GAO-13-279SP: International affairs: 31. Tobacco Taxes

International affairs > 31. Tobacco Taxes

Federal revenue losses were as much as $615 million to $1.1 billion between April 2009 and 2011 because manufacturers and consumers substituted higher-taxed smoking tobacco products with similar lower-taxed products. To address future revenue losses, Congress should consider modifying tobacco tax rates to eliminate significant tax differentials between similar products.

Why This Area Is Important

Tobacco use is the leading cause of preventable death, disease, and disability and a significant contributor to health care costs in the United States. Federal and state legislation has aimed to discourage tobacco use and raise revenues by increasing excise taxes on tobacco products. In April 2009, the Children’s Health Insurance Program Reauthorization Act (CHIPRA) increased federal excise tax rates for smoking tobacco products (cigarettes, roll-your-own tobacco, pipe tobacco, small cigars, and large cigars); however, it did not equalize the tax rate across all of these smoking tobacco products. The Department of the Treasury (Treasury) collects federal excise taxes on tobacco products.

What GAO Found

As GAO reported in April 2012, large federal excise tax disparities among smoking tobacco products, which resulted from CHIPRA, created opportunities for tax avoidance and led to significant market shifts by manufacturers and price-sensitive consumers towards the lower-taxed products. While revenue collected for all smoking tobacco products from April 2009 through September 2011 amounted to $40 billion, GAO estimated that federal revenue losses, due to market shifts from roll-your-own to pipe tobacco and from small to large cigars, ranged from about $615 million to $1.1 billion for the same period. Though CHIPRA increased federal excise tax rates for pipe tobacco and large cigars, the rates for pipe tobacco remain significantly lower than for other smoking tobacco products and large cigar rates can be significantly lower, depending on price. According to GAO’s analysis and interviews with government, industry, and nongovernmental organization representatives, the tax disparities created incentives for price-sensitive consumers to substitute higher-taxed products with lower-taxed products, particularly as manufacturers have made changes so that their lower-tax products more directly substitute for the higher-tax products.

Cigars are differentiated from cigarettes by their wrapper and whether the product is, for a number of reasons, likely to be offered to, or purchased by, consumers as a cigarette. Large and small cigars are differentiated by a weight threshold alone—with small cigars being defined as those weighing 3 pounds or less per thousand sticks. Roll-your-own tobacco and pipe tobacco are defined by factors such as the use for which the product is suited and how they are offered for sale, as indicated by their appearance, type, packaging, and labeling. The following photograph shows a sample of different cigarette and cigar products. Several of the products closely resemble each other in size and shape.

Examples of Cigarette and Cigar Products

Examples of Cigarette and Cigar Products

Prior to CHIPRA, roll-your-own and pipe tobacco were taxed at the same rate ($1.10 per pound). However, CHIPRA raised the federal excise tax rates for roll-your-own tobacco and pipe tobacco by different amounts, resulting in a $21.95 per pound difference between the higher-taxed roll-your-own tobacco ($24.78 per pound) and the lower-taxed pipe tobacco ($2.83 per pound). As a result, of the three cigarette products shown in the photograph above, the cigarette made with pipe tobacco is taxed at a much lower rate than either the factory-made cigarette or the cigarette made with roll-your-own tobacco. As shown in the figure below, from January 2009 to September 2011, monthly sales of pipe tobacco increased from approximately 240,000 pounds to over 3 million pounds, while monthly sales of roll-your-own tobacco dropped from about 2 million pounds to 315,000 pounds during the same time period. According to government officials and representatives of industry and nongovernmental organizations, roll-your-own tobacco manufacturers shifted to producing lower-taxed pipe tobacco with minimal, if any, changes to their products, and consumers substituted pipe tobacco for use in roll-your-own cigarettes.

Monthly Sales for Roll-Your-Own and Pipe Tobacco, and for Small and Large Cigars, Fiscal Years 2001 through 2011

Monthly Sales for Roll-Your-Own and Pipe Tobacco, and for Small and Large Cigars, Fiscal Years 2001 through 2011

