail in our earlier study,[*] but we discuss them again briefly below.

The Realities of Cigarette Smuggling

When states and nations maintain markedly different cigarette excise taxes, smuggling ensues. Cigarette packs are light, popular and easily concealed, so they make ideal contraband for those willing to break the law.[*]

Unfortunately, many observers confuse declines in cigarette sales following a tax hike with smokers “breaking the habit.” That is, they often assume that if legal cigarette sales drop by 20 percent after a tax hike, it is a direct function of people no longer smoking.

For example, on July 1, 2009, a $1.00 per-pack cigarette tax hike took effect in Florida. By November 2009, sales had declined by 20 percent, with some counties witnessing sales declines of 50 percent.[30] From July 1, 2009, to July 1, 2010, Florida’s legal cigarette sales were down 31.2 percent, according to a spokesperson for the Florida Department of Business and Professional Regulation.[31] Florida state Rep. Jim Waldman, who supported the tax hike, was quoted as saying: “It’s working exactly the way it was designed to work. People are quitting. If I could, I’d raise it another dollar.”[32]

While it is technically accurate to say people are quitting, it is probably misleading. A 2005 study by economist Mark Stehr indicated that “up to 85% of the tax paid

sales response”[33] to a cigarette tax hike is due to tax avoidance, not quitting.[†] When Florida was first considering $1.00 per-pack tax hike in 2009, we estimated in an unpublished calculation that legal sales of cigarettes in Florida would decline by 19 percent as a direct result of smuggling.

There is ample empirical evidence that such smuggling occurs. In our 2008 study, we reviewed some of this evidence.[34] Since then, more has emerged.

For example, in March 2010, the U.S. Bureau of Alcohol, Tobacco, Firearms and Explosives reported that prior to 2003, the bureau averaged only 40 new tobacco “diversion” (smuggling) cases each year. Since 2003, that annual average has leapt to 131.[35]

In the state of Michigan, there are currently two significant federal cases being prepared against seven individuals for their alleged involvement in massive cigarette smuggling. The complaints were recently dismissed, but only to allow the government more time to prepare indictments.[36] Both cases involve individuals located near a Michigan Indian community and cigarette shipments from and to low-tax Kentucky.

In the first case, the affidavit filed in support of arrest warrants for the suspects alleges that between October 2008 and July 2009, they acquired more than 40 million untaxed cigarettes from an undercover ATF agent.[37] The cigarettes were allegedly purchased with $4.3 million in cash, cashier’s checks and money wired to the account of the undercover agent. Remarkably, these men not only may have transported untaxed cigarettes into Michigan (and had them mailed using the U.S. Postal Service); they also allegedly exported a large portion of untaxed cigarettes to Louisville, Ky.[38]

In the second case, in an affidavit filed in support of the arrest warrants, five individuals were alleged to have purchased more than 16 million untaxed cigarettes for approximately $1.8 million between July 2007 and July 2009. The cigarettes were shipped to Michigan, Nevada and California. According to the affidavit, the orders shipped to all three states were “brokered” by a man from Baraga, Mich., and the checks used to pay for the cigarettes were allegedly drawn from Upper Peninsula businesses, including an outfitter, a pizza shop and a tobacconist.[39]

Channeling to Other Tobacco Products

Tax avoidance involves more than just casual and commercial smuggling; it also includes “channeling” to other forms of tobacco, such as chewing tobacco and “roll your own” cigarettes. A study by Harvard University researchers published in the June 11, 2008, Journal of the American Medical Association found that from 2000 to 2007, 30 percent of the decline in legal sales of cigarettes in the United States was offset by the acquisition of other tobacco products.[40] These products were small cigars, moist snuff and loose tobacco, which can be used to “roll your own.” The Harvard researchers measured the increase in sales of such products and found that it was equivalent in nicotine to 1.1 billion packs of cigarettes, partly counterbalancing the approximately 3.7 billion-pack decline in legal cigarette sales during the period.[41]

