Chapter 8 Tax avoidance and tax evasion

Introduction

Tax avoidance and tax evasion can next section explains the motivation to products illegally traded across decrease the economic welfare for tax avoidance and tax evasion, borders. Illicit trade is defined in by making tobacco products more and categorizes these motives based Article 1 of the WHO Framework affordable and available, thus whether they are related to profit Convention of Tobacco Control exacerbating the negative health generation, costs of supplying illicit (World Health Organization, 2005) as consequences associated with products, deterrence or an overall any practice or conduct prohibited by tobacco use and secondhand state of the economy. The third section law and which relates to production, smoking. provides the most recent estimates shipment, receipt, possession, Furthermore, tax avoidance of the extent of tax evasion globally, distribution, sale or purchase, and tax evasion can undermine the regionally and also in some selected including any practice or conduct impact of tobacco control measures, countries. The following section intended to facilitate such activity. primarily tobacco tax policies. The reviews the literature on the impact Illicit tobacco trade covers more existence of illicit tobacco trade of tax avoidance and tax evasion activities than the circumvention of has been used to increase political on public health measures such as taxes, but includes all illegal activities pressure on governments and smoking rate, smoking intensity and related to the tobacco trade. discourage them from adopting and heath disparities. The final section Economists mostly refer to the implementing effective tobacco tax reviews the impact of policies circumvention of taxes, and prefer to strategies. Moreover, illicit tobacco attempting to curb illicit tobacco trade use the terms tax avoidance (legal trade can channel sales proceeds to and summarizes the lessons learned methods of circumventing tobacco organized crime and lead to a loss in from the implementation of those taxes) and tax evasion (illegal government tax revenues. policies. methods for circumventing tobacco This chapter reviews and taxes). summarizes the research evidence Defining and measuring tax This section defines the activities related to tobacco tax avoidance and evasion and avoidance of tax avoidance and tax evasion that tobacco tax evasion from published fall into each category and briefly literature and empirical evidence. This Among those working on tobacco describes approaches to measuring body of information is organized in five tax issues, a variety of circumventing the extent of both, drawing heavily sections. The first section explains the activities for not paying all tobacco from the classification scheme difference between tax avoidance and taxes are often grouped together proposed by Joossens and colleagues tax evasion, defines the activities that and referred to as “smuggling” or (2000) and the methods described fall into each category, and describes “illicit trade” in tobacco products. in IARC’s Handbooks of Cancer methods used in measuring the A clarification of the terms used is Prevention Volume 12, Methods for extend to which these activities supply necessary as those terms cover Evaluating Tobacco Control Policies tobacco products to the market. The different activities. Smuggling refers (IARC, 2008), the World Bank’s tool

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on tobacco smuggling (Merriman, US states). However, enforcement of through direct channels (Chaloupka 2001), and the book chapter by these provisions is difficult. et al., in press). Differences in legal Merriman and colleagues (2000). Tourist shopping. This type of obligations for paying taxes in the tax avoidance is similar to the cross- home jurisdiction can make this Tax avoidance border shopping described above, type of activity more a form of tax but involves the purchase of tobacco evasion than tax avoidance (e.g. EU Tax avoidance includes legal activities products in more distant jurisdictions, countries). and purchases in accordance with again subject to the constraints Industry reformulation or customs and tax regulations, most imposed by customs laws and/or repositioning. Tobacco companies of which include the payment of other policies (e.g. consumption can reduce the tax imposed on some tobacco taxes, and are done of tax-paid cigarettes by the large their products by reformulating or mostly by individual tobacco users, tourist population in Thailand). This repositioning their products. For including cross-border shopping, is a more limited phenomenon, but example, in countries with multitiered tourist shopping, duty-free shopping, can account for a significant share tax structures where higher taxes Internet and other direct purchases, of overall tobacco product sales in are levied on higher-priced brands, industry reformulation and/or popular tourist destinations. a company can lower the price of repositioning. These include: Duty-free shopping. This type of its product so that it moves from a Cross-border shopping. This tax avoidance is similar to the others, higher tax tier to a lower tax tier. As type of tax avoidance involves but in this case involves the purchase occurred recently in Germany, where individual tobacco users residing in of tax-free tobacco products cigarette taxes are based on quantity, higher tax jurisdictions purchasing purchased in airports, on airlines, companies produced long cigarettes tobacco products in nearby lower- and in other travel-related venues. that were readily cut into smaller, tax jurisdictions for their own Again, most governments impose standard size cigarettes, effectively consumption within the customs limits on how much an individual can reducing the tax per cigarette. constraints. This can involve crossing purchase and bring home from duty- national borders, particularly where free sources. Tax Evasion such border crossing is freely or Internet and other direct relatively easily done (as between purchases. This type of tax avoidance The activities included under tax the European Union Member States) involves individual tobacco users evasion are the illegal methods or can take place within a given buying tobacco products online, of circumventing tobacco taxes, country where there are significant through the mail, or over the phone such as the purchase of smuggled differences in subnational taxes (as from establishments based in low- and illicit manufactured tobacco in Canada where provincial taxes tax jurisdictions for consumption in products. Those activities include differ, or in the United States where their own higher tax jurisdiction. This both small and large quantities and state and local taxes can vary has attracted the most attention in often, but not always, involve efforts considerably across jurisdictions). the USA, given relatively widespread to avoid paying any taxes. Many of Within some countries, this also access to the Internet and significant these activities are done by larger involves purchases from shops differences in subnational taxes. criminal networks or other large- located in tax-exempt areas, such For US consumers, for example, scale operations. as Aboriginal reserves in Canada these may include purchasing from Small-scale smuggling. This type and Native American reservations vendors based on Native American of tax evasion involves the purchase, in the USA. In some cases, there reservations, in low-tax states or by individuals or small groups, are limits on how much can be in low-tax countries; as above, of tobacco products in low tax purchased outside of the jurisdiction however, purchasers are obligated jurisdictions in amounts that exceed in which the individual resides (e.g. to pay taxes to their home state on the limits set by customs regulations, the European Union), while in others these types of purchases. Over the for smuggling or resale in high-tax the individual is supposed to pay the past several years, US states have jurisdictions. difference between the tax in their taken steps to curb direct purchases This type of tax evasion is home jurisdiction and the tax they through a variety of policy and illegal in that the quantities involved have paid on the products purchased enforcement actions and Internet exceed the allowable limits and that in other jurisdictions (e.g. in various and few smokers purchase cigarettes the purchase does not include the

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taxes that are supposed to apply in Illicit manufacturing. This type of Over the past few decades, multiple the jurisdiction where they are used. tax evasion refers to the production approaches have been developed As with cross-border shopping, of tobacco products contrary to law. and applied, each of which captures this is more likely to occur when The laws in question may be taxation some part of the full picture. The tax differentials among nearby laws or other laws (such as licensing various approaches used to estimate jurisdictions are large and where or monopoly-related laws) that the scope of tax avoidance and border crossing is relatively easy. For restrict the manufacture of tobacco. evasion are briefly described below; example, small-scale smuggling is This type of tax evasion includes estimates based on these methods for one form of tax evasion that occurs underreporting of actual production various countries are presented later between US states, most notably quantities with the difference between in this chapter. Given the different low-tax states with no tax stamps reported and actual production dimensions of tax avoidance and (such as South Carolina) where diverted through illegal channels or, evasion captured using the different small-scale smugglers buy tax-paid in some cases, complete avoiding of methods and the inherent limitations cigarettes and then resell in high-tax reporting with all production diverted in each method, a combination of states. to black markets. This type of illegal multiple methods will be most likely Large-scale smuggling. This type manufacturing is more likely to occur to produce a good measure of the of tax evasion involves the illegal in countries without effective tax extent of overall tax avoidance and transportation, distribution, and administration that includes monitoring evasion (IARC, 2008). sale of large quantities of tobacco of actual production, and in regions Expert opinion. One widely used products, conducted by criminal where distribution of the illegally approach to assess the extent of networks, that generally avoid all produced cigarettes is relatively easy. overall tax avoidance and evasion is taxes. As Joossens and colleagues Counterfeit tax stamps are often to ask “experts” for their estimates (2000) describe, this typically applied to illegally manufactured of these activities, where the involves: international brands that products when these products are experts may be customs and other are sold by multinational tobacco distributed in countries that require law enforcement officials, industry companies and which are easily sold; tax stamps. The destination of the representatives, researchers, transportation over longer distances illegally manufactured cigarettes tobacco control advocates or others and often involving “in-transit” can be the domestic or a foreign with a particular interest in the issue regimes and tax-free zones; the market. Illicit manufacturing includes (Merriman, 2001). Such estimates passing of tobacco products through counterfeiting. are subjective and can be biased a wide range of owners; large Counterfeiting. Counterfeiting based on the individual expert’s organized-crime networks; and a involves the production and position and interests. Tobacco sophisticated system for distributing distribution of products bearing a industry informants, for example, smuggled cigarettes locally. To avoid trademark without the approval of the may have an incentive to report high detection, counterfeit tax stamps are trademark owner. These products levels of tax avoidance and evasion often applied to smuggled cigarettes are produced illegally, often bear as a way of averting tax increases, that are being sold in jurisdictions counterfeit tax stamps (depending while tobacco control advocates that require such stamps. Large- on where they are being sold), and may understate the extent of the scale smuggling has also been used are distributed through the networks problem in their efforts supporting for large consignments of counterfeit established by large-scale smuggling tobacco tax increases. Estimates cigarettes or for legally manufactured operations. China has been a based on expert opinion are most cigarettes which are targeting the major manufacturer of counterfeit prominent in trade and government illicit markets in other countries. One cigarettes (Shen et al., 2010) publications. Overall, however, example is the cigarette brand Jin measures based on expert opinion Ling, which is legally manufactured in Measuring tax avoidance are generally consistent with those the Russian Federation, but destined and evasion derived from other approaches, for the illegal market in Germany and suggesting that such measures are other European countries and which Given the illicit nature of tax valid (IARC, 2008). was one of the most seized cigarette avoidance and evasion, developing Comparison of export and brands in Europe in 2008 (World accurate measures of the extent import statistics. One approach to Customs Organization, 2009). of these activities is challenging. estimating the extent of large scale