CHIPRA also significantly changed the tax rates on cigars, resulting in a large tax-rate disparity between low-priced large cigars and small cigars. Large cigars are unique among tobacco products in that the tax rate is ad valorem (a percentage of the manufacturer’s or importer’s sale price per thousand sticks), up to a maximum tax per thousand sticks. While CHIPRA increased small cigar tax rates from $1.83 to $50.33 per thousand sticks, the ad valorem rate for large cigars increased from 20.72 percent to 52.75 percent of the manufacturer’s or importer’s sale price, up to a maximum tax of $402.60 per thousand sticks. As a result, cigars with a manufacturer’s price of $50 per thousand, for example, would experience a tax savings of $23.95 per thousand if they qualified as large rather than small cigars. While the small cigar and filtered large cigar shown in the photograph above are similar in appearance, they are likely taxed at significantly different rates, depending on the price of the filtered large cigar. According to government officials and representatives of nongovernmental organizations, because weight is the only characteristic that distinguishes small cigars from large cigars, many cigar manufacturers made their small cigars slightly heavier to qualify for the large cigar tax rate and avoid higher taxes levied on small cigars after CHIPRA. As shown in the monthly sales figure above, from January 2009 to September 2011, large cigar sales increased from 411 million to over 1 billion cigars, while small cigar sales dropped from about 430 million to 60 million cigars during the same time period.

Although Treasury has taken steps to respond to these market shifts, it has limited options. For example, Treasury has attempted to differentiate between roll-your-own and pipe tobacco for tax purposes but faces challenges because the definitions of the two products in the Internal Revenue Code of 1986 do not specify distinguishing physical characteristics. Treasury also has limited options to address the market shift to large cigars because, according to Treasury officials, the agency lacks the authority to take action against manufacturers’ legitimate modifications of small cigars to qualify them for the lower tax rate on large cigars. In addition, Treasury faces added complexity in monitoring and enforcing tax payments due to the change in large cigar tax rates.

Actions Needed

GAO suggested in April 2012 that Congress, as it continues its oversight of CHIPRA, may wish to consider taking the following two actions:

  • consider equalizing tax rates on roll-your-own and pipe tobacco; and

  • in consultation with Treasury, consider options for reducing tax avoidance due to tax differentials between small and large cigars.

Taking these two actions will address further revenue losses that amounted to an estimated $615 million to $1.1 billion between April 2009 and September 2011. Two bills have been introduced in the 113th Congress that would address this issue of tobacco tax disparities, but as of March 8, 2013, Congress had not acted on either bill.

How GAO Conducted Its Work

The information contained in this analysis is based on findings from the product listed in the related GAO product section. GAO analyzed documents and interviewed agency officials from Treasury’s Alcohol and Tobacco Tax and Trade Bureau, the U.S. Food and Drug Administration (FDA), and the Centers for Disease Control and Prevention, as well as tobacco industry members, representatives of public health, and other nongovernmental organizations, and academics, to obtain information on tobacco legislation and regulations, tobacco product sales trends, and consumption patterns. GAO analyzed Treasury data to identify sales trends across the different tobacco products from October 2001 through September 2011. GAO collected and analyzed data on federal excise tax rates for smoking tobacco products and the revenues generated from their sale during the same time period. GAO estimated what the effect on tax revenue collection would have been if the sales trend for roll-your-own and pipe tobacco and for small and large cigars had not been affected by substitution between the products but had been affected by the increase in price due to the tax—in other words, if the market shifts resulting from the substitution of higher-taxed products with lower-taxed products had not occurred. GAO’s analysis takes into account the expected fall in quantity demanded due to the price increases resulting from higher federal excise tax rates that CHIPRA imposed on all four of these smoking tobacco products. Table 22 in appendix IV lists the programs GAO identified that might have opportunities for cost savings or revenue enhancement.

Agency Comments & GAO Contact

In commenting on the April 2012 report on which this analysis is based, Treasury generally agreed with GAO’s overall conclusion that CHIPRA’s introduction of large tax disparities between similar products contributed to the substitution of higher-taxed tobacco products with lower-taxed tobacco products. Treasury also agreed with GAO’s observation that modifying tobacco tax rates to eliminate significant tax differentials between similar products would address the market shifts that GAO identified.

GAO provided a draft of this report section to Treasury for review and comment. Treasury generally agreed with GAO’s overall conclusions. In commenting on this report section in January 2013, a Treasury official noted that the substitution trends have continued. The official observed that in the year proceeding CHIPRA, of all of the cigars “sold” in the United States by domestic manufactures, 52 percent were small cigars and 48 percent were large cigars. In the 2 years following CHIPRA, these numbers were 8 percent for small cigars and 92 percent for large cigars.

For additional information about this area, contact David Gootnick at (202) 512-3149, or gootnickd@gao.gov.