Other tobacco products are a natural alternative for cigarette smokers, because the taxes are typically lower. Such products can also be smuggled, both casually and commercially. In our 2008 study, we noted that officials in the United Kingdom estimated in 2007 that 50 percent of hand-rolled tobacco used in the U.K. is smuggled.[42]

Moreover, entrepreneurs have begun providing access to “roll-your-own” machines to help customers avoid excise taxes by purchasing loose tobacco. A page on the U.S. Treasury Department’s website reports that such machines can turn out 200 cigarettes in as little as eight minutes.[43] The RYO (Roll Your Own) Machine Rental LLC out of Ohio reports on its website that RYO cigarettes can cost as little as one-third the price of “pre-manufactured” cigarettes.[44] Many smokers roll cigarettes using pipe tobacco, which faces a dramatically lower federal excise tax.[45]

Counterfeiting

Some contraband cigarette traffickers have taken to manufacturing counterfeits of popular brands, such as Marlboro and Camel. We wrote about this extensively in our 2008 study, and since that time, there have been major investigations, indictments and convictions of people trafficking counterfeit brands.

In July 2009, for instance, 12 million counterfeit cigarettes were seized by the ATF in Virginia alone.[46] In October 2010, the federal government secured a conviction in a Southern California case involving a conspiracy to smuggle counterfeit cigarettes, smuggled cigarettes, drugs and shoulder-fired missiles.[47] According to an FBI press release, this case and related work in New Jersey led to indictments of 87 people on smuggling charges.[48]

In November 2009, the British Journal of Criminology published the research paper “The Dragon Breathes Smoke: Cigarette Counterfeiting in the People’s Republic of China.” The authors report that from 2002 through 2008, nearly 1.5 million “cases of cigarette counterfeiting became known to the Chinese authorities.”[49] During this time, Chinese officials discovered more than 22,200 cigarette production areas and 8,800 machines for rolling counterfeit cigarettes. More than 30,800 people were arrested, though only about one-third were sentenced. The authors note that these are just the cases known to the authorities.[50]

International smuggling is so extensive that some smugglers have established their own brand: “Jin Ling,” the only one known to have been created for the sole purpose of smuggling. It is typically produced in China, Russia or Russia’s former satellites.[51] The October 2010 pictures featured in Graphic 9 show Jin Ling cigarettes shipped from China and encased in cement barriers as part of a smuggling operation to England.[*], [52]

Graphic 9: Jin Ling Cigarettes Smuggled in Concrete Barriers

Source: ukhomeoffice photostream (flickr), “Cigarettes hidden in a concrete block,” www.flickr.com/photos/49956354@N04/5135789331/in/photostream/, “Concrete concealed cigarettes,” www.flickr.com/photos/49956354@N04/5135789323/in/photostream/.

Illegal cigarettes may be adulterated. In our 2008 study, we mentioned that counterfeit smokes often used sawdust as a filler.[53] The study “The Dragon Breathes Smoke,” discussed above, indicated that counterfeits may also contain rotten tobacco, sulfur, carbamide and “heavy metals to a greater extent than cigarettes produced by authorized manufacturers.”[54]

Violence

The history of cigarette smuggling is also a history of violence, threatened or actual, against people and property.[*] In our previous work, we detailed numerous examples. More recently, in March 2010, a man from Virginia admitted guilt in a murder-for-hire deal with a hit man in a case involving smuggled cigarettes.[55] In November 2008, an elderly couple from New York was killed just inside the Canadian border after a suspected cigarette smuggler plowed into their car while fleeing police.[56]

One cigarette wholesaler in Detroit — Martin & Snyder Product Sales — has had two of its trucks hijacked. One of the company’s “cash and carry” customers was shot three times as the merchandise he had just purchased — including cigarettes — was stolen from him, along with his car. While the customer survived, he lost a kidney in the shooting.[57]

