Mr. Chairman and members of the committee, my name is Dr. William Orzechowski. I am the senior partner of the economic consulting firm Orzechowski and Walker. We specialize in the economics of tax and regulatory issues. Our firm has over 30 years of combined experience in analyzing cigarette tax trends. Our firm publishes the Tax Burden on Tobacco, a comprehensive survey of historical data on tobacco revenues, prices and volume at the local, state and federal levels. The book is updated each year and is widely used across the nation.

Thank you for this opportunity to provide my perspective on the tobacco excise tax increases that are being proposed. 

Kansas is currently considering a cigarette tax increase proposal of 50¢ per pack followed by 4 cent increases in each of the subsequent 5 years.   If passed, the Kansas cigarette tax would rise from 79¢ to $1.29 per pack in 2008 -- a rate 658% greater than the 17¢ per pack tax in neighboring Missouri. It is well known in economics that consumers will seek lower priced substitutes if they are readily available. 

Given the proximity of low-tax neighboring states, finding cheaper alternatives should not be difficult. At $1.29 or $1.49 (five years from now), the proposed tax would be substantially above taxes in Nebraska (64¢), and Colorado (84¢). Given the exceedingly complex nature of Oklahoma’s new tribal compacts consumers could find similar savings with some OK tribal merchants where taxes as low as 5.75¢ per pack are available. These so-called exception rate compact stamps comprised 81.3 million packs in FY 2007 or about 27% of all Oklahoma cigarette sales. Adding in special “original” compact stamps at 26¢/pack jumps the total to 108 million packs. This is about 75% of total tax-paid sales in Kansas in FY 2007. Surely many of these compact packs could find their way into Kansas should it hike taxes. Certainly, the 60.75¢ special Kansas-border tax that Oklahoma currently offers tribes should be quite available. Finally, with the Internet many Kansas smokers can simply dodge high Kansas cigarette taxes by letting their fingers do the shopping tax-free.
 
When taxes are increased to high levels they can trigger a cross border backlash. This is all part of our system of fiscal federalism where we have 50 independent states and 50 independent tax policies. The virtue of this system is that allows competition across states. If a state tax is relatively high to its neighbors, citizens can simply “vote with their feet” by shopping in another state for a better deal. For example, high income and business taxes can cause people to take jobs and move their businesses to more favorable environments. In a similar fashion high excise and sales taxes can lead shoppers to states where taxes are lower. The advantage of our fiscal federalism is that such competition tends to keep taxes from getting too high in general.

When low-tax options are widely available the cross border dynamic is likely to lead to considerable reduction in sales for merchants in tax-increasing sales. Economists sometimes refer to this as the “elasticity of demand,” or the sensitivity of demand to tax-induced price increases. When cross border effects are included this elasticity of demand can be quite sensitive. In consequence, we see that the tax increase can often unleash many unintended cross border effects, such as smuggling, counterfeiting, and border shopping treks. For example, according to a study commissioned by the state of New York, 58% of New York smokers reported buying from sources that would not be reflected in taxable cigarette volume (1).  It is little wonder, then, that New York has seen its tax- paid cigarette sales volume fall by 45% since 1999 shortly before NY and NYC embarked on large tax increase.

The proposed $1.29 Kansas tax (in 2008) could likely spawn such a dynamic. In consequence, it is estimated that the 50¢-tax hike could reduce Kansas cigarette sales by nearly 20% as Kansas merchants see their competitive edge eroded by cigarette tax increases and Internet penetration.

Tax Incentives and the Kansas Cigarette Market

** The OK excise tax is $1.03 per pack but carries no sales tax. However, by compact, OK also permits particular tribes to buy 5.75¢/pack stamps. All OK tribal merchants near the KS border can buy 60.75¢/pack special KS border stamps.