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smuggling is to compare export of a measure based on this approach Hyland and colleagues (2006), for and import statistics. The difference (IARC, 2008). example, reported data from the between recorded exports and Modelling of tobacco product International Tobacco Control Policy recorded imports is likely to reflect demand. A relatively widely used Evaluation Study’s (ITC) surveys of product diverted to illegal markets approach among tobacco control representative samples of smokers while in transit. This approach is researchers is the econometric in Australia, Canada, the United likely to produce a valid measure modeling of tobacco product Kingdom and the United States which for the global level of large-scale demand using data from multiple include questions on cross-border, smuggling of legally manufactured neighbouring jurisdictions (e.g. US duty-free, native reserve, Internet cigarettes, but is unlikely to produce states, European Union Member and other direct purchases, and the same for small-scale smuggling States). Researchers using this other options that potentially reflect and illicit manufactured cigarettes approach have included variables untaxed or lower taxed purchases. or at the country level (IARC, 2008). measuring the opportunities for They found relatively low rates of Merriman and colleagues (2000), tax avoidance and evasion based individual tax avoidance in Australia for example, used this approach in on differences in prices across (0.7–1.1%), Canada (3.1–3.7%), and their efforts to assess the extent jurisdictions, population distributions the United States (4.8–6.1%), but of illicit trade in cigarettes, finding near borders, extent of cross-border high rates in the United Kingdom that about one third of recorded or tourist traffic, Internet penetration, (15.3–19.7%), with rates increasing exported cigarettes in the mid-1990s and other factors reflecting access in each country over the two waves did not appear in recorded imports, to lower tax/price jurisdictions. of their surveys. accounting for about 6% of global Coefficient estimates from the Observational data collection. cigarette consumption. resulting models can be used to A relatively untested but potentially Comparison of tax-paid sales and predict what tax-paid sales would promising approach to assessing individually reported consumption have been if the variables reflecting multiple dimensions of tax avoidance measures. If there are no reporting the incentives/opportunities were set and evasion is direct observation biases in measures of tax-paid to zero, with the difference between of tobacco product vendors or sales and measures of average predicted sales and actual sales collection of packs/containers from consumption and prevalence reflecting the extent of tax avoidance tobacco product users or other obtained from representative and evasion. Depending on what sources. Products can be examined population surveys, then the opportunities are being modelled, for tax stamps, local warning labels, difference between the two will reflect this approach can be used to assess other pack markings, and product the extent of overall tax avoidance individual cross-border shopping and constituents to identify products and evasion (IARC, 2008). However, direct purchases, as well as small- that do not bear the appropriate it is likely that there will be some scale smuggling. This approach has stamps/labels/markings or that temporal biases in tax-paid sales been used widely in the USA (see, include constituents that differ from measures, as these generally reflect for example: Becker et al., 1994; those contained in locally produced shipments at the factory or wholesale Yurekli and Zhang, 2000; Farrelly et products. As part of the ITC survey level rather than actual consumption. al., 2003) and, to a limited extent, in in Poland, for example, interviewers More importantly, there is likely to be European countries (Merriman et al., were trained to recognize Polish tax some degree of underreporting of 2000). stamps, warning labels and other tobacco use in population surveys. Survey of tobacco users’ purchase pack markings, as well as the same To the extent that the bias in each behaviours. Representative surveys for Ukraine, Belarus and the Russian is constant over time, changes in of tobacco product users that collect Federation in an effort to assess the the difference between the two can information on various aspects extent of tax avoidance/evasion in the indicate whether tax avoidance and of purchase behaviour, including Polish cigarette market (IARC, 2008). evasion are increasing or decreasing purchase location and price, can Merriman (2010) applied a novel twist over time (Merriman, 2001). However, be helpful in assessing the extent on this approach by collecting littered as social norms against tobacco use of various forms of individual tax cigarette packs around Chicago strengthen over time, the extent of avoidance, including cross-border in an effort to assess the extent of underreporting in population surveys shopping, direct purchases, and avoidance/evasion of the local Cook is likely to grow, reducing the validity duty-free purchases (IARC, 2008). County and Chicago cigarette taxes,

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finding that three fourths of the packs In a competitive market, profits extensively in the USA and in Europe collected in Chicago did not bear the from illicit tobacco trade will be driven where sufficient data exist and where Chicago tax stamp. In an ongoing to zero. This implies that, in the long a sizable population lives in a close effort, the ITC project is collecting run, the cigarette tax revenue the proximity to another state/country cigarette packs from survey government loses to smugglers is (Vedder, 1997; Cnossen, 2005). respondents in a variety of countries entirely consumed by excess travel Several US studies measured the that will be examined for relevant costs and costs to avoid detection. strength of the relationship between pack markings, with sophisticated This is a wasteful use of scarce the price/tax differences and cross- product testing methods used to test societal resources (Bhagwati and border shopping. Baltagi and Levin for various product constituents that Hansen, 1973). (1986) studied cigarette small- appear at higher levels in counterfeit scale smuggling in the USA using a cigarettes. These approaches are Price/tax differences and their dynamic demand model and a panel limited by observers’ abilities to magnitude as determinants of profit data from 46 states on per-capita distinguish licit and illicit (particularly sales over the period 1963–1980. counterfeit) products and by the ability Cigarette prices are high relative to They found the cigarette demand to differentiate licit and illicit products their production costs, in part due to be sensitive to price differences based on product constituents, but to higher level of taxation. Price of between the state of residence and do appear promising for capturing at tobacco products and the total tax the neighbouring states: a 10% price least some aspects of tax avoidance levied on them are related to the increase in a neighbouring state and evasion. amount of profit for those involved in caused a 0.8% increase in taxed illicit trade. sales in the home state in the short Determinants of tax avoidance/ The absolute price level and run and a 0.21% increase in the evasion the relative price differences can long run. Baltagi and Levin (1992) affect the method of delivery of illicit updated their previous study by The determinants of tax avoidance/ cigarettes to the market. adding data for 8 additional years evasion are related to tax/price Small-scale smuggling and extending their panel data to 1963– differences, tobacco products’ legal cross-border shopping are 1988 for these 46 US states. Using affordability, corruption, weak tax primarily motivated by the relative various model specifications, they administration and/or customs, and price differences between adjacent found similar results with respect to informal distribution networks as well geographical areas. These price the price sensitivity of the cigarette as to the involvement of global and differences may be driven by tobacco market to the price difference with new firms. The determinants of the taxes or tobacco industry pricing the neighbouring states. supply of illicit tobacco products are strategy (Baltagi & Levin, 1986, Goel (2008) used more recent related to the profit from the sale of 1992). The difference in price or/and cross-section state-level cigarette these illegal products. The greater tax rate represents the upper limit sales data from the United States the reward and the lower the costs on the incentive to bootleg or shop from 2002 to conclude that price of supplying these illicit products, the across the border due to transaction differences provide the main greater the probability an individual costs involved in this form of supply motivation for cigarette smuggling as will engage in it. The reward depends (Licari & Meier, 1997). compared to non-price factors related on the difference in profits from Wholesale/large scale smuggling to the probability of apprehension. legally sold versus illegally supplied is likely to be correlated with the According to his study, a 10% cigarettes. country’s absolute retail price of increase in the lowest cigarette price The costs are related to the cigarettes (Merriman et al., 2000), in adjacent US states increases a probability of detection, the magnitude because the larger the retail price, state’s cigarette sale by about 10%. of punishment, the opportunity costs the larger the profit for large-scale DeCicca et al. (2010) found like foregone salaries from other smugglers who pay wholesale relatively larger sensitivity of tax employment and the cost of the international price for their supply (FIA avoidance and tax evasion to the capital employed in smuggling. Other International Research Ltd, 1999a). tax/price difference: 1% increase costs may include the cost of bribery The motivation for small- in home-state price increased the (Merriman et al., 2000). scale smuggling and legal cross- likelihood of purchasing cigarettes border shopping has been studied in a neighbouring state by 3.1%

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while controlling for the distance to A review of 24 peer-reviewed represent a fairly small part of the the border. However, the study used studies and studies by reputable total cigarette market. However, legal individual-level survey data that do researchers using US data provided cigarette purchases by tourists and not capture small-scale smuggling, evidence that tax avoidance/evasion foreign visitors (that are not part of and self-reported prices that can be via Internet was related to the level of local consumption) were significant— endogenous. Their result that the cigarette taxes: US smokers living in up to 50% of legal sales. This probability of cross-border shopping states and cities with high cigarette has been confirmed by the Finish approaches zero at a distance to the excise taxes were more likely to authorities that reported that legal border of about 300 miles does not purchase non-taxed cigarettes cross-border cigarette shopping by seem realistic and indicates problems online than smokers living in low-tax Finish travellers amounted to 12% of with the model specification. The jurisdictions (Ribisl et al., 2006). total national sales in 1996 (Lipponen author suggested that there is a In Europe, Merriman et al. et al., 1998). surge in cigarette tax avoidance (2000) used cigarette sales data Buck, Godfrey and Richardson and evasion immediately after a for 1989–95, cigarette prices and (1994) showed that in the early to tax increase, which then quickly frequency of travel from 18 countries mid-1990s there was little incentive subsides within several months. A to estimate the incentives for small- for cigarette cross-border shopping similar observation was made by scale smuggling and cross-border between France and Britain, because Farrelly, Nimsch, and James (2003). shopping. Controlling for the level the savings on 800 cigarettes bought As noted above, Merriman (2010) of corruption and income, he found in France and taken back to Britain employed a novel empirical approach that policies that raise incentives for would be outweighed by the cost to estimate tax avoidance/evasion in small-scale smuggling and cross- of the trip. Cross-border shopping the city of Chicago and its sensitivity border shopping, such as a cigarette existed at that time, but only when to tax differences in the neighbouring tax increase, will significantly reduce smokers were already across the jurisdictions. He collected a random domestic tax-paid cigarette sales. border for other reasons. Estimates sample of 2391 littered cigarette If these incentives to bring cheaper of United Kingdom Department of packs in the city in 2007 and studied cigarettes from abroad were reduced HM Customs & Excise confirmed that their probability of having the correct to zero, the official domestic sale legitimate cross-border shopping local tax stamp. The difference would increase by 3%. If foreigners was a minor problem in 1997 when between the tax in Chicago and would not have incentives to buy the legitimate personal imports of surrounding counties equal to $2.68 cheaper cigarettes in a country, this tobacco products was less than 0.5% decreased the probability that a country’s domestic sale would fall by of total cigarette sales (HM Customs littered pack has a local stamp by 1%. For example, a unilateral 10% & Excise, 1998). almost 60 percent. On the other cigarette price increase in Germany The situation changed in the hand, increasing the distance to would reduce yearly cigarette sale second part of 1990s when cigarette the lower-tax state border by a one by 6 packs per capita, but would prices in the United Kingdom mile increased the probability a increase yearly cigarette purchases increased by about 25% from 1997 to pack has a local stamp by about one abroad by 3 packs per capita, 2000. The United Kingdom Treasury percent. That means that compliance resulting in a 3-pack per capita estimates that the market share of increases rapidly with the distance reduction in consumption. illicit cigarettes in the United Kingdom to lower-taxed border and that the Taal et al. (2004) analysed sales rose from about 3% in 1996–97 distance provides a significant and survey data from Estonia, to about 18% by 1999–2000 (HM barrier to tax avoidance. However, a European country with high Customs & Excise, 2000). the results of Merriman (2010) are not incentives for small-scale smuggling In France, similarly, the substantial directly comparable to econometric and cross-border shopping from tobacco tax increases in 2003 and studies that report tax compliance 1993 to 2000, when cigarette prices 2004 that led to higher cigarette at the national or state level due to there were up to four times lower than prices were blamed for an increase the potential selection bias. This bias in neighbouring Finland and Sweden in cross-border purchases of tobacco arises due to the possibility that those (but considerably higher than in products (both legal and illegal) who litter are also less law obedient, another neighbour, the Russian IURPDQHJOLJLEOHDPRXQWWRí therefore more likely to engage in tax Federation). They found that illegal of total sales in 2005 and 2006 avoidance/evasion. purchases of cigarettes by Estonians (Lakhdar, 2008).

