Large Disparities in Rates for Smoking Products Trigger Significant Market Shifts to Avoid Higher Taxes
GAO-12-475: Published: Apr 18, 2012. Publicly Released: Apr 18, 2012.
- VIDEO: Using a Commercial Roll-Your-Own Machine with Pipe Tobacco to Make a Carton of Cigarettes
A GAO employee uses a commercial roll-your-own machine to make a carton of cigarettes with pipe tobacco, which has a lower federal excise tax rate than most smoking tobacco products. Customers can save money when using the machines to make cigarettes with pipe tobacco. As manufacturers and consumers switch to lower-taxed tobacco products, GAO estimates a significant loss in potential federal revenue.
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What GAO Found
Large federal excise tax disparities among tobacco products, which resulted from the Childrens Health Insurance Program Reauthorization Act (CHIPRA) of 2009, created opportunities for tax avoidance and led to significant market shifts by manufacturers and price sensitive consumers toward the lower-taxed products. Monthly sales of pipe tobacco increased from approximately 240,000 pounds in January 2009 to over 3 million pounds in September 2011, while roll-your-own tobacco dropped from about 2 million pounds to 315,000 pounds. For the same months, large cigar sales increased from 411 million to over 1 billion cigars, while small cigars dropped from about 430 million to 60 million cigars. According to government, industry, and nongovernmental organization representatives, many roll-your-own tobacco and small cigar manufacturers shifted to the lower-taxed products after CHIPRA to avoid paying higher taxes.
While revenue collected for all smoking tobacco products from April 2009 through fiscal year 2011 amounted to $40 billion, GAO estimates that federal revenue losses due to market shifts from roll-your-own to pipe tobacco and from small to large cigars range from about $615 million to $1.1 billion for the same period. The Department of the Treasury (Treasury) has limited options to respond to these market shifts. 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 and faces added complexity in monitoring and enforcing tax payments due to the change in large cigar tax rates.
Unlike cigarettes and roll-your-own tobacco, pipe tobacco and cigars are not currently regulated by the Food and Drug Administration (FDA) and thus are not subject to the same restrictions on characterizing flavors, sales, or distribution. In 2011, FDA indicated its intent to issue a proposed rule that would deem products meeting the statutory definition of tobacco product to be subject to FDAs regulation. However, FDA had not issued the proposed rule as of March 2012. FDA officials told GAO that developing the rule was taking longer than expected.
Why GAO Did This Study
In 2009, CHIPRA increased and equalized federal excise tax rates for cigarettes, roll-your-own tobacco, and small cigars. Though CHIPRA also increased federal excise tax rates for pipe tobacco and large cigars, it raised the pipe tobacco tax to a rate significantly below the equalized rate for the other products, and its large cigar excise tax can be significantly lower, depending on price. Treasury collects federal excise taxes on tobacco products.
Also passed in 2009, the Family Smoking Prevention and Tobacco Control Act (Tobacco Control Act) granted FDA regulatory authority over tobacco products. This act directed GAO to report on trade in tobacco products, including the effects of differing tobacco tax rates. This report (1) reviews the market shifts in smoking tobacco products since CHIPRA; (2) examines the impact of the market shifts on federal revenue and Treasurys actions to respond; and (3) describes differences in FDAs regulation of various smoking tobacco products. GAO interviewed agency officials, industry members, and public health representatives. GAO analyzed tax and revenue data and reviewed relevant literature.
What GAO Recommends
As Congress continues its oversight of CHIPRA and Tobacco Control Act implementation, it should 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. Treasury generally agreed with GAOs conclusions and observations.
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Matter for Congressional Consideration
Comments: As of March 2020, Congress has not passed legislation to eliminate tax differentials between roll-your-own and pipe tobacco or between small and large cigars. In the 116th Congress, five bills have been introduced to create tax equity between roll-your-own and pipe tobacco, as GAO suggested in its April 2012 report. However, these bills have not been enacted. In addition, the 116th Congress has not passed legislation to address tax differentials between small and large cigars. Modifying tax rates to eliminate the tax differentials between similar tobacco products could address potential future revenue losses stemming from the substitution of higher-taxed products with lower-taxed products.
Matter: Disparities in tax rates on smoking tobacco products have negative revenue implications because they create incentives for manufacturers and consumers to substitute higher-taxed products with lower-taxed products. In light of that fact, as Congress continues its oversight of CHIPRA and Tobacco Control Act implementation, it may wish to consider modifying tobacco tax rates to eliminate significant tax differentials between similar products. Specifically, Congress may wish to consider equalizing tax rates on roll-your-own and pipe tobacco and, in consultation with Treasury, also consider options for reducing tax avoidance due to tax differentials between small and large cigars.