After a 50¢ Kansas tax hike, tax savings with Missouri, Oklahoma tribes, and Nebraska would exceed the Advisory Council on Intergovernmental Relation's (ACIR) bootleg "flashpoint" of roughly $5.89 per carton.  ACIR found that tax differences above the “flashpoint” are likely to encourage investments in cigarette smuggling within a geographic region (2).  A typical smoker could save over $400 per year purchasing cigarettes in Missouri. Smokers could also reap huge savings via the Internet as well. Smugglers would also be enticed as a vanload of cigarettes from Missouri to Kansas would have a gross profit potential of about $63,000.
 
Evidence of Cross Border Effects

There is ample evidence that large cigarette tax differences among states can cause significant cross border effects. An eminent tax research group, the Tax Foundation, estimated that by 1997 Michigan had lost 30% of its cigarette market to smuggling and cross border sales (3).  The Michigan press took notice.  The headline of the Detroit Free Press on February 17, 1995 read “Smugglers Win.” The story was about cigarette smugglers in Michigan. And, according to the article “the money they get is more than they can get selling drugs."

When Michigan increased its cigarette tax from 25¢ to 75¢ per pack in May of 1994, Michigan cigarette sales nose-dived by 33 percent between FY 1994 and FY 1997.  During the same time period, annual cigarette sales went up by 15% in Kentucky, 16% in South Carolina, 10% in Indiana, 7.5% in Tennessee, 6% in North Carolina, 4% in Missouri, and 2% in Ohio.  Incredibly, the sales volume gain in the low-tax states more than matched the 300 million pack loss in Michigan and occurred during a time period when national cigarette sales volume stayed about the same.

In order to understand why Kansas retailers could suffer significant repercussions as a result of the tax, it is critical to understand the incredible changes in the national cigarette market over the last decade.  Cigarette purchasing patterns have changed dramatically due to more than 120-state cigarette tax increases since 1989.  High-tax states have seen tax reported sales plunge, while low-tax states have seen a corresponding increase.  The Tax Foundation examined this shift in a 1996 study, The Effect of Excise Tax Differentials on Smuggling and Cross Border Cigarette Sales.  They discovered that tax differentials between high and low-tax states were creating substantial increases in both casual cross-border purchases and the organized smuggling of cigarettes.  In a subsequent study, the Tax Foundation estimated that cross-border sales represented nearly 14% of total U.S. sales in 1997.

The Tax Foundation noted in the 1997 study that the following high-tax block of states -- California, Massachusetts, Michigan, and New York -- with an average tax of 73¢ per pack, sold fewer cigarettes than the following low-tax states -- Indiana, Kentucky, Missouri, New Hampshire, North Carolina, Tennessee, and Virginia -- with an average tax of 13¢ per pack.  Yet the four high-tax states had a population (65.4 million) nearly double that of the low-tax states (34.4 million).

More recent studies suggest that the current state cigarette market is even more sensitive to tax hikes, due to both rising interstate tax differences and the Internet. Moreover, because of these changes in the market, the revenue potential of cigarette tax hikes is being eroded (4). 

Recent cross border episodes include:

New York   - It has been estimated that contraband and cross border cigarette sales took nearly 25% of the New York market before large tax hikes in 2002 (5).  It is likely that contraband now takes over 40% of the New York market.  A 2005 New York State Department of Health report estimated that nearly 60% of New Yorkers evade the New York cigarette taxes (6). Sales from Indian reservations alone have a market share equal to 33% of New York 2005 tax-paid cigarette sales.  This estimate of a 33% contraband share is presumably a minimum estimate, since it just reflects sales on reservations. But surveys of New Yorkers who buy tax evading product “frequently” suggest that while 33% buy from Indian reservations another 11% buy from out of state (7).  In other words, it could be that the tax evading share could come close to 45% of present New York tax-paid sales. More ominously, cigarette smuggling has taken a violent turn with gangs involved in a smuggling war there responsible for 3 deaths in NYC (8). 