Details recently became available in an older Michigan case we have mentioned before.[58] On Oct. 13, 2004, 107 cases of Philip Morris cigarettes were stolen from a truck operated by Columbian Distribution Services — a Grand Rapids-based company — while it was at a terminal of Eby-Brown Company in the city of Ypsilanti, Mich. The cigarettes were valued at the time at $173,340.[59] The robbery apparently involved a five-man team, but two have never been apprehended, according to an attorney at the U.S. Department of Justice.[60] Court documents state that the driver-victim in this incident was “struck in [sic] the head with a heavy object, bound, blindfolded, robbed and left sitting on the ground as the truck was unloaded.”[61]

Remarkably, one of the three defendants in this case had been convicted of committing a “near[ly] identical crime, just a few years prior in time.”[62] In that 1997 crime, “the victim was wrestled to the ground, bound and gag[g]ed”[63] and told “ ‘we will get you’ ” should he talk.[64] According to the government’s sentencing memorandum, the defendant had also stolen cigarettes from Eby-Brown while working there as an employee. Ironically, he worked in the company’s stamping department, where tax stamps are placed on cigarettes to help thwart smuggling.

While serving time in prison for the 1997 robbery, the defendant had shared a cell with an individual who was then doing time for bank fraud, and who would later assist in the commission of the Eby-Brown robbery.[65] The third of the perpetrators had a lengthy police record of prior offenses, including assault, burglary and receiving stolen property.[66]

State Cigarette Tax Hike Proposals

Whatever the unintended consequences, a number of states have been considering cigarette tax hikes. Since 2009, for instance, new cigarette tax hikes have been proposed in Michigan,[67] Ohio,[68] Illinois[69] and California.[70] We have generated forecasts of the effects if these were adopted.

Michigan

The Great Lakes State currently levies a cigarette tax of $2.00 per pack. Gov. Jennifer Granholm has proposed a 25-cent per-pack cigarette tax increase.[71] We estimate that this hike would raise Michigan’s overall smuggling rate to 28.3 percent of the state’s total consumption and the commercial smuggling rate to 18.8 percent — up from 26.0 percent and 16.6 percent, respectively. Legal sales would drop 3.3 percent, but revenue to the state is estimated to increase by approximately 9 percent.

Ohio

Ohio currently levies a cigarette tax of $1.25 per pack. The proposed tax hike of $1.25 per pack, to $2.50 per pack, is the largest of the four states we consider here.[72] Should the $1.25 tax proposal be adopted, the Buckeye State would see its total smuggling rate rise to 23.3 percent of the state’s consumption, up from a relatively modest 9.2 percent. This estimated smuggling rate increase would no doubt be fueled by the proximity of Ohio to states like Kentucky, which has a tax of only 60 cents[73] per pack.[*] Commercial smuggling, however, would make up the vast majority of the total smuggling that occurred in the state.

Illinois

There have been a couple of proposals to hike the Illinois state cigarette excise tax in recent years, including Senate Bill 44, which passed the Illinois Senate in 2010.[74] This proposal would have hiked taxes by $1.00 per pack, creating a total state excise tax burden of $1.98 per pack. We project that this would have increased total smuggling in the state to 26.3 percent of total state cigarette consumption, up from just 5.9 percent in 2009. As with Michigan and Ohio, the majority of Illinois’ smuggling would be commercial, making up an estimated 24.3 percent of total consumption.

Such large smuggling increases might seem unlikely, but in a 2010 paper titled “The Micro-Geography of Tax Avoidance: Evidence from Littered Cigarette Packs in Chicago,” David Merriman calculated that 75 percent of the discarded packs of cigarettes he found in Chicago lacked a city tax stamp. More of the littered packs — 29 percent — came from Indiana than from Chicago itself, perhaps because Gary, Ind., is just 25 miles from downtown Chicago.[75]