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The evidence on tax avoidance/ They found that the countries with Islamic Republic of Iran (World evasion in Asia is scarce. Tsai, Sung, the lowest income had the lowest Health Organization, 2003) have Yang and Shih (2003) used survey average prices for legally sold prohibited or severely limited the data collected in 2000 among 437 cigarettes, but also the highest illicit importation of foreign cigarettes. smokers of imported cigarettes and cigarette market share. This suggests The tax on imported cigarettes in found that higher cigarette prices a negative relationship between the China was 244% in 1997 (reduced were the primary motivation for illicit cigarette market share and the to 217% in 1999), but foreign purchasing of smuggled cigarettes cigarette price level. cigarettes with prices lower than in Taiwan, China. A 1% increase in Joossens and Raw (1998) found this tax were easy to find in urban cigarette price raised the likelihood the same situation in EU countries China (Hu & Mao, 2002). Viet Nam of purchasing smuggled cigarettes in 1995: many European countries banned cigarette imports from 1990 at least 2.60 times (95% confidence with high tobacco taxes and prices till 2007. Yet, foreign cigarettes were interval: 1.08–6.26). Smokers who had low estimates of cigarette sold at a premium in the street of spent more money on cigarettes were smuggling, while illicit cigarette trade Hanoi (Joossens, 2003). Even after more likely to purchase smuggled was prevalent in southern European lifting the import ban, cigarettes cigarettes, but personal income countries where taxes and prices and cigars are subject to an import was not significantly associated were low. The authors suggest that duty of up to 225%. The illegally with smuggled cigarettes purchases the size of illegal market in a country imported brands (primarily Winston (Tsai et al., 2003). is determined by fraud and illegal and Magna) represented about 50% Nelson (2002) suggested that trade, and not by the level of tobacco of the total cigarette market in the the size of the potential cross-border taxes/prices. Islamic Republic of Iran in 1994, and market plays an important role in the Data from southeastern Asia the industry estimated that the illegal formulation of tax policy for cigarettes. also point to no relationship between or tax-free products had 68% market US states with a large potential countries’ tax rates, cigarette prices share in the country (World Health cross-border market are more likely and the level of illicit cigarette trade. Organization, 2003). to set tobacco tax rates below that For example, in the early 2000s Two older studies suggest that of neighbouring states to attract non- cigarette tax in Singapore was smuggling in low- and middle-income residents to purchase cigarettes in among the highest in the region countries increases with the level their state, therefore exporting their (about 51% of retail price), but the of tariffs and taxes (Bhagwati and tax burden. This seems to be the estimated share of illegal cigarettes Hansen, 1974; Simkin, 1974). case of Luxembourg, a country with on the market was only 2% of Differential pricing for cigarettes a high density of foreign population domestic sales. On the other hand, intended for export and for the living near its borders that is setting its illicit cigarettes accounted for about domestic market can motivate re- cigarette taxes at a level considerably 37% of domestic sales in Cambodia, import of products designated for lower compared to its neighbours. yet the tax represented only 20% export. To limit this behaviour, in Using data from 1993, the estimates of retail price, one of the lowest tax 2000 the US federal government indicate that 85% of cigarette sales rates in the region (Ministry of Health banned imports of cigarettes that in Luxembourg were due to cross- Republic of Indonesia, 2004). are intended for export only (FIA border sales (Joossens & Raw, 1995). International Research Ltd, 1999b). There is less evidence to support Differential treatment of domestic the theory that wholesale/large-scale versus foreign products Cost of supplying illicit tobacco to the smuggling is likely to be correlated market determines net profit with the country’s absolute retail price. Restrictions on the supply of imported Merriman et al. (2000) found tobacco (by imposing quotas, tariffs, The costs of supplying illicit products no significant correlation between and other non-tariff barriers such as a include the cost of manufacturing experts’ estimates of large-scale prohibition on sale, which is similar to and/or obtaining tax-free cigarettes, smuggling from 38 countries and the an infinite tax) can lead to significant the cost of access to capital, average legal cigarette price. price differences and motivate illicit transportation, distribution and Joossens et al. (2010) employed trade (Taylor et al., 2000). countering the government’s effort a larger data set of low-, middle- and China (Hu & Mao, 2002), Viet to control tobacco illicit trade as high-income countries (84 in total). Nam (Joossens, 2003) and the this relates to the possibility that

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the smuggler\counterfeiters will The transportation costs for small- Insufficient pack markings reduce be apprehended and penalized if scale smuggling will be lower if the probability of illicit cigarettes being caught. In addition, these costs a large share of the population confiscated, therefore reducing the depend on the opportunity cost of lives near the border with another costs of involvement in illicit cigarette time (as this influences the cost jurisdiction (Saba et al., 1995). This trade. Press articles have reported of labour) and social norms with is particularly relevant for Europe that introducing a tax-stamp by the respect to supplying illicit cigarettes and the USA, where a sizable state of Michigan in 1998 helped to (people who believe that engaging population lives in a close proximity reduce the sale of illicit cigarettes in cigarette smuggling is immoral to another state/country (Vedder, (Hyde, 1998). will need to be compensated more 1997; Cnossen, 2005). The relatively weak government to convince them to get involved in Joossens (1998) argued that the controls and the slowness of this activity). ease of evasion of legal authorities the judicial process reduce the The costs of obtaining legally might be more important than price opportunity costs of illegal cigarette produced cigarettes are related to when it comes to the proclivity of manufacturing in Brazil (Ramos, export/wholesale prices and can individuals to engage in tobacco 2009). The majority of cases vary by the country of destination smuggling. involving illicit cigarettes do not (Yurekli & Sayginsoy, 2010). The perceived probability of fall under criminal jurisdiction, and New technology such as interdiction depends on the actual contraband cases are mostly treated sophisticated and less-expensive level of enforcement. Anthony (2004) as low-priority misdemeanours that computer scanners reduce the suggests that drug smugglers ignore end with the release of the prisoner production costs of counterfeit the risk of being caught up to a and sometimes even include the cigarettes and boost their supply on point, and that there is a threshold restitution of goods and/or vehicles the market, such that in 2007 these interception rate beyond which the involved. Inadequate legislation cigarettes made up 15% of illicit smuggling rapidly declines. However, compounded by a lack or absence cigarette trade globally (Euromonitor some smugglers are undeterred of specialized prosecutors and International, 2008). even when there is 100% probability judges does not enable authorities to Obtaining tax-free tobacco of detection. This could be due to confront associated drug trafficking can require capital investment the practice of receiving advanced and money-laundering activities. In into transportation equipment. payments for taking the risk, which addition, handling illicit merchandise Smugglers’ transport costs are likely could be greater than the lost earnings is socially accepted in Brazil. As to be greater than those engaged due to jail time. a result, the production of illegal in transporting a similar weight and In the United States, small- cigarettes in Brazil reached some 9 volume of legal goods, because of scale smugglers often use the billion cigarettes in 2007, about 6.4% the need to avoid detection (Bhagwati superhighways, where the likelihood of the total cigarette market (Ramos, and Hansen, 1974). Therefore, this of detection is minimal (Walsh & 2009). The size of the illegal market activity represents inefficient use Ottaway, 2000). Compared to large- in Brazil is unclear, but experts of limited resources (Bhagwati and scale smugglers, they face lower estimate that it is about 30% of total Hansen, 1974). In Malaysia, for costs of supplying illegal products to sales (Ramos, 2009). example, smugglers use speedboats the market, because purchasing tax- The opportunity costs of time to increase their chances of escaping paid tobacco in a low-price jurisdiction can determine the willingness of when chased by police and/or border and transporting it to a high-priced population to engage in illegal patrol (Unknown, 1995). one reduces the legal risk for those activities. When Australian farmers’ On the other hand, Jensen involved in the business (Licari & opportunity costs of time dropped and colleagues (1991) argued that Meier, 1997). due to declining official market price transport costs in the USA account Goel (2008) found that the of raw tobacco and the diminishing for only 0.5 percent of the value of probability of apprehension, legal outlet for tobacco, some of tobacco products, and that their measured by the number of police per them began to divert their tobacco effect on smuggling is negligible. 1000 inhabitants, plays a relatively to illicit markets (Geis et al., 2003; Transportation costs may wary minor role in cross-border cigarette Geis, 2005). by geographical regions and the smuggling in the USA. The costs of distribution of illicit type of tax avoidance/evasion. cigarettes are important motivators.

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These are discussed in more details Germany. Taal et al. (2004) reported US$ 2 068 668 revenue loss for the below. that Finns made approximately 3 state of Washington (The Financial million visits to Estonia in 1998, Action Task Force, 2010). Duty- The supply chain for illicit tobacco and that travellers from Finland and free shops facilitated small-scale (distribution) reduces cost of illicit Sweden consume up to 50% of smuggling from Estonia to Finland and transactions total legal cigarette sales in Estonia. Sweden (Taal et al., 2004). Higher prices in Sweden motivated The Akwesasne Indian reservation, Increase in international/interstate airline passengers from the Russian located on the US–Canadian border, trade. Large-scale organized Federation to bring with them was used by the tobacco industry for cigarette smuggling generally cigarettes when they travelled to re-importation of cigarettes exported involves cigarettes that have passed the country (Unknown, 1994). There from Canada to avoid Canadian taxes through a wide range of international is anecdotal evidence that youth (Cunningham, 1996; Segal, 1999). traders (European Parliament, in Scotland have been given free Native American reservations in 1997). A loose export-import vacations in Europe in exchange for the USA are also the primary source recording system combined with smuggling tobacco back to Scotland of tax-free cigarettes sold over the large quantities of traded cigarettes (Unknown, 1994). Internet. In 2005, nearly two thirds of reduces the probability of detection. Presence of tax free zones. Tax- the US web sites selling cigarettes Pitt (1981) concluded that the greater free zones or free-trade zones play a were affiliated with a reservation. In the volume of legal trade, the lower significant role in illicit trade in both 2003, 95% of Seneca tribe cigarette the costs of smuggling. In Hong genuine and counterfeit cigarettes sales were conducted over the web or Kong Special Administrative Region, (World Customs Organization, 2007). phone (Chen, 2008). trucks with smuggled cigarettes The Financial Action Task Force Informal market/retail networks, have been disguised as containing (FATF) of the OECD estimated that street-selling, existing smuggling routes duty-free components for assembly there were about 3000 free-trade and black markets. The opportunity at factories within mainland China zones in 135 countries around the cost of labour could determine the (Unknown, 1999). The opening of the world in 2009 and that their numbers existence of the informal distribution market in Taiwan, China in 1987 led are growing (The Financial Action networks. If the potential rewards to an increase in cigarette smuggling Task Force, 2010). from legal occupations are very small measured by an increase in cigarette The International Consortium of compared to engagements in shadow/ seizures and reports by the industry Investigative Journalists discovered underground economy, people should (Wen et al., 2006). that free-trade zones on the island be more willing to provide an informal Liberalization and frequency of Aruba and in Colombia are being distribution network for illicit products of international travel. The ease of used for cigarette smuggling into including cigarettes (Merriman et small-scale smuggling is proportional other areas of Colombia, such as the al., 2000). However, Merriman et al. to the total number of cross-border city of Bogota (Beelman, 2000). (2000) found no association between travellers taking into account Free-trade zones have been experts’ estimates of smuggling in 38 the stringency of border controls misused for money laundering and countries and these countries’ income (Merriman et al., 2000). terrorist financing. A US company measured by per-capita GDP. Travellers can also take used a free-trade zone to repackage In some countries, illicit cigarettes advantage of duty-free sales. In 1996, tobacco and ship it to another free- are distributed via separate channels, approximately 45 billion cigarettes trade zone, ultimately smuggling it but in some countries illicit tobacco were sold through duty-free outlets. into US market. The profit was used products are distributed alongside This represents 0.8% of all cigarettes to finance the Abu Sayyaf Group, a the legal products via regular retail sold in the world (Market Tracking terrorist organization based in the channels. The existence of smuggling International Ltd, 1997). Philippines (The Financial Action routes and black markets for other Merriman et al. (2000) partially Task Force, 2010). Large-scale products as well as the presence of attributed a higher share of the cigarette smuggling from China to the unlicensed distributors reduce the German cigarette market being United States (state of Washington) transportation and the distribution supplied via cross-border shopping has been facilitated by a free-trade costs of illicit tobacco supply (Thursby and small-scale smuggling to high zone in Hawaii. The cigarettes seized & Thursby, 2000; Campaign for frequency of travel from and to in this free-trade zone represented a Tobacco-Free Kids, 2008).