Illinois - Since 2002, Cook County has increased its cigarette tax to $2.00/pack. In response, its tax-paid sales have plummeted by over 50%. Tax paid per capita sales in Cook County were about 18.6 packs in FY 2007 compared to 135 packs per capita in nearby low-tax Kentucky

Kansas - The Sunflower State can to look to its recent past as a model. Kansas increased its tax by 55¢ in FY 2003 and its tax-paid cigarette volume skidded by 22% in FY 2003. This was a drop from 208.8 million packs in FY 2002 to 163.7 million packs in FY 2003.  By FY 2004 Kansas tax-paid volume had slipped to 153.5 million, a drop of nearly 27%. This was a very sensitive reaction to the tax hike, but is normal for states that border low-tax states and have a significant portion of the population living near such areas.  Kansas certainly fits this category since nearly 42% of its population lives in border counties. In fact, approximately 32% of the KS population resides along the low-tax Missouri border.

Missouri, which has kept its tax rate stable at 17¢, has benefited. While Kansas sales slipped by 55 million packs after the 2002 tax hike Missouri sales went up by about 40 million packs. In fact, tax-paid per capita sales in FY 2002 were fairly close between Missouri at 99.2 packs and Kansas at 77.5 packs. However, by FY 2007 tax-paid per capita sales were almost 100% greater in Missouri (100.6 packs) compared to Kansas (53.1 packs). This is a sure indicator that Missouri retailers have reaped a commercial bounty at the expense of other states such as Kansas. 

Similar reactions have occurred with other regional states that have a profile similar to Kansas. New Mexico saw its tax-paid sales fall by 30% after a 70¢ tax hike in 2003 due to the existence of tax-free tribal locations near its large cities. Nebraska lost nearly 20% of its tax-paid sales due to a 30¢ increase in 2002. Nebraska has some tax-free merchants in the Omaha area and it also borders low-tax Missouri.

Commercial Losses – 50¢ Cigarette Tax Increase

• The Impact of a 50¢ Cigarette Tax Hike – A 50¢ per pack tax hike would cause the tax per pack to rise from 79¢ to $1.29.  It is estimated that this tax hike would drop Kansas tax-paid cigarette sales volume by approximately 18%. The subsequent 4¢ tax hikes for the next five years would like drop Kansas sales by another 5% by 2014 (a 23 % drop in sales all told)
• Loss in Cigarette Sales Volume – Cigarette volume would fall by 27 million packs if the tax were increased by 50¢ in FY 2009.  Most of these sales would be lost to low-tax states, Indian Reservations, and Internet merchants. 
• Loss in Kansas Gross Profits (value added) - Gross profits lost to Kansas retailers and wholesalers would be about $20 million due to the loss of cigarette sales and sundry products. 
• Convenience Store Losses – C-Store cigarette sales would fall by nearly 18 million packs.  Gross profit losses on average would exceed $11,000 per store due to the loss of cigarette volume and sundry product sales.  This means each store would have to boost gross retail sales of other items by $60,000 to make up for the damage wrought by the tax hike. At $5/six pack, a C-Store would have to sell about 12,000 more six-packs per year to replace the lost tobacco customers that would be buying over the Internet or seeking cross border options.

Commercial Losses – Raising the OTP Tax From 10% to 57% of Wholesale Value

The OTP Market In Kansas –   It is estimated that nearly $75 million of OTP was sold in Kansas. This included an estimated 17 million containers of smokeless tobacco product (about 84% of this moist is snuff). Cigar volume was estimated to about 78 million units. If Kansas increased its OTP tax from 10% to 57 % of wholesale value the tax would tower over the tax in Missouri (10% of wholesale value) and Nebraska (20% of wholesale value). At 57%, a Kansas consumer of premium moist snuff would have to pay about $1.77 per can in Kansas taxes.  The same can in Missouri would only be taxed at 31¢ - the savings would be about $1.46 per can or $14.60 per sleeve of 10. Such incentives would likely entice many tax-evading sales since many of these OTP sales do not carry a tax stamp.

Loss in STP Sales Volume Due To Increasing the OTP Tax from 10% to 57% of Wholesale Value – Overall, STP (smokeless tobacco product) volume is estimated to likely to fall by about 37%. For example, it is estimated that moist snuff tobacco volume would fall by over 6 million containers.   Most of these sales would likely be lost to low-tax states and Internet merchants. 