California

California has long been a major smuggling state, largely due to its many ports and its border with Mexico.[*] Voters in California will decide in February 2011 whether to hike cigarette taxes by $1.00 per pack, for a total tax of $1.87 per pack. Should this proposal be approved, we estimate an increase in the state’s smuggling rate to 51.9 percent of the state’s total cigarette consumption, up from 36.3 percent. Most of the smuggled cigarettes would originate in Mexico. Based on our 2009 rankings, this would make California America’s biggest smuggling state in both smuggling rate and volume.[†]

Policy Recommendations

Lawmakers consistently advance cigarette excise taxes in order to raise revenue, improve health or both. Few seem aware that the higher tax is unlikely to raise the projected revenue or cause smokers to abandon cigarettes in droves.

With high cigarette excise taxes, states like Michigan, California, New York and New Jersey have already created massive illegal cigarette markets. Indeed, state tobacco taxes have provided profits for organized crime. There are real societal costs to smuggling and its unintended consequences: violence against innocent victims, strain on police and the legal system, theft, property damage and use of unfiltered legal cigarettes and adulterated counterfeit tobacco products.

With extremely high rates of excise taxation, it is even possible that a net decline in cigarette tax revenue could occur, thwarting lawmakers’ aims. This appears to have happened in New Jersey. State cigarette tax revenues had been increasing for several years prior to a state cigarette tax increase in July 2006 (the beginning of the 2007 fiscal year), when the tax was hiked from 240 cents per pack to 257.5 cents per pack.[76] This increase corresponded to a decline in gross state cigarette tax revenues, from $788.7 million in fiscal 2006 to $766.5 million in fiscal 2007; $764.7 million in fiscal 2008; and $728.1 million in fiscal 2009.[77]

Remarkably, New Jersey was not finished raising taxes. The state’s 2010 fiscal year began in July 2009 with another cigarette tax hike, this one from 257.5 cents to 270 cents.[78] Revenue in the first full year of the tax hike did increase, but by less than one-half of 1 percent, to $735 million — an amount that was still well below 2006 levels.[79]

As states with high cigarette tax rates contemplate further increases, they should consider the negative consequences. They should also consider rolling back excise taxes to thwart smuggling and other unintended harms. It may not be enough for high-tax states to do no more harm; some, like Michigan, should consider rolling back tobacco tax rates to levels similar to their neighboring states’.

We used our model to estimate what would happen if Michigan cut its cigarette tax to 102.5 cents per pack, the average excise tax rate for Indiana, Ohio and Wisconsin. We estimate that while cigarette revenues would decline by 42 percent, or about $324 million, Michigan’s overall smuggling rate would fall from 26 percent of the state’s total consumption to 16.3 percent — a decline of about 37 percent.[*]

Policymakers should also realize that cigarette taxes disproportionally target low-income people. In other words, they are regressive taxes. Economists Philip DeCicca, Donald S. Kenkel and Feng Liu report that their research shows cigarette excise tax avoidance actually increases with a person’s income, suggesting that cigarette taxes may be even more regressive than they appear.[80]

Lawmakers should also question whether tobacco revenue should be used to support general fund spending. Targeting a minority of the population for taxes to fund programs for the majority is bad public policy. It removes an important link between those who pay for and those who receive the benefits of government spending. Severing this link may only encourage the majority to happily overtax weaker constituencies and ignore the cost of the programs they use. Indeed, if lawmakers are serious about curbing the deleterious health consequences of smoking, they should consider dedicating such revenue to that purpose alone.