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Joossens and Raw (1998) and time and the lower the probability of These resources are related, for Joossens et al. (2000) pointed to the buying illicit products. In California, example, to travel costs or to costs of association between the tradition of most smokers purchased their getting internet access (Hyland et al., street-selling and higher share of cigarettes from the most convenient 2005; DeCicca et al., 2010). illicit cigarettes in markets in Spain (but more expensive) sources Social norms with respect to the and Italy. despite relatively large price use of illicit products and government Social networks often serve as differences between the legal and interventions can be an important important distribution channels for illegal cigarettes (Emery et al., 2002). determinant of the demand for non- illicit products (Merriman et al., 2000). Very few (5.1%) of California smokers taxed products. In Taiwan, China, In the United Kingdom, between purchased cigarettes from non- or smokers who opposed cigarette 2.5% and 3.3% of all cigarettes sold lower-taxed sources, such as out-of- taxation policy were 1.69 times more in 2002–2003 were supplied via an state outlets, military commissaries or likely to buy smuggled cigarettes informal network of independent the internet (Emery et al., 2002). (Tsai et al., 2003). United Kingdom sellers (Hyland et al., 2006). Coleman The opportunity costs of time smokers living in socioeconomically (1998) found that the majority of illegal seemed to be a major deterrent of deprived areas were quite supportive tobacco products consumed in the cross-border shopping between of smuggling, as they perceive it United Kingdom were sold in pubs. California and Mexico, as the wait helpful in dealing with the rising Technology allowing virtual to enter Mexico was well over 30 financial costs of smoking (Wiltshire transactions (online purchases minutes and travellers were also et al., 2001). DeCicca et al. (2010) and mail-orders). In the USA, the subject to a customs check on return reports that anti-smoking sentiment number of web sites selling cigarettes to the USA (Emery et al., 2002). reduces the likelihood of cross- increased from 88 in 2000 to 772 in Using the 2003 CPS Tobacco border shopping. 2006 (Chen, 2008). Smokers in the Use Supplement (TUS) on individual US who purchase cigarettes online purchase quantities and locations, Ineffective tobacco tax are primarily motivated by lower Chiou and Muehlegger (2008) found administration, insufficient tax prices, because Internet vendors that the impact of a state’s tax change enforcement resources, and lack of generally sell cigarettes without on cigarette sales depends upon the control over the movement of tax- paying tobacco excise taxes for the tradeoffs between the cigarette price free cigarettes destination state (Kim et al., 2006). difference and distance to the state Almost all online cigarette sales are with lower cigarette prices. They The lack of clarity regarding the illegal due to failure to report the calculated that a consumer is willing regulations covering the control of transaction and/or verify the age to travel 2.7 miles to save $1 on a free-trade zones is a major reason for of the buyer (Chen, 2009). With the pack of cigarettes. The willingness their misuse for illicit trade according recent crackdown on this form of sale to travel depends on the number to the World Customs Organization. in the USA, the overseas internet of cigarette consumed: smokers As the government and the customs vendors expanded their role in the US who report smoking every day (or authorities dispute who has the market. In 2003, 10% of all internet individuals who smoke more than 14 jurisdiction over free-trade zones, vendors were based outside the cigarettes a day) have a significantly enforcement loopholes allow these USA, but in 2006 over 45% of them lower marginal cost of travelling than zones to play a facilitating role in were based overseas (Chen, 2009). smokers who only report smoking illicit cigarette trade (World Customs These overseas vendors are beyond some days (or those who smoke less Organization, 2007). the reach of the US law enforcement. than 14 cigarettes a day), and are Examining trade transaction therefore more likely to travel across between the USA and North Africa Transaction cost associated the border to purchase cigarettes. and between Hong Kong Special with illicit tobacco products Everyday smokers purchase Administrative Region and the rest approximately 3 times as many of SE Asia showed that inadequate The convenience of a transaction that cigarettes when crossing a border controls over the in-transit cigarettes reflects the opportunity cost of time is than do some-days smokers. results in a substantial leakage, related to costs of illicit tobacco use. A minimum set of resources seems with many of the cigarettes failing to The less convenient the transaction, to be necessary for a person to have arrive at their intended destination the higher the opportunity cost of access to low/untaxed cigarettes. (Joossens et al., 2000).

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In the USA, a change in the associated with a two-percentage- and fostered the development of a balance of enforcement activities point decrease in experts’ estimate of regional net of smuggling channels between the US state and US cigarette smuggling. Since corruption affecting neighbouring countries federal authorities after passing the is more pervasive in low-income like Bulgaria, Romania and Albania. Contraband Cigarette Act (CCA) in and middle-income countries, these These illegal activities became an 1978 generated a loophole in the countries are at greater risk of large- important source of income during tax audit (Thursby and Thursby, scale smuggling activities. the war for people of all social groups 2000). This led to an increase in Cambodia is an example of (Hajdinjak, 2002). illicit cigarette trade as well as to a country where a high level of The US Government a change in the preferred method corruption facilitates cigarette Accountability Office reported that of tax evasion. Commercial/large smuggling. It is estimated that 79% terrorist organizations including scale smuggling began to focus on of cigarettes imported into Cambodia Hezbollah made money through underreporting of the amount of are re-exported or smuggled across the tobacco black market (United cigarettes released to the distribution Cambodia’s borders (Ministry of States General Accounting Office, (“diversion”) that could have been Health Republic of Indonesia, 2004). 2003). The profit from large-scale discovered by the tax audit. The The European Commission cigarette smuggling via free-trade study concluded that effective (1998) identified over 50 criminal zones was used to finance the enforcement requires participation of networks potentially engaged in terrorist organization Abu Sayyaf both law enforcement agencies and large-scale tobacco smuggling. Group based in the Philippines (The tax administrators. In 2005, the investigation by the Financial Action Task Force, 2010). A law that would allow US states European Council concluded that Corruption and organized crime to recover taxes from cigarettes sold the threat imposed by cigarette does not seem to be a predictor of over the Internet (the Jenkins Act) is smuggling within the European Union small-scale smuggling and cross- enforced by the US federal authorities, is primarily related to the involvement border shopping. Goel (2008) found who are much less motivated than of organized crime (Council of the that the average number of public individual states to enforce the law European Union, 2005). corruption convictions is not a (Goolsbee et al., 2007). However, Cigarette smuggling is claimed to statistically significant predictor of in October 2002 Washington State be the third largest illegal business cross-border cigarette smuggling in successfully applied the Jenkins in Germany, behind drug trafficking the USA. Act to internet sales, leading to and illegal gambling, with extensive similar efforts in many other states involvement of organized crime (Von Tobacco companies’ profit motivation (Chaloupka et al., in press). Lampe, 1999 as cited in Merriman, translated to their marketing strategy 2001). In southern Italy, Calabrian and political agendas reduce the cost Corruption, war and organized crime gangsters have been involved in the of supplying illicit cigarettes facilitate law circumvention, reducing tobacco smuggling (Unknown, 1997). the cost of supplying illicit products The presence of organized crime The tobacco industry itself often networks can increase pressure promotes the smuggling of their Criminal networks specializing in on legitimate distribution networks products, because smuggling does cigarette smuggling operate more by reducing their profitability or by not impact their profit margins, easily in countries where corruption forcing them to join in the black reduces the impact of higher tax/ is high, the control of the authorities market (Joossens et al., 2000). price on cigarette consumption is lax and commodities other than Smuggling of various goods, and can be used to advocate for tobacco are also being smuggled and particularly cigarettes, was an excise tax reduction as a way to (Joossens, 1999). Using data from a prosperous “business” in the reduce smuggling and associated 38 countries, Merriman et al. (2000) Yugoslav republics during the Balkan criminal activities (Leverett et al., found that the level of corruption War in 1991–1995, helping to finance 2002). In fact, cigarettes confiscated (measured by the transparency weaponry and otherwise supporting and destroyed by law enforcement index) is positively related to the war operations (Hajdinjak, 2002). authorities increase demand for size of the illicit cigarette market. Smuggling was done with the close replacement cigarettes and therefore A one-point improvement in a cooperation of politicians, their the profitability of the industry country’s transparency index was security forces and organized crime, (Leverett et al., 2002).

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Delipalla (2009) developed a Canada’s significant increases of tobacco growers and cigarette decision-making model analysing in cigarette tax in 1980s and early manufacturers, has long argued the factors motivating the industry to 1990s motivated the tobacco that high taxes relative to those get involved in illicit tobacco trade. industry to orchestrate smuggling of neighbouring countries are The model assumes that the industry of cigarettes to Canada to exercise responsible for the growth in illicitly operates as an oligopoly, and that pressure on Canadian government traded cigarettes. They claim that illicit the market does not differentiate to reduce these taxes (Canadian cigarettes represent 20% of the total between legal and illegal products Cancer Society, Non-smokers’ market (Tobacco Institute of South (their prices are similar). To maximize Rights Association, Physicians for Africa, 2008) without providing solid its profit, each firm decides the a Smoke-free Canada, & Quebec evidence to support this claim. A peer- total quantity sold on the market Coalition for Tobacco Control, reviewed academic study contradicts and the fraction of that total it will 1999). The industry developed the industry estimates, estimating attempt to sell illegally (without tax) a tax-dodging scheme allowing the maximum penetration of illicit taking into account the probability of the company to smuggle billions FLJDUHWWHVRIíRIWKHWRWDO successful tax evasion, the level of of cigarettes into Canada using market in 2007 (Blecher, 2010). enforcement, the cost of smuggling, a Native American reservation in Illicit cigarette trade can provide and fines paid if caught. The paper the USA (Segal, 1999; Sugarman, the industry a market entry for then examines the relative effects 2002). In response, the government prohibited brands (brands that of specific and ad valorem taxes cut cigarette taxes in 1994. Imperial are not legally sold in the market). on the firm’s evasion decision given Tobacco Canada Limited and Producers then use customer that it is optimal for a firm to engage Rothmans Benson & Hedges, the loyalty as a political wedge to lobby in tax evasion. It concludes that two tobacco companies involved for legal access to the market. The the optimal fraction of tax-not-paid in this smuggling scheme, pleaded international trade journal World products is increasing in sales under guilty in 2008 and admitted “aiding Tobacco reported in 1996 that purely specific taxation and when persons to sell or be in possession “smuggling has helped to promote the ad valorem tax is imposed as a of tobacco products manufactured some of the world’s leading brands percentage of the fixed wholesale in Canada that were not packaged in markets which had remained price. When the ad valorem tax and were not stamped in conformity closed to foreign imports” (Market is imposed as a percentage of the with the Excise Act” between 1989 Tracking International Ltd, 1997). retail price, the optimal fraction of and 1994. The companies agreed to Since the 1980s, the British tax-not-paid products is decreasing. pay CA$1.15 billion, the largest fine American Tobacco (BAT) relied on The analysis suggests that (for ever levied in Canada (Joossens illegal channels to supply markets in given tax rates and enforcement) and Raw, 2008). R. J. Reynolds, the Africa (LeGresley et al., 2008). Illicit if demand falls (for example due to third tobacco company involved in cigarette trade has been an important effective tobacco control policies), the smuggling scheme, has agreed component of BAT’s market smuggling will also be reduced to pay CA$325 million ($325 million) entry strategy to gain leverage in under a specific tax regime, but it will to the Canadian governments in negotiating with governments for tax increase under an ad valorem one. April 2010 (Schneider, 2010). concessions, compete with other The impact of a mixed tax structure There is evidence that British transnational tobacco companies, on optimal illicit trade is ambiguous. American Tobacco (BAT) in circumvent local import restrictions, The analysis concludes that higher Bangladesh had some degree and to gain a market presence. BAT tax rates do encourage smuggling of control over the proportion exploited weak government capacity under purely or predominantly ad of contraband products on the to combat illicit trade and gained valorem taxation, but their effect market. BAT has altered the flow substantial market share in major is ambiguous under purely or of illicit cigarettes while making the countries (LeGresley et al., 2008). predominantly specific taxation. argument that tax increases lead to Smuggling has been an important The industry has used the higher consumption of illegal tobacco component of BAT’s market entry occasion of a tax increase to products (Collin et al., 2004). strategy in Lebanon, a country with a promote illicit cigarette trade to put In South Africa, the Tobacco state tobacco monopoly and chronic pressure on the governments to Institute of South Africa (TISA), a political instability. After the end of the reverse their decision. body which represents the majority civil war in the early 1990s, BAT and