Loss in Retail Sales – The lost value of STP sales is estimated at approximately $20 million. Sundry product sales, or products normally bought in conjunction with tobacco products, would fall by nearly $5 million (based on past estimates of this phenomenon by Price Waterhouse). 

Consumers Hit Hard by Tax   

Unfortunately, those who pay most of the cigarette taxes tend to be able to afford it the least.  A report by the U.S. Congress’ Congressional Budget Office (CBO) stated that excise taxes are the most regressive type of tax and tobacco excise taxes are “the most regressive of all.”   A more recent study by the Barents Group of KPMG Peat Marwick found that cigarette taxes are very regressive, extracting a far greater percentage of income from modest wage earners compared to those with high incomes.   

Barents looked at U.S. families in the bottom half of the income distribution, those earning approximately $30,000 a year or less.   While this group represents roughly 50% of all households in the country, it earns only 16% of all income generated nationwide.  This group paid about 15.3% of all federal income and FICA taxes, but paid over 47% of all tobacco taxes (9).   

The total tax burden on a pack of cigarettes is high in Kansas. The current state tax is 79¢/pack and the sales tax is about 21¢/pack. Kansas also received Master Settlement Payments of about $48.2 million in FY 2006. This settlement tax adds another 42¢.  Plus the federal excise tax is now 39¢. Add those taxes up and they total $1.81/pack. It is important to realize that Kansas’ high cigarette taxes are aimed at the working man or blue collar worker. According to a 2005 BLS report, average annual expenditures on tobacco were $582 per consumer unit for construction workers and mechanics, $482 for operators and laborers, and $377 for service workers. By contrast, tobacco expenditures for managers and professionals were $251. In other words, construction workers are spending on average about 131% more than do professionals on tobacco. Clearly Kansas’ high cigarette tax is discriminating against blue collar workers (10).   

If Kansas were to install a $1.29 cigarette tax, a Kansas consumer would have to drink nearly 13-six-packs of beer (KS tax is 10.1¢/six pack) to pay the potential $1.29 tax on just one pack of cigarettes in Kansas. The Kansas beer tax was last increased in July of 1977.

Notes

(1) Kevin Davis; Matthew Farrelly, Qiang Li, and Hyland Andrew, 2006. “Cigarette Purchasing Patterns among New York Smokers: Implications for Health, Price, and Revenue,” New York State Department of Health.
(2) The original ACIR estimate was $2.30/carton in 1983, which would be $5.89/carton in 2007 after adjustment for inflation. The flashpoint is not a definite trigger but rather a threshold. The further the flashpoint is exceeded, the more smuggling becomes attractive.
(3) “How Excise Tax Differentials Affect Interstate Smuggling,” Background Paper No.26, Tax Foundation, October 1998.
(4) Economists Austan Goolsbee and Joel Slemrod suggest that the sensitivity of cigarette demand has increased and that an elasticity of demand exceeding (1.2) is more commonplace due to smuggling and Internet options. See Goolsbee and Slemrod, “Playing with Fire: Cigarettes, Taxes and Competition From The Internet,” NBER (draft), December 21, 2004. Another recent article suggests that tax avoidance is rising and that cross border sales can take a high percentage of the recorded drop in tax –paid sales. See, Mark Stehr, “Cigarette Tax Avoidance and Evasion,” Journal of Health Economics, December 19, 2004.
(5) See, Organized Crime and the Smuggling of Cigarettes in the United States – the 2001 Update, FIA, The Corporate Forensic Investigator, September, 2001, page 52.
(6) New York Department of Health Study; see footnote 1.
(7) Ibid., p. 4-15.
(8) “3 Die in Cig War,” New York Daily News, 10 December 2003.
(9) Barents Group LLC, The Burden of Consumer Excise Taxes on Lower-Income Taxpayers (Washington, D.C.), 19 May 1997. Prepared for the Tobacco Institute.
(10) “Tobacco Expenditures by Education, Occupation and Age,” Consumer Expenditure Survey Anthology, Bureau of Labor Statistics, 2005.