Tobacco Industry Games Rules to Dodge Billions in Taxes

What’s the biggest difference between small and large cigars or pipe and roll-your-own tobacco? Their level of taxation, according to the Government Accountability Office (GAO), which estimates that tobacco companies have managed to dodge an estimated $3.7 billion in federal excise taxes since 2009 by superficially repackaging their products to fit within the legal definitions of the least taxed forms of tobacco.

A Senate Finance Committee hearing last week examined the egregious methods tobacco companies use to accomplish this. One panelist related in his testimony (PDF) that Desperado Tobacco had literally pasted a label saying “pipe tobacco” onto its existing roll-your-own tobacco packages so it could avoid the higher rate on roll-your-own tobacco. Perhaps even more stunning, another panelist noted during the hearing that some companies had added cat litter to small cigars to add enough weight to their product so that it fit the definition of the lower taxed “large cigars.”

What’s driving these outrageous tactics is the substantial difference in the way each product is taxed. For example, roll-your-own tobacco is taxed by the federal government at a rate of $24.78 per pound compared to the $2.83 per pound rate on pipe tobacco. Similarly, small cigars are taxed at a rate of $50.33 per thousand, whereas large cigars are taxed as a percentage of the manufacturer’s price, which in many cases results in a tax of about half that for small cigars. These differences in tax levels are so significant that according to the GAO, over the past few years there has been a dramatic rise (PDF) in both the purchase of large cigars and pipe tobacco along with a simultaneous collapse in the market for small cigars and roll-your-own tobacco, as consumers flock to the lower-priced alternatives.

The best way to solve this tax avoidance by tobacco companies would be for Congress to equalize the level of taxation of the varying tobacco products, which would once and for all end the incentive for companies to repackage their product to fit the different product definitions. In the event of congressional inaction, the Alcohol and Tobacco Tax and Trade Bureau (TTB) also has authority to issue clearer definitions between the varying tobacco products. For example, TTB could require that large cigars be defined as being six rather than three pounds per thousand. But it’s unlikely that any definitions the bureau could issue would adequately solve the problem of companies gaming their products.

While tobacco taxes are not the best source of revenue given that they are regressive and decline over time, they still provide billions in much needed revenue at the state and federal level to offset some of the social costs of smoking. For these reasons, lawmakers should put an end to the ridiculous games tobacco companies are playing to avoid paying taxes.