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other transnational tobacco companies Kingdom (HM Customs & Excise, of global cigarette consumption is sought a legal presence in the country, 2001a, 2001b; House of Commons illicit, including 17% in low-income but continued to achieve substantial & Treasure Committee, 2005). countries, 12% in middle-income sales through illicit cigarette trade The volume of seized counterfeit countries, and 10% in high-income (Nakkash & Lee, 2008). cigarettes increased threefold countries. Smuggling has been used as between 2000 and 2004. In 2003– a market entry in Argentina, Italy, 2004, 54% of seized cigarettes were Europe Islamic Republic of Iran, Bulgaria, counterfeit (House of Commons, the former Soviet Union and China, Treasure Committee, 2005). European Union. Using cigarette for example (Joossens & Raw, 1998; sales data 1989–95 from 18 World Health Organization, 2003; Extent of tax evasion and tax European countries, Merriman et al. Gilmore and McKee, 2004). avoidance globally, regionally (2000) estimated that, in a typical After the market opening in and in key countries European country, the share of Taiwan, China in 1987, Japan cigarettes acquired by small-scale Tobacco International (JTI) set up a Joossens, Merriman, Ross and smuggling and/or cross-border Swiss plant as a legal cover for its Raw (2010) collected data on shopping accounted for about 3% of smuggling operation to the country. illicit cigarette trade from different domestic consumption. This allowed JTI to overcome the sources. Their estimates of illicit Based on in-depth analysis of existing legal quota of exports to market share (Table 8.1) are based data collected by the professional Taiwan, China (Wen et al., 2006). on academic articles, official services company Klynveld Peat The involvement of the industry government publications, estimates Marwick Goerdeler (KPMG, 2005), in smuggling operations in Europe from market research companies a study commissioned by the became clear when the level of illicit (whose clients include the tobacco European Commission estimated trade on the continent substantially industry and governmental that in 2004 total market penetration declined following the 2004 and organizations), tobacco trade of illicit cigarette trade represented later agreements between major journal articles, newspaper articles approximately 8–9% of European manufacturers (e.g. PMI, JTI) and the and sometimes estimates from Union (which had 25 Member EU authorities without admission of personal contacts in customs States at the time, designated liability. This agreement financially organizations. The estimates vary EU25) cigarette sales. The above- motivated the industry to control greatly in rigour and in the measure cited report noted also that the illicit the illegal supply of their products of illicit trade used. Some for market share in the new EU Member to the EU market. Since counterfeit example express the size of the illicit States (Estonia, Hungary, Lithuania, cigarettes are excluded from the market as a percentage but without Poland and Slovakia) were far above agreement, companies have an saying what it is a percentage of, the EU25 average (KPMG, 2005). incentive to have seized products and some do not even state what The KPMG report has limitations, declared as counterfeit (World measure was used. Nor is there a as it is based on cigarette seizures Health Organization, 2007). clearly defined methodology for in the EU and on studies provided The improved collaboration assessing if an estimate is accurate. by the tobacco industry and between the industry and the United Joossens and colleagues (2010) governments, however as its Kingdom government reduced have included in their estimates estimate falls between the higher the availability of genuine brand what seem reasonable in terms of estimates from the United Kingdom cigarettes on the black market. the country’s population, smoking and eastern and central European This can be regarded as evidence prevalence, legal infrastructure and countries and the lower estimates that cigarette manufacturers are other relevant parameters. Thus a from southern European countries indeed in a position to control combination of methods, including like Spain and Italy, the overall figure the supply of illicit cigarettes to informed expert judgement, is of 8–9% is a reasonable estimate. the market. However, counterfeit often necessary to cross-validate In 2008, the European products began to play a larger estimates. Bearing in mind these Commission estimated that around role in the supply of illicit cigarettes methodological challenges, the data 13% of total consumption in the 27 as evidenced by the type of illegal on illicit and legal market estimates EU Member States had not been cigarettes seized in the United from 2007 show that almost 12% taxed in the country of consumption.

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Table 8.1. Estimates of the illicit cigarette market around the world

Country % illicit market Measure used Year Illicit % total market

High-income countries

Hong Kong Special 42 Percentage of legal sales 2005 30 Administrative Region

UAE 30 Percentage of legal cigarette sales 2005 23

Singapore 18 Percentage of legal cigarette sales 2005 15

Percentage of total cigarette market: estimate Canada 15–20 2007 15–20 based on multiple sources and surveys Percentage of consumers that purchased USA 13–25 1992–2002 13–25 lower-priced cigarettes Percentage of total cigarette consumption (not United Kingdom 13 2006–2007 13 including hand rolled tobacco)

Taiwan, China 11 Percentage of legal cigarette sales 2005 10

Australia 6 Percentage of legal cigarette sales 2007 6

Israel 5 Percentage of legal cigarette sales 2005 5

Saudi Arabia 4 Percentage of legal cigarette sales 2006 4

Italy 2 Percentage of total cigarette market 2006 2

Japan 2 Percentage of legal cigarette sales 2006 2

New Zealand 1 Percentage of legal cigarette sales 2003 1

Spain 1 Percentage of total cigarette market 2006 1

Upper-middle-, lower-middle- and low-income countries

Georgia 49 Percentage of total cigarette market 2005 49

Bolivia 46 Percentage of legal cigarette sales 2005 32

Albania 40–50 Not stated Not stated 40–50

Bosnia & Herzegovina 35–45 Not stated Not stated 35–45

Smuggling as a percentage of total cigarette Uzbekistan 40 2006 40 consumption

Ethiopia 38 Percentage of total cigarette market 2006 38

Brazil 35 Percentage of legal cigarette sales 2006 26

Lao People’s Democratic 35 Not stated 2005 35 Republic

Iraq 35 Percentage of total cigarette market 2006 35

310 Tax avoidance and tax evasion

Country % illicit market Measure used Year Illicit % total market

Former Yugoslav Republic 30–35 Not stated Not stated 30–35 of Macedonia

Cameroon 26 Percentage of legal cigarette sales 2005 21

Syrian Arab Republic 26 Percentage of total cigarette market 2007 26

Estonia 19–32 Percentage of total cigarette market 2003 19–32

Sudan 25 Percentage of legal cigarette sales Not stated 20

Zambia 25 Not stated 2003 25

Croatia 25 Percentage of legal cigarette sales 2005 20

Malaysia 24 Percentage of total cigarette market 2008 24

Venezuela 23 Percentage of legal cigarette sales 2005 19

Russian Federation 23 Percentage of legal cigarette sales 2004 19

Peru 23 Percentage of total cigarette consumption 2006 23

Lebanon 23 Not stated 2000–2006 23

Morocco 23 Percentage of total cigarette market 2006 23

Algeria 20 Percentage of total cigarette market 2007 20

Philippines 19 Percentage of legal cigarette sales 2006 16

Nigeria 18 Percentage of total cigarette consumption 2006 18

Ghana 18 Percentage of legal cigarette sales 2005 15

Pakistan 17 Percentage of total cigarette market 2005 17

Armenia 16 Percentage of total cigarette consumption 2004 16

Côte d’Ivoire 15 Percentage of legal cigarette sales 2005 13

India 14 Percentage of total cigarette consumption 2004 14

Columbia 14 Percentage of total cigarette consumption 2004 14

Islamic Republic of Iran 14 Percentage of total cigarette market 2007 14

Ecuador 12 Percentage of total cigarette consumption 2006 12

Uruguay 12 Percentage of total cigarette market 2006 12

Guatemala 12 Percentage of total cigarette market 2006 12

Jordan 10–12 Percentage of total cigarette market 2007 10–12

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Table 8.1. Estimates of the illicit cigarette market around the world

Country % illicit market Measure used Year Illicit % total market

Thailand 11 Not stated Not stated 11

Yemen 11 Percentage of legal cigarette sales Not stated 10

Turkey 11 Percentage of total cigarette market 2006–2007 11

Nicaragua 10 Not stated 2001–2002 10

Panama 10 Percentage of legal cigarette sales 2000 9

Tunisia 10 Percentage of total cigarette consumption 2007 10

El Salvador 10 Not stated Not stated 10

Argentina 10 Percentage of total cigarette market 2006 10

Smuggling as a percentage of total cigarette Viet Nam 10 2004 10 market Percentage of total cigarette market: China 8–10 Multiple 8–10 extrapolated from multiple sources Smuggling as a percentage of total cigarette Kazakhstan 9 Early 2000s 9 consumption

South Africa 9 Percentage of total cigarette consumption 2007 9

Percentage of total cigarette market: multiple Ukraine 9 Multiple 9 sources

Costa Rica 9 Percentage of legal cigarette sales 2006 8

Indonesia 5–6 Percentage of total cigarette market 2005 5–6

Mexico 3 Percentage of total cigarette sales 2006 3

Chile 3 Percentage of legal cigarette sales 2006 3

Adapted from Joossens L, Merriman D, Ross H, Raw M. The impact of eliminating the global illicit cigarette trade on Health and Revenue. Addiction. 2010; 105(9):1640–1649 with permission from John Wiley and Sons. Notes: The% illicit market has been rounded to nearest integer; UAE = United Arab Emirates; Russian Fed. = Russian Federation; the EU-25 average illicit market share is 8.5%. In this table we list only countries for which we have country-specific data. The EU-25 countries, which are included in the model calculations using 8.5% illicit market share, are: Austria, Belgium, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, Netherlands, Poland, Portugal, Slovenia, Slovakia, Spain, Sweden, United Kingdom. EU-27 includes in addition to the EU-25 Bulgaria and Romania. Estimates contained in Table 8.1 uses standardized terminology determined by the authors to facilitate cross-study comparison; verbatim study terminology are reported in the online version. The third column, ‘Measure used’, reports the measure used in each source document, as described in the original publication, including where the measure was not specified. There is no standard measure thus the table reflects the varied data sources.

About 8–9 percentage points had commissioned by the Commission in products being sold in the past six been attributed to tax evasion and 2005 (KPMG, 2005). months which they think might have around 4 percentage points to legal According to a survey of 26 500 been smuggled into the country. The cross-border shopping (European Europeans (EU27 plus Norway; EU27 proportion of respondents who had Commission, 2009). These is EU25 plus Bulgaria and Romania; seen potentially smuggled tobacco estimates are in line with the findings see Table 8.1 footnotes) conducted in products being sold in the past six of the KPMG study cited above on December 2008, just over one tenth of months was the highest in Lithuania the EU25 tobacco market in 2004 EU citizens (12%) had seen tobacco (36%), followed by Greece (25%),

312 Tax avoidance and tax evasion

then Poland, Hungary and Latvia (22– suspected that some of the USA. Cigarette taxes in the 24%). In Belgium, the Netherlands, cigarettes that they had purchased US vary at the different levels of Italy, Portugal, Luxembourg and in the last year were illicit. Half of government. Saba, Beard, Ekelund Denmark, on the other hand, only 5% these respondents cited a missing and Ressler (1995) used data from of respondents had seen potentially tax stamp, and/or a missing Albanian the 48 continental US states and smuggled tobacco products in the health warning and/or not having the District of Columbia from 1960 past six months. In Norway, where in nicotine/tar information in Albanian to 1986 to estimate that small- January 2008 a packet of Marlboro as features of an illicit cigarette pack. scale smuggling accounts for a cost $12 (the country with the highest Another 29% cited tax stamps and small portion of market, usually not cigarette prices in the world), only health warnings written in a foreign exceeding 2% of legal sales despite 6% of survey respondents had seen language, and 27% cited the taste the price/tax differences. tobacco products during the last 12 of cigarettes. It is important to note In a more recent study using data months which they believed were that is not illegal to purchase illicit from the Behavioural Risk Factor smuggled. In Lithuania, where in cigarettes in Albania, and smokers Surveillance System (BRFSS), Stehr January 2008 a packet of Marlboro would not be subject to legal (2005) found that the tax avoidance cost $2 (the country with the lowest sanction by providing this information represented up to 9.6% of sales cigarette prices in the EU) the (Zaloshnja et al., 2010). in the US between 1985 and 2001. percentage was 36% (European Russian Federation. The However, according to Stehr’s Commission, 2009). European Regional office of the findings the level of legal border United Kingdom. According to World Health Organization estimates crossing in the USA was low relative United Kingdom customs officials the that in the Russian Federation 20– to other forms of tax avoidance. illicit market share (of consumption) 30% of cigarettes are smuggled, Combined federal, state and city in 2006–07 was 13% for cigarettes and concludes that the Russian taxes are highest in New York City. and 53% for hand-rolled tobacco Federation remains the biggest illicit In 2004, 57% of smokers in New in the United Kingdom. The United European market in terms of volume York state purchased cigarettes at Kingdom is one of the few countries (World Health Organization, 2007). least once from a low-tax or untaxed to produce reliable yearly estimates Independent research estimated source, while 37% purchased low-tax of illicit trade, with a methodology that 23% of legal sales were illicit in or untaxed cigarettes regularly (New based on the discrepancy between the Russian Federation in 2004 (70 York State Department of Health, trends in legal sales and household billion cigarettes) (Ross et al., 2008; 2006). The large tax differentials survey smoking habits (HM Revenue Joossen et al., 2009). between Chicago and neighbouring & Customs, 2008). jurisdictions provide an incentive for Finland. The Finish authorities Americas cigarette tax avoidance. Data from reported that legal cross-border a random sample of cigarette packs cigarette shopping by Finish travellers Canada. The Canadian tobacco littered in Chicago in 2007 reveals a amounted to 12% of total national industry contracted a research high degree of tax avoidance: three sales in 1996 (Lipponen et al., 1998). company, GfK Group, to assess fourths did not display a Chicago tax Poland. A 2004 survey of the smoking trends in Canada. Their stamp (Merriman, 2010). Based on a Cancer Epidemiology & Prevention research reported that 16.5% of comparison between cigarette sales Division of the city of Warsaw also smokers said in 2006 that they had data and cigarette consumption data suggested that only 11% of smokers purchased illicit tobacco products from surveys, a researcher from the could have bought cigarettes on the within the previous seven days, the Department of Economics of Drexel illicit market in Poland (Gumkowsky figure rising to 22% in 2007. The major University estimated that in 1985 in et al., 2006). Studies based on source of the Canadian illegal trade the USA, 7.2% of cigarettes were six surveys in the period 2004–6 is cigarettes illicitly manufactured purchased without payment of state concluded that 11% of cigarettes in aboriginal native reserves on the taxes and that this had risen to 12.7% sold in Poland were illicit (Ciercierski, border between Canada and the USA, in 2001 (Stehr, 2005). A researcher 2007). which are smuggled into Canada from the Stanford University Institute Albania. In 2009, approximately (mainly the provinces of Ontario and for Economic Policy Research 19% of smokers in urban areas Quebec) (Royal Canadian Mounted estimated that between 13% and 25% and 27% in rural areas in Albania Police, 2008) (average 17.5%) of US consumers

