The Unintended Consequences of Cigarette Tax Hikes

Good morning.

It is a great pleasure to be here today. I always enjoy good policy discussions and I can’t imagine a better forum than an ALEC conference for a lively exchange of ideas.

There once was a lady who owned a pet parrot that had a bad habit of always saying in front of company, "say fellas, I’m a swinger." Out of worry, she one day took her parrot to her Priest, and sure enough, the parrot chimed in, "say fellas I’m a swinger." The Priest confidently announced, "I can solve your problem. I have two birds who are devoutly religious. They say their rosary all day long and are extremely pious. Leave yours with mine and mine will surely straighten yours out." So she does and a few minutes later the woman’s parrot says "hey fellas, I’m a swinger." One of the Priest’s birds looks at the other and says, "put your beads away Charlie, our prayers have been answered."

Unintended consequences. Nothing illustrates the principle better than cigarette taxes. They’ve been in the news a lot lately as state governments try to close their deficits — at least in part — by hiking the tax paid on each carton or pack of cigarettes.

In 2002, 20 states implemented higher excise taxes on purchases of cigarettes. There have been more than 80 cigarette tax hikes since 1989 in the United States. The immediate consequence of hiking taxes, it is hoped, is more revenue. There are often ancillary impacts, however, that are not anticipated, and that have negative effects —smuggling, theft, in Europe there have been murders over cigarette smuggling, and financing terrorism.

The term "unintended consequences" was first coined by sociologist Robert Merton. Merton described five sources of them, but the first three are the most widely used and recognized. They are: ignorance, error, and "an imperious immediacy of interest."

With respect to ignorance, many people just don’t understand that the policies they advocate may have side effects that do more than they intend — that the policies hurt those they wish to help. Error is a similar category, but one in which the policy advocates understand the law of unintended consequences, and simply fail to anticipate the type and degree of those consequences. The third category, the "imperious immediacy of interests" describes policy changes marked by the desire to ignore the unintended effects because policymakers’ desire for some new policy overrides their concern for the unanticipated effects.

Regardless of the "unintended consequences" category that a policy fits into we now know that large cigarette tax increases in a number of states have led to at least three ancillary problems that must be reckoned with. They include: Interstate smuggling, theft, and "channeling." Channeling simply describes changes in the way people obtain the product they seek. "Rolling your own," is a good example. In Michigan, sales of kits to help people make their own unfiltered cigarettes have leapt.

The most pertinent of these three is smuggling. Smuggling has traditionally been associated with moving goods across international borders to avoid paying duties or tariffs on the product. Indeed, the earliest recorded cases involve smuggling wool from England in the 1300s. Smuggling, however, does not have to go across international borders. We banned alcohol and had smuggling across state and county lines, and even today alcohol is smuggled across borders to avoid excise taxes.

There are usually five key characteristics about a product that increase the likelihood that it will be smuggled somewhere for a profit. They are: product tax differential; transportation costs; transaction cost (that is, finding a willing buyer); effort needed to obtain the product; and the likelihood of police intervention. Cigarettes, therefore, make the perfect smuggling product: They represent a product people want, are very lightweight, and possess large tax differentials between locations.

The Tax Foundation has, to their great credit, been tracing the effects of cigarette excise taxes on the increased use of contraband — or illicit — tobacco in the United States since 1960. They estimate that, in 1962, when the average cigarette tax was just 26 cents a pack (1997 constant dollars), 5.6 percent of all cigarettes were "procured through some type of cross-border activity."

By 1997, when the average cigarette tax was 35 cents per pack 7.8 percent of all cigarettes were obtained through cross-border activity. Today the average tax stands at 60 cents per pack. What impact would an average 71 percent increase in the cost of cigarettes have on smuggling? The Tax Foundation has not yet calculated the exact change in cross-border activity resulting from the latest hike in excise taxes. Executive Director Scott Hodge of the Tax Foundation believes it will be dramatic. Edward Hudgins, a regulation expert and adjunct scholar with the Cato Institute, estimated in 2000 that profits made illegally from smuggling cigarettes ranged from $10 billion to $17 billion.

Why should state legislators be concerned about this unintended consequence?