Ultimately, lawmakers must consider and respect the value of individual freedom when setting tax policies, including cigarette excise tax rates. People who purchase legal products from licensed retailers are adults. They are considered able — and free — to determine their own destinies. That includes the decision to use tobacco products or not. True, taxation is not prohibition, but as Supreme Court Chief Justice John Marshall once wrote, “That the power to tax involves the power to destroy … [is] not to be denied.”[81]

Lawmakers should also consider the revolutionary proposition the Founders advanced when they wrote of an “unalienable right” to “life, liberty and the pursuit of happiness.” Last August, writer Vincent DeMarco of the Maryland Citizens Health Initiative wrote in the Baltimore Sun that Maryland should hike its alcohol and tobacco taxes to — among other justifications — save lives.[82] On the popular blog site Cafe Hayek, George Mason University economist Don Boudreaux offered a stinging rebuke, writing:

The lives of individuals are the property neither of any government nor of officious “public interest” groups such as the one that Mr. DeMarco leads. The life of each individual Marylander belongs to that individual. If he or she chooses to endure the higher statistical chance of dying sooner rather than later in order to enjoy smoking, drinking, hang-gliding, or gulping down gasoline[,] it is no business of the state or of the likes of Mr. DeMarco. …[83]

We hope lawmakers are careful about imposing excise taxes in the name of living in a tobacco-free world. As we have written before, freedom matters too.

Appendix

In this appendix, we discuss the empirical models and results used to produce the casual and commercial smuggling estimates presented in Graphic 2 of this report. The results of this study build upon the existing literature, in which much support appears for the existence of substantial tax-induced smuggling, both casual and commercial.[*]

Much of this literature employs empirical models of representative consumer demand, including such variables as cigarette price, tourism, income, race, religious affiliation and other demographic variables, in addition to the primary variables of interest: tax (or price) differentials; American Indian and military population; and distance from North Carolina.

The empirical method chosen here does not estimate consumer demand; rather, it follows the two-stage method proposed by LaFaive, Fleenor and Nesbit in 2008. We first estimate in-state consumption and then use the residual from that regression as a measure of smuggling. We then take that measure of smuggling (unexplained state sales) and regress it as a function of tax differentials and other commonly employed variables used to describe casual and commercial smuggling.

What follows is a brief description of the estimation procedure and a discussion of the results. A more thorough description of the empirical model can be found in Appendix A of LaFaive, Fleenor and Nesbit’s 2008 study.[84]

Legal per-adult tax-paid cigarette sales (hereafter per-adult sales) can be defined as the sum of in-state consumption and net smuggling, as presented in Equation 1:

Our first-stage regression equates to a naïve version of Equation 1, in that we do not control for any smuggling. Instead, we include only measures of in-state consumption on the right-hand side of the equation. If the smuggling of cigarettes is not prominent, then sales within the state will be approximately equal to in-state consumption. However, if smuggling is a prominent feature of the cigarette market, such a naïve model will fail to explain a large percentage of the variation in per-adult sales, resulting in residuals of large magnitude.

The sign and magnitude of the residuals from the estimation of the naïve model are of particular interest to us. Specifically, for low-tax states, the naïve model should systematically underpredict actual sales, as consumers from other states travel across state and international borders to purchase cigarettes there. Thus, actual sales in the low-tax state should exceed the consumption within the state, resulting in a positive residual. Similarly, the naïve model should systematically overpredict actual sales for high-tax states, resulting in a negative residual, as in-state residents choose to purchase cigarettes from nearby lower-tax states, Indian reservations, military bases or illegal markets.

In order to estimate our naïve model of per-adult tax-paid cigarette sales, in-state per-adult consumption is characterized by Equation 2:

State-by-state data on smoking prevalence is available from the Centers for Disease Control and Prevention through its Behavioral Risk Factor Surveillance System. Unfortunately, state-by-state data on smoking intensity is not readily available. LaFaive, Fleenor and Nesbit observe that smoking intensity at the national level declined roughly linearly from 1995 to 2006 and assume that smoking intensity does not vary significantly across states, allowing for a linear trend to capture the variation in smoking intensity through time, as indicated in Equation 3:[†], [85]

We estimated our naïve model of per-adult sales using state-level data for the U.S. continental states for the period 1990-2009. North Carolina is excluded from our sample because it is modeled as the primary source of commercially smuggled cigarettes in the second-stage regression.

Descriptive statistics and sources for all variables used in this study can be found in Graphic 10. All dollar amounts are represented in 2009 prices.