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purchased cigarettes in a lower-price Middle East and Africa as 80% of the cigarette market in bordering state or Native American Guinea Bissau and the Libyan Arab reservation over the period 1992– Islamic Republic of Iran. Based Jamahiriya is illicit. In Mali the illicit 2002 (Lovenheim, 2007). on a report of the Iranian tobacco market share is 40%; estimates companies and the Central are lower for other listed countries Asia and Australasia Headquarters of the Fight against (United Nations Office of Drugs and Smuggling, which is a department Crime, 2009). China. There are varying and of the Presidential office, the illicit contradictory estimates of the level cigarette market share in the Islamic Impact of tax avoidance/evasion of illicit cigarette trade in China. Republic of Iran was 74% of the total on public health China is by far the biggest producer market in 2001 (40 billion cigarettes) in the world of counterfeit cigarettes, and 14% of the total market in 2007 The impact of tax avoidance/ which are destined for domestic (8.3 billion cigarettes) in the Islamic evasion on tobacco products on and foreign markets. A 2005 Republic of Iran (Joossens et al., public health can be classified as national survey conducted by the 2009). The extremely high level the impact on average tobacco China National Bureau of Statistics of smuggling in 2001 is probably price, on health disparity, on other on behalf of the China National because there was insufficient tobacco control policies, and Tobacco Company (CNTC) found domestic production to meet demand, generally on public safety. that about 10% of cigarettes on the and imported cigarettes were subject The impact of higher taxes/prices market were counterfeit (Joossens to high import duties, so the Islamic on tobacco use is not diminished by et al., 2009). China’s State Tobacco Republic of Iran was a target for smuggling if the market equilibrium Monopoly Administration announced internationally smuggled cigarette quantity of the taxed products in the in January 2008 that it had seized brands. However, between 2001 and absence of tax avoidance/evasion is 9.28 billion counterfeit cigarettes in 2007 the market was liberalised and equal to the quantity of their supply 2007 (Globalink news service, 2008). national production was increased, in the presence of tax avoidance/ Thus the production of counterfeit leading to a dramatic fall in smuggling. evasion. This equilibrium depends cigarettes can be estimated at 93– Studies on illicit cigarettes undertaken on the degree of substitution 186 billion cigarettes if we assume by the Tobacco Prevention and between legal and illegal cigarettes that the seized cigarettes represent Control Research Center and relying and whether the availability of about 5–10% of total illicit counterfeit on smoker self-reports, found that illegal substitutes increases total production, a plausible assumption. 22.5% of the cigarettes consumed in consumption. To the extent that Japan. Most observers in the field Teheran in 2006 were illegal (Heydari legal and illegal tobacco products agree that illicit cigarette trade is low et al., 2009). A similar study was are not perfect substitutes, an in Japan. A possible explanation for undertaken during a randomized increase in cigarette taxes translated the low level of smuggling is the strict cross-sectional survey in Tehran in to increased cigarette prices will control of the distribution network in 2008–2009, finding that 21% of the reduce their consumption even when this country. All retailers of tobacco cigarettes were smuggled (Heydari smuggling is possible (Merriman et products have to be approved, et al., 2010). al., 2000; Merriman, 2002). and are licensed by the Ministry of South Africa. An independent The degree of substation Finance. researcher estimates the size of the between legal and illegal products is Australia. The large difference illicit market in South Africa to have based on the notion that consumer between the price received by grown substantially from 1997 until incurs both “transaction” and tobacco farmers in Australia, and peaking in 2000 between 9.4% and “inconvenience” costs (Merriman, the price of raw tobacco purchased 11.5% of the total market. The most 2002). The transaction price/cost on the market has motivated tobacco recent estimate for 2007 suggests is the amount of money paid for the growers to sell their products to illegal that the illicit market occupied product at the point of sale. The markets to increase their profit from between 7.0% and 11.2% of the total inconvenience price/cost is the tobacco growing (Geis et al., 2003). market (Blecher, 2010). value of the additional time it takes North and West Africa. According to obtain a product illegally as well to a report of the United Nations as the value of discomfort to engage Office on Drugs and Crime, as much in an illegal activity. Although the

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price of inconvenience does not break the law, and only some of them manufactured in the United Kingdom, require a monetary transaction, it are willing to use illegal products. was higher than the locally produced represents real costs since black Therefore, the observed reduction 555, because the smuggled market purchasers may face in the legal consumption after a tax cigarettes were perceived as being potential legal sanctions and other increase is only partially driven by of higher quality (Joossens, 2003). risks. For example, the location of the substitution towards contraband. Several studies used the gap street sellers can be undependable, Even though the theory suggests between the legal and illegal there can be uncertainty about that the impact of illicit cigarette trade products and calculated the impact the authenticity of the brand, or on cigarette prices is likely to be of eliminating this price difference consumers may fear embarrassment small, the competition between the on tobacco use and on public health. or legal penalties if caught buying legal and the illicit cigarettes could Joossens and colleagues (2009) smuggled cigarettes. The sum of the result in lower average cigarette used data from 84 countries and transaction price and inconvenience prices and therefore in higher estimated that the global average price represent the “effective” price, consumption (Joossens et al., 2000). cigarette price in 2007 was about the price that consumers consider The empirical evidence on prices 3.75% lower due to the presence of when deciding whether to make of illicit tobacco products is mixed, illegal trade in cigarettes. If the global a purchase or not. In general, the as the price differences between illicit market were eliminated in 2002, higher the effective price, the lower legal and illegal cigarettes vary by 164 000 premature deaths would be the quantity of cigarettes demanded. country, the location of the selling averted a year from the year 2030 on. Illicit products often have a lower point, and the brand name and That means that by 2036, close to a transaction (or sales) price than legal the perceived quality of the illicit million tobacco-related premature products, because consumers who cigarettes. In general, the price of deaths would not occur. purchase smuggled cigarettes pay the illicit cigarettes is lower than A similar study has been higher inconvenience price. Given the retail price of legal products. In conducted in the United Kingdom, that the general theoretical model of the United Kingdom, for example, where in the presence of smuggling smuggling is applicable to a broad smuggled cigarettes in 2005 were the average tobacco product price range of societies, it is reasonable sold at 50% of the duty-paid products was found to be about 11.6% to expect that conclusions based on (West et al., 2008). In Germany, the under the legal market equilibrium. empirical evidence from high-income price of the smuggled Chinese brand Eliminating the illicit cigarette trade countries will be applicable to certain Jin Ling was 40% of the retail price of in the United Kingdom would reduce degree to middle- and low-income a premium brand in 2009 (Candea et the cigarette consumption by 5.0– countries (Merriman et al., 2000). al., 2009). The price of illegal “chop- 8.2% and lower the tobacco death Therefore, in theory, smuggling chop” tobacco in Australia ranged toll in the United Kingdom by 4000– does not completely reduce the from AUS$45 to AUS$100 per 6500 premature deaths a year (West public health benefits of cigarette kilogram in 2001, while a kilogram et al., 2008) taxes (Merriman, 2002). of legal roll-your-own tobacco was Experience from several There is some empirical evidence AUS$320 in the same year (Geis et European countries suggests that that consumers are aware of the al., 2003). an increase in cigarette taxes can inconvenience price. A study in the Internet sites often sell cigarettes result in increased smuggling, but United Kingdom found that 17% of tax-free or with taxes from low-tax also in the decline in total cigarette adult smokers prefer to buy cigarettes jurisdictions (Ribisl et al., 2006). consumption. from recognized outlets rather than The average online site selling Two sizeable tobacco tax individuals even if the transaction cigarettes in the USA passes about increases in Sweden (December price of the cigarettes sold by the 90% of the tax savings through to 1996 and August 1997) led to a 43% individuals is £1.00 per pack lower the consumer (Goolsbee et al., 2007) increase in average cigarette prices, (DTZ Pieda Consulting, 2000). making cigarettes available at prices but also an increase in the estimated Using United Kingdom data, Duffy substantially lower than in stores. amount of cigarette smuggling (from (2006) also suggests that smuggled In some markets, however, 200 million cigarettes in 1996 to 500 and non-smuggled tobacco products the price of illicit cigarettes can be million in 1998). However, smoking are imperfect substitutes. The higher. In Viet Nam, for example, the prevalence has also declined (from majority of smokers are not inclined to price of the smuggled brand 555, 1996 to 1997 there were 19.1%

