Tobacco makers were able to avoid paying billions of dollars in federal excise taxes by reclassifying their “roll-your-own” tobacco products as pipe tobacco, and small cigars as large cigars, according to a new government report and witnesses at a Senate hearing Tuesday.

The federal government lost an estimated $2.6 billion to $3.7 billion in tax revenue between April 2009 and February 2014 after passage of the Children's Health Insurance Program Reauthorization Act (CHIPRA) of 2009 created opportunities for tax avoidance and led to significant market shifts toward lower-taxed products by manufacturers, importers and price-sensitive consumers, according to a Government Accountability Office report.

Slow passage of regulations and lax enforcement have only contributed to the tax revenue losses, along with a booming business in illegal cigarette sales and counterfeit products and cigarette tax stamps.

“The tax evasion tale goes like this: In 2009, Congress renewed the Children’s Health Insurance Program, which currently provides insurance coverage to more than eight million children each year,” said Senate Finance Committee chairman Ron Wyden, D-Ore., in his opening statement at Tuesday’s hearing. “To pay for that coverage, Congress raised excise taxes on certain types of tobacco products, including cigarettes and loose, roll-your-own tobacco. The tax rates on tobacco for pipes and some large cigars, however, remained lower. So immediately after the law was enacted, companies pried open a big loophole. They started changing the labels on their packaging. Products that would have been labeled ‘roll-your-own’ tobacco one day were labeled ‘pipe’ tobacco the next, and the tax bill on them plummeted. Companies also stuffed ‘small cigars’ with a few extra grams of tobacco. That way, they’d be considered ‘large cigars’ and be taxed at a lower rate.”

Thanks to the tax loophole, sales of pipe tobacco have skyrocketed more than tenfold in just five years. “It seems implausible that so many more Americans would suddenly start smoking pipes,” said Wyden.

He pointed out that after five years, the Treasury Department’s Alcohol and Tobacco Tax and Trade Bureau, or TTB, still has not drawn a meaningful distinction between tobacco products. “Instead, they’ve ignored everything except for the words on the package: ‘roll-your-own’ or ‘pipe.’ All it takes to exploit this loophole is some ink on a label. No muss, no fuss, no teams of tax lawyers poring over legal documents.”

Wyden contended that the loophole undermines the effort to discourage smoking among America’s children and teens, with evidence from the Surgeon General showing that raising the cost of cigarettes stops kids from smoking. “When tobacco is cheap because of a blatant loophole, young people will buy it,” he said.

He acknowledged, however, that TTB has only four criminal agents to enforce the law for the entire country, and when the Food and Drug Administration was dragged into the situation, it made matters worse by actively allowing companies to continue using the loophole, even sending letters to companies giving them the OK.

Wyden’s Republican counterpart on the committee, ranking member Orrin Hatch, R-Utah, pointed out that TTB nevertheless collected approximately $23 billion in taxes in fiscal year 2013, making it the third largest tax collection agency in the U.S. government.

“This amount is even more significant when you consider the number of tobacco-related transactions undertaken and that millions of Americans are represented somewhere in that $23 billion,” said Hatch. “Of that amount, around $14 billion came from collecting taxes on tobacco products. It seems that there is some truth to the quip attributed to former House Majority Leader Thomas Foley, that ‘If you don’t drink, smoke, or drive a car, you’re a tax evader.’ Because of the large sums of money involved in this issue and because of the number of people and businesses affected, it is important that federal excise taxes are administered accurately and fairly.”

Turnaround in Roll-Your-Own
TTB administrator John Manfreda told the Senate hearing that before CHIPRA, the tax rates on pipe tobacco and roll-your-own tobacco were the same ($1.0969 per pound). CHIPRA increased the tax on pipe tobacco to $2.8311 per pound, while the tax on roll-your-own tobacco was increased to $24.78 per pound to make it generally equivalent to the cigarette tax. “Because the two products can be similar (and even interchangeable) , and because the tax on roll-your-own tobacco was significantly increased, a portion of the roll-your-own tobacco market has switched to pipe tobacco, resulting in a dramatic shift in the volume of pipe tobacco and roll-your-own tobacco reported as removed by domestic manufacturers,” he added. “In the 12 months preceding CHIPRA, roll-your-own tobacco accounted for 86 percent of the combined roll-your-own and pipe tobacco market, with pipe tobacco representing the remaining 14 percent.”

Since CHIPRA (from April 2009 through calendar year 2013), there has been a near-complete reversal in these figures, with pipe tobacco accounting for 85 percent of combined roll-your-own and pipe tobacco removals and roll- your-own tobacco falling to 15 percent, Manfreda pointed out. He said TTB believes the increase in pipe tobacco removals is partly due to increased consumer demand for pipe tobacco based on the price differential between pipe and roll-your-own tobacco (for use in a pipe or in a personal cigarette-making machine used at home), but it is exacerbated by the use of pipe tobacco in cigarette-making machines that have been made available for commercial purposes. The growth in the hookah tobacco market, which is classified as pipe tobacco for purposes of the Tax Code, may also be a contributor.

