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A recent article in Tax Analysts' Tax Notes Weekly by former NY Times tax reporter David Caye Johnson got me thinking about the recent flurry of cigarette tax changes and the state enforcement activity accompanying these changes. See David Caye Johnson,"Behind the Cigarette Tax Evasion Crackdown," 127 Tax Notes 927 (May 24, 2010). Before reading the Tax Analysts' article I thought the real motivation behind the activity in the cigarette tax area was that cash-strapped states needed to find some way to raise additional revenue before they all go down like the Titanic. Or, as a more altruistic motive, perhaps the state legislators have finally clued in to the fact that smoking makes for sick people. And well, yes, sick people are expensive, especially when their insurance is provided as part of their state or local pension and the states and insurance companies have to foot part of that bill.
But, Caye Johnson purports that the cigarette tax developments are in fact due, at least in part, to the support and pressure of big tobacco companies. Under the Master Settlement Agreement of 1998 (MSA), signed by the states and the big tobacco companies, the states are under an obligation to do what they can from a tax enforcement perspective to protect the signatory tobacco companies' market share in cigarette sales, as compared with the market share of smaller tobacco companies not a part of the MSA, or new entrants into the cigarette-selling industry. If the MSA signatory companies' market share collectively declines by more than 2 percent, and they can demonstrate that a lack of significant enforcement of tax laws by the state was a "significant factor" in the decline, the companies are entitled to hold back some of the annual payments they are required to make to the states under the MSA. And, the companies have the right to arbitration regarding the held back funds. For eight years now, the companies have alleged that the 2 percent market share loss threshold has been met and as a result, they have been withholding funds. The withheld funds now amount to over $5 billion. Arbitration is about to begin to determine whether the companies can keep these withheld funds or whether some should be paid to the states.
So what does this have to do with cigarette tax hikes and enforcement? The general thinking is that higher the cigarette tax on a pack of cigarettes, the more likely a consumer is to turn to a less expensive alternative. This may mean buying a cheaper "off-brand" cigarette or a cigarette made by a new player in the market who woos customers with promotional rates which indirectly causes a loss of market share to the larger tobacco companies. But, higher cigarette taxes could also cause smokers to turn to cigarettes sold on the black market with no tax at all. It's under this scenario that the tobacco companies would have the greatest ability to say that the states did not protect their market share because they did not enforce the tax on these black market players.
On May 27, John J. Manfreda, administrator of the Federal Alcohol and Tobacco Tax and Trade Bureau (TTB) spoke to the House Ways and Means Oversight Committee about the increased excise taxes over the past year and how these increased taxes have created a greater incentive for evading taxes through "underreporting, smuggling, direct-to-consumer sales and other clandestine activities." CCH Federal Tax Day, June 1, 2010. Among the questions and comments recorded in response to Mr. Manfreda's remarks was a comment that tobacco manufacturers who pay federal taxes are at a disadvantage because they compete with operators who do not pay tax.
It is hard to imagine tobacco companies supporting higher cigarette taxes. Ultimately though, it seems the stage is being set for some very interesting and important arbitration hearings on the over $5 billion of withheld funds. I found that RJ Reynolds Tobacco Co. (one of the MSA-signatory tobacco companies now involved in the pending withheld fund arbitration) hosts an anti-cigarette tax website entitled "NoCigTax.com." A casual observer surfing the web would think this site was in fact hosted by, or created by, convenience store operators. Perhaps someone has some thoughts regarding RJ Reynold's motivations in maintaining this website?