By increasing the price for cigarettes via taxation legislators announce to the world that there are profits to be made in the illicit delivery of cigarettes. Price acts as a signal to producers to make more or less of any product. In this case a price hike tells smugglers that there are profits to be made running cigarettes between two areas — one, a low-tax area; the other, a high-tax area. Consider as an example North Carolina and Michigan.

In the summer of 2000, FBI agents raided a house in Charlotte, N.C., in an action dubbed "Operation Smokescreen." Inside they found cash, weapons (including shotguns, rifles and an AK-47), documents written in Arabic — and cigarettes. Lots of cigarettes.

It appears that the raid was on a house that was used as a base for smuggling smokes. The smuggling operation exploited the tax differential between North Carolina, which has low cigarette taxes at 5 cents a pack, and Michigan, with high taxes at 75 cents (it is now $1.25) a pack.

The smugglers would drive the 680 miles from Charlotte to Detroit in a rented van with 800 to 1,500 cartons of cigarettes purchased with cash in North Carolina. The cigarettes would then be sold to Arab-owned convenience stores in Detroit, which sold them to customers. According to the U.S. Attorney, each trip — which required absolutely no special skills for the 13-hour drive — would net $3,000 to $10,000. The profits would then be shuttled back to Charlotte.

The homeowner and recipient of the profits was none other than Mohamad Hammoud, an individual with alleged links to Hezbollah in Lebanon. Hezbollah has connections with Osama bin Laden's Al-Qaeda organization.

Those $10,000 trips added up. In just one year, Hammoud deposited over $730,000 in one bank account, while paying for houses, luxury cars and other goods with cash. It's likely that millions of dollars were made on the smuggling operation between 1995 and 1999.

Here's the list of what the U.S. Justice Department claims Harb purchased and sent to Hezbollah with his cigarette smuggling profits: night-vision goggles, cameras and scopes, surveying equipment, global positioning systems,mine and metal detection equipment, video equipment, advanced aircraft analysis and design software, laptop computers, stun guns, radios, mining, drilling equipment, radars, ultrasonic dog repellent, laser range finders and blasting equipment. And this is not just one isolated incident of illicit cigarette sales being used to fund terror networks.

Government agents believe that all of these supplies were bought with profits from smuggling cigarettes. Indeed, overseas — where cigarette taxes are much higher — the problem is even worse. European officials have charged that the Russian mafia, Hezbollah, and even Saddam Hussein have profited from cigarette smuggling, an activity that officials say is more profitable than narcotics trafficking. The Irish Republican Army is suspected of funding arms purchases in Croatia with illicit cigarette sales. Worldwide, 28 percent of all cigarettes sold are now smuggled from low-tax areas to high-tax areas.

While these are some of the most blatant and tragic examples the Law of Unintended Consequences they serve as an important reminder for those of us who don’t know about, or refuse to consider, the downside to taxing one particular product too much.

The next big unintended consequence you will be reading more about in the coming years is the counterfeiting of cigarettes themselves. The Chinese are now exporting cigarettes designed with the look and feel of Marlboros and Marlboro lights. At Long Beach harbor last year, customs officials report a 10-fold increase in the number of counterfeit cigarettes uncovered over 2001. Remember, this is just one port, and one brand we’re talking about. Not even Phillip Morris employees can tell these apart from looking at them. And the counterfeit tobacco is often laced with things that shouldn’t be there, such as sawdust.

There are serious policy implications of going to the tobacco well for revenue, and I have only been able to mention a few of them here.

Now, some of you might think I'm being a bit extreme in taking terrorism as my main example. I mean, after all, would anyone be prepared to say that taxing cigarettes foments terrorism? In a word, yes — the taxation of any commodity can reach a point where people begin to modify their behavior. And once that line is crossed, the sky's the limit, including terrorism. There’s nothing whatsoever that should be surprising about this, when you understand the potency of government economic policy to modify behavior.

The reason that well-intentioned officials keep trying such policies is because they may either not understand the adverse consequences, don’t care about them, or have a view of the role of government that is not consistent with the limited one envisioned by America’s Founding Fathers and ALEC.