In response to this shift, Manfreda noted, TTB published an advanced notice of proposed rulemaking in the Federal Register in July 2010 regarding potential physical characteristics of roll-your-own and 10 pipe tobacco that could be used to set an objective standard to differentiate between the products. The comment period was re-opened in 2011 to allow public comments on an additional proposal received from an industry member.

Wyden expressed impatience that the regulations had not been finalized yet, but Manfreda contended that it was difficult to establish objective physical standards for differentiating between the two products, given the similarities and the wide variety among the products. “It is also difficult to identify factors that differentiate pipe tobacco from roll-your-own tobacco for tax classification purposes, given the current statutory standards, as reflected by the comments received in response to the rulemaking,” he pointed out.

Not a Pleasant Experience
Ron Bernstein, president and CEO of Liggett Vector Brands, the fourth largest cigarette manufacturer in the U.S., acknowledged the problem. “In 2009, Congress raised tobacco taxes to help fund the State Children’s Health Insurance Program,” he said. “The taxes on cigarettes, ‘roll-your-own’ tobacco, and on little cigars were raised to the equivalent of $10.07 per carton. At the same time, Congress only marginally raised the tax on pipe tobacco to $1.15 per carton equivalent. That means the federal excise tax on pipe tobacco is roughly 10 percent of that of cigarette tobacco. Before the ink was dry on the legislation, certain tobacco manufacturers embarked on a campaign to evade the tax increase by re-labeling roll-your-own tobacco as ‘pipe tobacco.’”

Bernstein showed illustrations of some of the ways that tobacco manufacturers got around the new law. “For example, this is what a smoker would have found in a store before the tax increase: 'Kentucky Select Cigarette Tobacco.’ This product was made available after the tax increase: 'Kentucky Select Pipe Tobacco.’ The chief difference between these two products is the label?and a substantially lower tax rate. Here is a bag of ‘Desperado.’ Astoundingly, this company just pasted on a label that says, ‘all natural pipe tobacco,’ and used tape to cover the statement ‘makes approximately 500 cigarettes.’ Everyone knows that this is cigarette tobacco. The manufacturer knows. The consumer knows. I know - because I tried smoking it in a pipe, and it was not a pleasant experience.”

Bernstein said his company met with representatives from TTB in 2010 and showed them that all of the growth in the category was coming from mislabeled “pipe tobacco” rather than genuine pipe tobacco. “TTB advised that they were aware and had expected this problem when Congress failed to equalize the tax on pipe tobacco with RYO and cigarettes in 2009,” he said. “Since the existing tax code definition of RYO included anything sold as cigarette tobacco or RYO, TTB already had clear authority to enforce the law—especially since the manufacturers of the products knew exactly what they were doing, and were using a variety of tactics to inform consumers that the product was really RYO tobacco. We were pleased to learn shortly after the meeting that TTB had issued a statement on its Web site indicating that specific guidance would be forthcoming in the near future. Four years later, we are still waiting for that guidance. Meanwhile, sales of pipe tobacco have grown by over 700 percent, while ‘roll-your-own’ has declined by over 80 percent and cigarettes have declined by over 20 percent.”

Sometimes a Cigar Isn’t Just a Cigar
The committee also heard from the owner of a cigar-manufacturing company, Rocky Patel, owner of Rocky Patel Premium Cigars, in Naples, Fla., who explained some of the complexities of the Tax Code involving cigars.

“Premium cigars are not defined under the Internal Revenue Code, but they are typically considered to be high-grade tobacco products wrapped in 100 percent tobacco filler, containing no filter, tip or non-tobacco mouthpiece, and weighing in at least at 6 pounds per 1,000 count,” he said. “The closest approximation to a premium cigar in the Internal Revenue Code is the ‘large’ cigar, which is a cigar that weighs at least 3 pounds per 1,000 count. Besides weight, the Internal Revenue Code does not have additional requirements for a cigar to be considered a large cigar. As a result, there are physical weight differences between what is considered a large cigar under the Internal Revenue Code and what we consider a premium cigar for large cigars that weigh between 3 and 6 pounds per 1,000 count.”

Patel noted that before CHIPRA, premium and large cigars were taxed at the larger amount of either 20.719 percent per each cigar or not more than 4.875 cents per cigar. After CHIPRA, federal excise taxes on premium and large cigars rose to the larger amount of either 52.75 percent per each cigar or not more than 40.26 cents per cigar. 