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and 4.4% declines among men and an increase in the consumption of free Canada, & Quebec Coalition women, respectively), particularly products evading taxes. for Tobacco Control, 1999). As in among youth and young adults (in Merriman et al. (2000) used data Sweden, the Canadian government the age group 16–24 there were from 23 European countries during responded to the political pressure 25% and 17.4% declines among íDQGSUHGLFWHGWKDWDWD[ to reduce cigarette smuggling and men and women from 1996 to 1997). increase in an individual country in 1994 reduced cigarette taxes. In addition, tobacco tax revenue will increase small-scale cigarette This led to a sharp increase in per- rose by 9% in 1997 compared to smuggling, but coordinating these capita consumption (a 27% increase 1996 (Wendleby & Nordgren, 1998; increases with neighbouring countries between 1993 and 1998) and higher Joossens, 1999). would reduce the incentives for this smoking prevalence among youth After the Swedish government type of tax avoidance. For example, and adults as well as loss of tax responded to pressure to reduce a unilateral 10% price increase revenue (Canadian Cancer Society, cigarette smuggling by reducing in Germany would reduce annual Non-smokers’ Rights Association, cigarette tax in August 1998, per- sales by 6 packs per capita, but total Physicians for a Smoke-free Canada, capita tax paid cigarette sales consumption only by 3 cigarette & Quebec Coalition for Tobacco increased, but tax revenue went packs per capita per year, with 3 Control, 1999). down (Joossens et al., 2000). packs per capita being smuggled Several empirical studies used France nearly doubled its nominal to Germany from other countries. Canadian data to study the response cigarette retail price between With a multilateral price increase, to these cigarette tax changes. September 1991 and December the consumption in Germany would Galbraith and Kaiserman (1997) used 1996 (74% increase in real terms) by still drop by 3 packs per capita, but monthly sales data from 1980–1994 increasing tobacco taxes. During the domestic sales would drop by only and found that the total consumption same time, cigarette sales dropped 4 packs (with one pack still being (taxed plus smuggled sales) was from 97 billion cigarettes in 1991 supplied from other countries). This less responsive to price increases to 83 billion in 1997, adult smoking means that the health impact of a (short-run elasticity of –0.40) than prevalence decreased from 40% in tax increase will be independent of taxed consumption (short-run 1991 to 34% in 1997 (Baudier, 1997), the coordination of tax increases, elasticity of –1.01), meaning that 1% and youth smoking prevalence (12– but the revenue impact will depend increase in price due to tax increased 18 years old) dropped from 30% in on this coordination. If incentives illicit cigarette trade by 0.5–0.6%. 1991 to 25% in 1997 (Arènes et al., for small-scale smuggling in Europe Gruber, Sen and Stabile (2002) and 1998). Tobacco tax revenue rose disappeared, legal cigarette sales Goel (2004) confirmed that taxed from 32 billion FF in 1991 to 57 billion would increase by 3%. cigarette consumption in Canada is FF in 1996 while illicit cigarettes kept The European experience more sensitive to price than is total occupying a relatively unimportant with tobacco tax increases and cigarette consumption, meaning that share of the market—around 2% their impact on tobacco use in the there is a substitution between the (Baudier, 1997). The relatively low presence of illicit cigarette trade has illicit and legal cigarettes, but a tax level of illicit cigarette trade in France been very similar to what happened increase is still an effective measure has been explained by its efficiently on the American continent. for reducing total cigarette use. controlled retail environment in which Canada’s significant increase A similar conclusion has been all tobacco retailers must be licensed. in cigarette prices due to its tax reached in the USA. Baltagi and Levin A United Kingdom study found policy in 1980s and early 1990s (1986) showed that price elasticities that higher taxes increased prices resulted in 43% decline in per-capita of cigarette demand in the USA were of both legal and illegal tobacco cigarette consumption from 1979 to lower after controlling for small-scale products and led to an overall 1993 despite the presence of illicit smuggling. Licari and Meier (1997) decline in tobacco consumption cigarettes on the market. Smoking used a pooled time series of cigarette (Duffy, 2006). However, the price prevalence fell sharply, particularly sales in all 50 US states from 1951 elasticity of duty-paid tobacco has among youth (15–19 years old): to 1994 and found that higher taxes also increased since 1995 when from 43% in 1981 to 23% in 1991 reduce consumption, but their effect cigarette smuggling began to grow, for this age group (Canadian Cancer is lower when controlling for cross- meaning that some of the drop in Society, Non-smokers’ Rights state small-scale smuggling. legal consumption was replaced by Association, Physicians for a Smoke-

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A study from California using data in the sensitivity of taxable cigarette real GDP growth. This reduction from the California Tobacco Surveys sales that is correlated with the rise would be even larger if enforcement found that a significant cigarette tax of internet use within states. The of anti-smuggling laws would improve increase in 1999 that resulted in growth of internet penetration in the at the same time. relatively large price difference with USA has induced an elevation in The studies above estimate the all its bordering states (including the taxable sales elasticity of over impact of tax avoidance and tax Mexico) motivated only 5.1% of 60%. Cigarette tax evasion over the evasion on the general public. There all smokers to purchase tax-free internet has substantially reduced are also studies that have examined cigarettes. The study concluded that the revenue-generating potential the impact of this behaviour on health higher cigarette taxes did not pose a of cigarette tax increases: states disparities, since the availability of threat to the public health objective have collected 8% less cigarette tax lower-priced smuggled cigarettes of reducing smoking despite the revenue between 2001 and 2005 could have a disproportionate impact presence of tax avoidance/evasion due to tax-free cigarette internet on smoking and health among (Emery et al., 2002). sales. This has serious implications children and the poor given their One US study using data from for funding of state programmes, greater price sensitivity (Townsend four waves of the CPS Tobacco including tobacco control and et al., 1994; DTZ Pieda Consulting, Supplement 1992–2002 found that other public health programmes. In 2000; Joossens et al., 2000). In the possibility to obtain cheaper addition, unregulated web sites offer addition, illicit cigarettes are primarily cigarettes from another state or Native various price promotions or gifts products of the multinational tobacco American reservation could reduce with purchases, and many require companies, because these are the average price responsiveness a minimum purchasing quantity easy marketable and have price of consumers to zero, but the price thus further encouraging cigarette advantage over less-known brands sensitivity also varied with the consumption (Ribisl et al., 2001). Of (Joossens & Raw, 1998). Marlboro, distance of residence to a lower-price 88 internet sites selling cigarettes in for example, represented 66% of all border: a 1% increase in distance the USA in 2000, one third featured seized cigarettes worldwide in 2005 resulted in a decrease in the home promotional programmes (Ribisl et (World Customs Organization, 2007). state price elasticity by about 0.2 al., 2001). International brands, and particularly percent (Lovenheim 2007).The study The evidence on the impact Marlboro, are favoured by young found that cross-border purchases of higher prices/taxes on the people in low-income and middle- increase consumption by 4.0–8.2% substitution between legal and illegal income countries where Western and the smoking participation by cigarettes outside Europe and North products are especially attractive 2.0–4.3%. The study concluded that America is limited. (Joossens & Raw, 1998). cigarette price increases would be Yurekli and Sayginsoy (2010) This evidence of the impact of effective in reducing cigarette use if used the market shares of illicit illicit trade on health disparities is cigarette smuggling was eliminated. cigarettes in 110 countries to much more scarce compared to the Making cheaper cigarettes estimate the impact of a tax increase evidence on the general population, available via the internet can on tax avoidance/evasion. Assuming and most of it comes again from undermine the public health gain a perfect substitution between North America and Europe. from imposing higher tobacco legal and illegal cigarettes in their A study from Canada using data taxes. Kim et al. (2006) found that econometric and simulation models, from 2006/2007 Youth Smoking New Jersey adult smokers who they found that a global tax-induced Survey reported that over 13% of purchased cheaper cigarettes via the increase in real cigarette prices daily teenage smokers reported internet significantly increased their would lead to higher smuggling if it is usually consuming contraband consumption over time, compared not accompanied by an improvement cigarette brands (Callaghan et al., to smokers who reported paying full in law enforcement. Despite the tax 2009). These smokers consumed price at retail stores. avoidance, the overall cigarette use significantly more cigarettes Goolsbee, Lovenheim and would be reduced: a 10% increase compared to those who smoke Slemrod (2007) used US sales data, in total tax (excise and VAT) would legally circulating cigarette brands. smoking prevalence and tax rates reduce total consumption by 1.97% Contraband cigarettes represented from 1980 to 2005 to find that there with no change in Gross Domestic 17.5% of all youth daily-smokers has been a considerable increase Product (GDP) or by 0.2% with 5% cigarette consumption in Canada,

317 IARC Handbooks of Cancer Prevention

but in some regions such as Ontario smoking and perceived smugglers as al., 2007). In addition, the presence and Quebec, the share of illegal “providing a valuable service” to the of smuggled cigarettes can result cigarettes were much higher—over community (Wiltshire et al., 2001). in a competitive disadvantage for 25% of the youth cigarette market The availability of cheaper illicit legitimate retailers, increasing consisted of illicit cigarettes. cigarettes undermined the desire of their motivation not to comply with Another study analysing cigarette many smokers to quit, thus reducing tobacco-control laws (Joossens et butts collected in 2007 at smoking the impact tobacco tax policy can al., 2000). locations near high schools in two have on consumption (Wiltshire et There is some evidence that illicit Canadian provinces found that 26% al., 2001). cigarette trade undermines efforts and 36% of them were contraband in One study from Asia, in Taiwan, to limit youth access to tobacco Ontario and in Quebec, respectively. China, indicated that low-income products, since vendors of smuggled The comparison with 2006 results and poorly-educated smokers are cigarettes are less likely to comply when the share of illicit butts was more likely to purchase smuggled with these restrictions (Joossens 24% and 35%, respectively, suggests cigarettes (Lee et al., 2009). Smokers et al., 2000). Data from the USA an increasing trend in illicit cigarette who had a personal monthly income suggest that retailers selling tax-free use among the teenage population of less than NT$10 000 in 2004 cigarettes via internet, phone or by (Canadian Convenience Stores (US$287) and had the least amount mail often fail to check the age of the Association, 2007; Unknown, 2008). of education were 54% more likely buyer. Of the 88 internet sites selling Gruber, Sen and Stabile (2002) to smoke smuggled cigarettes than cigarettes in the USA in 2000, 18.2% used data from the Canadian those with just one or none of these did not feature a minimum age of Survey of Family Expenditure characteristics. sale warning (Ribisl et al., 2001). The 1982 –1998 and concluded that Using data from 84 countries, issue of youth access to cigarettes via cigarette smuggling disproportionally Joossens et al. (2009) found that Internet may become more important affects low-income groups: illicit the burden of illicit trade falls with better retailers’ compliance trade reduces the average price of disproportionately on lower-income with youth access laws, as it may tobacco products, leading to the countries, where the illicit cigarettes drive youth to use the internet disproportionally higher consumption in 2007 made up on average 16.8% more frequently as their source of of tobacco among the poor, who are of the market; The average market cigarettes (Ribisl et al., 2006). more price sensitive compared to share of illicit cigarettes in high- A US study found that only 28.4% the general population. Therefore, income countries was about 9.8% of internet sites selling cigarettes cigarette smuggling increases in that year. The tax loss associated featured the legally required health smoking-related disparities. with illicit cigarette trade was warning (Ribisl et al., 2001). Only Cantreill et al. (2008) interviewed estimated at US$18.3 and US$13 3.5% (5 sites) of internet cigar 614 Chinese-American smokers billion in low- and high-income vendors had health warning on their living in New York City between countries, respectively. If the problem web sites (Malone & Bero, 2000). September 2002 and February 2003 of illicit cigarettes were solved, low- Internet sites selling cigarettes often and found that younger smokers and middle-income countries would failed to comply with advertising were most likely to engage in tax experience 132 000 fewer premature ban and, instead promote specific avoidance behaviour and were also tobacco-related deaths per year from tobacco brands and use of other less likely to change their smoking 2030 on. In high-income countries, tobacco products such as cigars behaviour in response to the tax the toll attributable to illicit cigarette and loose tobacco, and feature links increase. Close to 55% of male trade is lower, about 32 000 per year. to pro-smoking or smoker’s rights Chinese smokers engaged in at least In addition to the impact on the organizations (Ribisl et al., 2001). one low- or no-tax strategy after a average tobacco price, the presence Illicit tobacco trade can affect substantial increase of tobacco tax of illegal cigarettes on the market public safety by attracting organized in 2002. can interfere with other tobacco crime and by increasing the general Smokers in socioeconomically control regulations, such as those level of corruption (FIA International deprived areas of Edinburgh in the related to youth access to tobacco Research Ltd, 1999a). In New York United Kingdom admitted buying and requirements of tobacco product City, cigarette smuggling has been contraband products as a way to contents and labelling of products associated with organized crime as deal with the rising financial costs of (Stephens et al., 2005; Pappas et well as activities of small-time crooks,