Graphic 11 presents the maximum likelihood estimates of our naïve model corrected for groupwise heteroskedasticity to allow for nonconstant variance across states. We present both linear (Columns 1 and 2) and log-linear (Columns 3 and 4) specifications for robustness, but the log-linear specification appears to more closely fit the data and hence is the preferred specification.

Per the results presented in the final two columns of Graphic 11, a 1 percentage point increase in the smoking prevalence rate results in a 5.8 percent increase in per-adult sales in the state. Furthermore, per-adult sales are shown to decrease by an average of 1.7 percent per year, which we attribute to the decline in smoking intensity over time.

Graphic 10: Descriptive Statistics and Sources of Data

[1] Tax Burden on Tobacco, various years
[2] Behavioral Risk Factor Survelliance System Survey Data (BRFSS ), various years
[3] U.S. Census Bureau, Intercensal County Population Estimates
[4] Computed
Note: All prices are represented in constant year 2009 dollars.

Graphic 11: Maximum Likelihood Estimation: State Per-Adult Cigarette Sales, 1990-2009

Notes: Statistical significance of 1 percent, 5 percent and 10 percent are represented by ***, ** and *, respectively. Results are corrected for groupwise heteroskedasticity via the HREG command within NLOGIT 3.0. Regressions include state fixed effects; these are withheld here for space considerations, but are available upon request.

As mentioned above, it is not the coefficient estimates from the naïve model that interest us; rather, it is the model’s residuals that are important. States with high tax rates relative to their neighbors and to North Carolina are expected to have residuals that are negative and large in magnitude, with predicted per-adult consumption exceeding the state’s observed per-adult sales, suggesting that the state’s consumers are obtaining their smokes in other jurisdictions or markets. Low-tax states are expected to have residuals that are positive and large in magnitude, with observed per-adult sales exceeding predicted per-adult consumption, suggesting that the states are net exporters of smuggled cigarettes.

We attribute most of the variation of the residual from the naïve model to the occurrence of “casual” and “commercial” smuggling. Casual smuggling can take the form of cross-border shopping between states; cross-border shopping either in Mexico or from Canada; or the purchase of untaxed cigarettes on military bases and Indian reservations by nonmilitary personnel and nontribe members. We include the weighted average tax differential — i.e., home state tax rate – weighted average border state tax rate — between the home state and the bordering states to account for tax-induced shopping across state lines. Similar to Coats’ 1995 study, this study weights the average border tax rates by county border populations.[86]

However, even with large average tax differentials, proportionally little casual smuggling is likely occur if few people live along the border relative to the state’s population. Thus, we include the population living on either side of the border divided by the home state’s total population (percent border population). This percentage can take on a value greater than one when the border population in surrounding states is sufficiently large, thus causing the border population to exceed the home state’s total population. Finally, we include an interaction term between the average tax differential and percent border population.

To capture the impact of the presence of Indian reservations, we include the sum of the state excise tax and the federal excise tax rate for those states with Indian reservations. This is effectively the tax differential between the home state and the tribal land, since taxes are not generally applied to cigarettes sold on Indian lands.[‡]

Ideally, we would also like to include the tax differential with Canadian province(s) and Mexican state(s) for any U.S. states bordering Canada or Mexico. Unfortunately, accurate data on such tax rates, particularly for Mexico, were not available. Exchange rate fluctuations would further complicate the calculation of these tax differentials. As such, we simply include the sum of the home state excise tax and the federal excise tax for those states bordering either Canada or Mexico.

As described in Thursby and Thursby’s 2000 paper, commercial smuggling primarily occurs either by “diversion” or “over-the-road.”[87] Diversion involves the manipulation of accounting records, reporting only a portion of the sales.[§] Over-the-road smuggling occurs when bulk cigarettes are purchased legally in low-tax states and shipped to higher-tax states, where the cigarettes receive counterfeit stamps and enter legal markets.[¶] Our empirical model controls only for over-the-road smuggling, as has been common in the literature, with the exception of Thursby and Thursby (2000).