“This resulted in as much as a 726 percent tax increase on premium and large cigars per thousand ‘sticks,’” said Patel. “This represents one of the highest increases in the history of the IRS tax code. By comparison, taxes on small and large cigarettes increased by approximately 158 percent per thousand sticks after CHIPRA.”

The tax increases have had a significant impact on the premium cigar community, Patel noted. “While manufacturers or importers of premium cigars usually pay the applicable FET, the tax is passed on to premium cigar retailers when purchasing inventory,” he said. “In addition to paying a price that includes the cost of the FET, premium cigar retailers must also pay a state ‘Other Tobacco Product,’ or ‘OTP,’ tax. Such taxes can go as high as 95 percent of the wholesale price. OTP taxes are generally based on the price for which the cigars are sold by the manufacturer or importer to the retailer, which includes the FET. In effect, this means that a premium cigar retailer pays a ‘tax on a tax’ as a basic cost of doing business. Paying both FET and OTP taxes has a significant impact on the premium cigar retailer, requiring a significant up-front investment that retailers must carry in inventory until, and if, the cigars are sold.”

High Taxes Encourage High Crime
Economist Scott Drenkard, manager of state projects at the Tax Foundation, a research and analysis organization, noted that tobacco taxes are the highest they have ever been in the United States. The federal rate currently stands at $1.0066 per pack of cigarettes, and state and local rates add as much as an additional $6.16 per pack, as in Chicago.

“These combined rates are equivalent to a tax in excess of 200 percent in some locales,” said Drenkard. “The high tax burden on tobacco results in de facto prohibition of the products, bringing all the undesirable outcomes associated with alcohol prohibition in the 1920s. In our research we have found evidence of substantial tobacco smuggling from low- to high-tax jurisdictions, violent crime, theft of tobacco and tobacco tax stamps, corruption of law enforcement officers, and even funding of terrorist organizations through crime rings.”

Drenkard noted that the Mackinac Center for Public Policy, a Michigan think tank, estimates that 56.9 percent of the cigarettes consumed in New York State in 2012 were smuggled into the state from other locales. Other states with substantial smuggling problems include Arizona (51.5 percent), New Mexico (48.1 percent), Washington (48.0 percent) and Wisconsin (34.6 percent).

“In addition to smuggling authentic cigarettes from low- to high-tax jurisdictions, criminals sometimes skirt the legal market altogether and counterfeit name brand products and state tobacco tax stamps,” said Drenkard. “Cigarette counterfeiting is a highly profitable international business that exposes consumers to products with increased levels of dangerous chemicals like lead and thallium. Other sources report finding insect eggs, dead flies, mold and human feces in counterfeit cigarettes. One source estimates that the Chinese cigarette counterfeiting business produces 400 billion cigarettes per year.”

In 1994, Drenkard pointed out, federal cigarette excise taxes in Canada were cut from $16 to $11 per carton because cigarette smuggling had grown so pervasive.

The steady decline in tobacco consumption since the 1960s also makes tobacco tax revenue an unstable revenue source, Drenkard cautioned. The Obama administration’s plans to fund pre-kindergarten education with a federal cigarette tax increase are not sustainable in the long term, because revenues are projected to decline, while costs will grow, he added.

“Public policies often have unintended consequences that outweigh their benefits,” Drenkard warned. “One consequence of high state cigarette tax rates has been increased smuggling as criminals procure discounted packs from low-tax states to sell in high- tax states. Growing cigarette tax differentials have made cigarette smuggling both a national problem and a lucrative criminal enterprise. The Virginia Crime Commission found that a well-organized cross-state smuggling operation could bring in $4 million with one shipment.”

Public Health and Taxes
Michael Tynan, policy officer in the Oregon Public Health Division, pointed out that tobacco use is the leading cause of death and disease in the United States, and each year, more than 480,000 people die from smoking and exposure to secondhand smoke.

“The good news is we know how to end the tobacco use problem in this country,” he said. “There are key evidence-based interventions that have been proven to lead tobacco-users to quit, prevent youth from starting to use tobacco and reduce consumption among tobacco users. These interventions include increasing tobacco taxes, implementing comprehensive smoke-free laws, warning about the dangers of tobacco use with media campaigns, and increasing access to evidence-based cessation services. Of this list of interventions, increasing the price of tobacco is one of the most effective tobacco prevention tools available for public health.”

Tynan pointed out that excise taxes are the most direct way for governments to increase the price of tobacco products. Every state and the federal government implements a tax on tobacco, with state cigarette taxes ranging from 17 cents per pack in Missouri to $4.35 per pack in New York State, he noted. State excise taxes for cigarettes average $1.54 per pack.

Every 10 percent increase in the price of cigarettes results in a 4 percent decline in consumption, and can have an even greater impact on youth and other price-sensitive populations, Tynan noted. “Simply put, as cigarette and tobacco prices increase, people smoke less,” he said.