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and has led to murders, kidnappings governments and international neighbouring or overseas jurisdictions. and armed robberies to earn and organizations. Key informants Inter-agency cooperation (both protect illicit profits. Such crime has were chosen for their overall domestic and international) emerges exposed average citizens, such as knowledge of tobacco smuggling as a vital component of all successful truck drivers and retail store clerks, or their intimate knowledge of a anti-contraband strategies. The to violence (Fleenor, 2003). specific anti-contraband policy dynamic nature of contraband supply Money gained from illicit tobacco measure. requires a comprehensive approach trade is used for other serious criminal 3. Four expert focus panels that focuses on both immediate and enterprises, including terrorist were convened to validate, future threats. Policies designed operations (United States General enrich understanding of, and to ensure that contraband tobacco Accounting Office, 2003). In 2002, further assess the feasibility of products do not appear in the a US federal court found Mohamad implementing the various policy legitimate retail sector (such as Hammoud guilty of providing material measures. tax-paid markings, licensing and support for terrorists in his role as In its conclusions, the report record-keeping) and measures to leader of a Charlotte, North Carolina– identifies and defines the different ensure that counterfeit products are based cell that raised money for the forms of contraband tobacco, easily identified (such as enhanced Lebanese terrorist group Hezbollah including casual small-scale taxation stamps) are vital resources. by smuggling cigarettes within smuggling, organized international Adequate investment in enforcement the United States (Fleenor, 2003). smuggling, illicit manufacturing, tax is also essential to the success of Thus, illicit tobacco trade can have avoidance from duty-free sources, anti-contraband measures. Given implications for the overall welfare of and counterfeit cigarettes. The the global scope of the phenomenon, the country (Bhagwati and Hansen, effectiveness of ten anti-contraband greater international cooperation and 1973; Ray, 1978) including the overall policy measures are explored: information sharing is paramount. public health. licensing, tax-markings/stamping, A central theme in the research tracking and tracing, record-keeping/ findings is the multifaceted nature Policies to curb tax avoidance/ control measures, enhanced of successful anti-contraband evasion; new policies/ enforcement, export taxation, tax tobacco policies, which require technologies harmonization, tax agreements/ combinations of regulation, fiscal/ compacts, legally binding taxation policy, enforcement, and Sweeting, Johnson and Schwartz agreements with the tobacco industry, public awareness campaigns. made an extensive review of the memoranda of understanding and The literature on the effectiveness effectiveness of policy measures to public awareness campaigns. of anti-contraband policies is rather combat cigarette contraband in 2009. According to the authors, the limited, and even less evidence is While focusing on the Canadian analysis suggests that both the available for measures to reduce situation, the report provides updated type of contraband and means tax avoidance. The methodology information on anti-contraband of distribution influence the of the illicit trade estimates is often policies in different parts of the world. effectiveness of different policies poorly described, and the research Case studies in Brazil, Canada, and the unintended consequences of is underfunded for an area which is Australia, United Kingdom, Spain and action. For example, policy measures described as difficult. For evident the EU are discussed in detail in the that were effective in the 1990s for reasons, smugglers do not keep report (Sweeting et al., 2009). legally manufactured cigarettes records and are not interested Their research methods consisted smuggled across borders are less in research on their activities. of three elements: effective for the illicitly manufactured Enforcement agencies are often 1. A systematic literature review and counterfeit cigarettes that reluctant to make their findings public was undertaken, collecting both dominate contraband activity today for confidentiality reasons. One of the academic and non-academic in many countries. major recommendations of Sweeting publications on contraband Case studies indicate that and colleagues (2009) is to make tobacco and relevant policies. while contraband sources often statistics and information regarding 2. Interviews were conducted with emerge domestically, given the the tobacco trade and contraband representatives from academia, ease of transport and manufacture, tobacco much more available to the nongovernmental organizations, sources can be easily displaced to public, to assist with research and

319 IARC Handbooks of Cancer Prevention

debate on this subject. For example, Under the new system, retailers Case study: Washington State many jurisdictions (including Canada) and distributors can easily detect do not provide official estimates counterfeit cigarettes by using Cigarette tax evasion from Internet of the size of the illicit market or specific hand-held scanners. Law sales motivated the state of comprehensive data on contraband enforcement field inspectors are Washington to apply the Jenkins Act tobacco seizures made by federal equipped with more sophisticated (15 USC 376a), a US federal statute and provincial agencies, making it scanners which give them access to originally intended to curb tax evasion extremely difficult to evaluate and a whole range of data for compliance resulting from the interstate sale of assess approaches in this area verification. The legislation mail-order cigarettes (Chaloupka (Sweeting et al., 2009). imposes fines of up to US $25 000 et al., in press). The Act requires There are many forms of illicit for possessing, selling or buying vendors who market or ship cigarettes trade, and illicit activities may change counterfeit cigarettes or fraudulent across state lines to register with over time as illicit traders adapt their cigarette tax stamps. the tobacco tax administrator of the business as a result of the measures The results of the Californian destination states, and to send that taken by governments. Some system have been evaluated office monthly statements or copies examples of the changing nature of positively. The costs have been of invoices documenting the names the illicit trade of tobacco products calculated to be US$9 million per year and addresses of recipients and and the effectiveness of the anti-illicit in return for significant additional tax the quantities of cigarettes shipped. trade policies are described below revenue on cigarettes—an additional This information should aid states in the case studies of California, US$75 million was collected between with collecting excise taxes from Washington state, Brazil and Europe. January 2004 and March 2006 as a recipients of cross-state shipments. result of the licensing act and the tax However, the effort to apply the Case study: California stamps. Investigators have tracked Jenkins Act met resistance from retailers’ tax compliance since the internet cigarette vendors and The Californian Board of Equalization provisions of the Act commenced received little support from the US estimated in 2001–2002 that 25% operation. Their reports suggest federal government. However, in of the state’s retailers were selling that after implementation, the 2002 the state of Washington filed a counterfeit cigarettes (California seizures of counterfeit products at complaint against an online vendor State Auditor, 2006). To reduce the retail locations and the percentage who failed to provide information losses in revenue, the authorities of retailers carrying counterfeit on Internet sales to Washington introduced licensing obligations, high- products decreased (California State residents. A federal court decided tech tax stamps and investigative Auditor, 2006). that the state has the right to enforce authority to better control the In combating illicit trade, no one the Jenkins Act to crack down on distribution chain. In January 2004, measure is likely to be effective when cigarette tax avoidance, and the the Cigarette and Tobacco Products implemented in isolation. Tax stamps online vendor agreed to provide the Licensing Act was introduced, which and coded information should be information required by the Jenkins required all entities engaged in the implemented in combination with Act (Banthin, 2004). Washington’s sale of tobacco products within the other measures such as licensing. success in applying the Jenkins state to be licensed. In January California had a problem with the Act led to similar efforts in many 2005, the attachment of tax stamps retail selling of counterfeit cigarettes; other US states. Comprehensive to tobacco products containing coded the solution was easy detection of information on the extent of these information that was more difficult to the counterfeit cigarettes combined efforts, their costs, and the revenues counterfeit than the stamps previously with the introduction of high-tech generated from them is not publicly used was required. The stamping tax stamps, better control over the available, but newspaper articles machines applied a new generation distribution chain by the enforcement suggest that these efforts are cost- of tax stamps using invisible ink, officers and the withdrawal of the effective. For example, Michigan featuring a unique covert code licence for those retailers who sell reported collecting US$5.9 million containing product data relating to illicit cigarettes. from about 9000 residents based on each cigarette pack and uploaded to lists provided by 13 online vendors a central Data Management System. (Christoff 2006).

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Case study: Brazil manufacturers on the cigarette and enforcement) that led to positive packs (Fisch, 2006, 2009). results. The illicit tobacco trade has been a The high-tech tax stamps contain concern for the Brazilian authorities a unique code using invisible ink Case Study: United Kingdom since the mid-1990s. In 1998, for each cigarette pack. The codes Brazilian manufacturers were on the tax stamps include product In the United Kingdom, the main exporting 34 billion cigarettes to data relating to each cigarette problem was genuine cigarettes neighbouring countries, many of pack, which is uploaded to a Data produced in the United Kingdom that which returned illegally to Brazil Manager Server under the control of were exported in large numbers to as contraband. To deal with this the Ministry of Finance. Besides the dubious export markets, then illegally problem, the government imposed possibility of verifying whether the imported though smuggling networks an export tax of 150% on cigarettes products are authentic or counterfeit, back into the United Kingdom to neighbouring countries. After the the stamps are encrypted with the (Joossens and Raw, 2008). export tax was introduced, exports following information, such as name Over the last decade, illicit of cigarettes declined rapidly, but of the manufacturing site, the date cigarette trade fell from about 21% cigarette smuggling continued, as the stamp was validated, and the tax to 13% in the United Kingdom (HM newly established factories in a category of the stamp. Revenue & Customs, 2008). Anti- neighbouring country were fuelling If a manufacturer uses tax stamps smuggling measures in the United the contraband market. In addition to whose electronic codes are not Kingdom included scanners for the smuggling problem, 14 domestic detected, not allocated to that specific container detection, prominent cigarette companies were not paying manufacturer, or not in accordance fiscal marks on packs, increased the taxes on cigarettes. According with the fiscal category of the pack, punishment for offenders, more to the Brazilian Ministry of Finance, the Data Manager Server will issue customs officers, and parliamentary the illicit cigarette trade represented an alert to the Secretariat of Federal hearings, which exposed tobacco 35% of the market in Brazil in 2006: Revenues to start an investigation. industry export practices. The United 20% smuggling from neighbouring Inspectors, retailers and Kingdom strategy to tackle illicit countries and 15% illicit domestic distributors can easily detect trade was continuously updated manufacturing (Fisch, 2006, 2009). counterfeit cigarettes by using and included a strong cooperation To tackle illicit domestic specific hand-held scanners. Law between different agencies. The manufacturing, the licensing enforcement field inspectors can approach includes improved of manufacturers was made have access online to package intelligence, risk profiling, tasking and mandatory. Noncompliance with related data available on the Data coordination to detect and disrupt the the legislation or failure to pay taxes Manager Server by scanning the supply of illicit tobacco products (HM could lead to the withdrawal of the code. Revenue & Customs, 2008). manufacturer’s license and the According to the Brazilian Ministry closure of the factory. In addition to of Finance, the implementation of Case study: Italy and Spain the licensing obligations, a national the programme led to the closure integrated control and monitoring of several companies that did not In the 1990s, cigarette smuggling system for cigarette production comply with the licensing rules and was a significant problem in the EU. was fully implemented in 2008. The to US$100 million less tax evasion at In 1996, US cigarette companies system included the installation of the domestic market in 2008 (Fisch, were exporting billions of cigarettes automatic production counters at 2009). to Europe, under the transit regime, each production line and mandated The new policy was not intended many of which disappeared during the implementation of a digital to have an impact on the smuggling transport and ended up in the illegal tax stamp, with capabilities for of cigarettes from the neighbouring markets of Italy, Spain, Germany and identifying each individual pack. The countries, and its impact on this other EU markets. However, over the purpose of the new legislation was type of illicit trade is probably minor last decade illicit cigarette trade fell to ensure that all due taxes were or non-existent. As in the case of from about 15% to 1–2% in Italy and collected on cigarettes produced in California, it was only a combination Spain (Joosens & Raw, 2008). Brazil and to verify the authenticity of policies (control and monitoring In Italy, following Italian and of the tax stamps applied by the system, licensing of manufacturers European investigations which led

321 IARC Handbooks of Cancer Prevention

to legal action against the tobacco dramatic fall in US exports to Europe 1989–95 sales data suggests that industry, and subsequently to a legally (Joossens and Raw, 2008). coordinated multilateral increases binding agreement with Phillip Morris, The European examples have in cigarette taxes would result in there was a dramatic fall in customs common factors. Smuggling was significantly less tax avoidance seizures and corresponding rise in reduced by interrupting the supply and tax evasion than unilateral tax legal sales. The supply of smuggled chain from the manufacturers to increases. cigarettes into Spain was reduced by the illicit market, and the evidence Combating tax evasion remains a combination of measures, including suggests that the supply chain is difficult, but empirical evidence from intelligence, customs activity in to a great extent controlled by the around the world suggests that a border areas, and international tobacco industry. International combination of measures such as cooperation, both within Europe and cooperation was also crucial. more investment in enforcement and with US authorities over the supply Enforceable measures to control dissuasive penalties, international of seized US brands. The European the supply chain, and international cooperation, including information Fraud Office (OLAF) investigation cooperative measures including sharing and cooperation in the of the tobacco companies in the US information sharing and cooperation investigation and prosecution of in 1998 and the Spanish and Italian in the investigation and prosecution offences, legislative measures to customs activities and ensuing of offences are essential to deal with control the supply chain and the legal lawsuit against American tobacco the cross border illicit cigarette trade. business can lead to positive results. companies also appear to have had One study (Merriman et al., 2000) a significant impact. Over the period on small-scale smuggling and cross- covered by these actions there was a border shopping in Europe using

322 Tax avoidance and tax evasion

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