North Carolina has generally been modeled as the primary source of commercially smuggled cigarettes, and we follow the same convention. The tax differential between the home state and North Carolina is included as our measure of commercial smuggling. Distance from North Carolina is not included in the model, since much of the previous literature suggests that transportation costs account for less than 1 percent of cigarettes’ total value. As such, transportation costs should exert a negligible impact on smuggling.[**]

Columns 3 and 4 of Graphic 12 provide the OLS estimation results of regressing the residuals from the log-linear naïve model against the tax differential and population variables described above. When interpreting these results, recall that the dependent variable is the actual per-adult sales minus the predicted consumption from the naïve model. This dependent variable represents net smuggling exports. Thus, a positive value of the dependent variable suggests the state is a net exporter of smuggled cigarettes, while a negative value of the dependent variable suggests the state is a net importer of smuggled cigarettes.

With the exception of the coefficient describing net smuggling to Canada, all estimates are of the correct sign and are statistically significant. An increase in the tax differential with North Carolina (our measure of commercial smuggling) is shown to reduce net smuggling out of the state, indicating an increase in commercial smuggling of cigarettes from North Carolina. States bordering Mexico or containing Indian reservations, and particularly states with larger tax rates, are shown to experience significantly increased smuggling imports from Mexico and the reservations, respectively.

The implications concerning casual smuggling are not as clear, as the coefficient of average tax rate differential is positive while the interaction term is negative. However, given the mean percent border population of 1.305, the impact of a $1 increase in the average tax differential is clearly negative, leading to a 0.161 percent reduction in net casual smuggling out of the state.[††] This is consistent with the expectation that the larger the home tax rate is relative to the average bordering tax rate, the greater the net smuggling imports will be from the lower-tax neighboring states.

Graphic 12: Unexplained Per-Capita Sales From Naïve Model, 1990-2009

Notes: Statistical significance of 1 percent, 5 percent and 10 percent are represented by ***, ** and *, respectively.

Given the above estimation results, we compute smuggling by type as a percentage of estimated cigarette consumption in the state. Graphic 13 presents our state-level estimates of the percent of estimated cigarette consumption that was smuggled, both by type of smuggling and in total, for 2009, the last year in our dataset. Those states for which the percentage smuggled is negative are net importers of smuggled cigarettes. The table is ranked by net total smuggling imports as estimated here for 2009; the 2006 rankings are based on unpublished estimates by LaFaive, Fleenor and Nesbit.

Graphic 13: Estimated State Cigarette Smuggling Exports as a Percentage of Total State Cigarette Consumption (Legal and Illegal), 2009

Notes: Because the table provides smuggling exports, the smuggling percentage is negative when the state is a net importer of smuggled cigarettes, and the percentage is positive when the state is a net exporter of smuggled cigarettes. The sum of commercial, casual and Canada/Mexico smuggling does not equal the totals presented in the final column due to the nonlinear nature of the model. North Carolina, Hawaii and Alaska are not included.

Acknowledgments

The authors would like to thank the following people for their help with this project. Any errors in the manuscript are, of course, the authors’ responsibility alone.

• Michael Hicks, director of Center for Business and Economic Research at Ball State University and adjunct scholar with the Mackinac Center for Public Policy, for his review of a draft of this manuscript.


• J. Scott Moody, president of Public Choice Analytics for the U.S. States, for his review of a draft of this manuscript.


• James Hohman, fiscal policy analyst at the Mackinac Center for Public Policy, for reviewing a draft of this manuscript and fact-checking many elements in it.


• Hannah Mead, assistant editor at the Mackinac Center for Public Policy, for fact-checking many elements of the paper.


• Jarrett Skorup, research associate for online engagement at the Mackinac Center for Public Policy, for media outreach.


• David Dietsche, summer research intern at the Mackinac Center for Public Policy, for research assistance.