Excise Taxes, Illegal Cigarettes And Altria: The Case Of Massachusetts

According to the Altria Group‘s (NYSE: MO) company’s website, between 2000 and 2013, federal and state governments increased cigarette excise taxes more than 120 times. Company’s such as Altria oppose tobacco excise tax increases saying that, among other things, it create incentives for contraband and counterfeit tobacco product trafficking. ^[1] However, a study commissioned by the Commonwealth of Massachusetts has suggested that reducing state taxes may not reduce the avoidance of cigarette taxes. It said that such a move would simultaneously reduce tax revenues and compromise on the public health objective of reducing tobacco usage. ^[2] In this article we analyse the rationale behind these arguments and try to get a sense of the impact of excise taxes on Altria, by taking up the case of Massachusetts.

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Altria’s  Concern About Excise Taxes And Illegal Cigarettes

According to the Altria website, high excise taxes provide a significant financial incentive to criminals to engage in contraband cigarette trafficking. Quoting an unnamed agent of the The Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF), they say that there is a direct relationship between the increase in a state’s tobacco excise tax and increase in illegal trafficking and the import of counterfeit cigarettes manufactured in countries such as China. ^[1]

It is estimated that counterfeit and contraband cigarette import into the U.S. resulted in an estimated $5 billion in annual tax revenues lost across the nation. ^[1] Assuming the industry tax rate is the same as that we have applied for Altria in our model, i.e., 38%, this represents a loss of  after-tax revenues of  ~$8.2 billion a year for the cigarette industry in the U.S. With slightly over half the market in terms of retail sales to itself, Altria has reason to be concerned about the ~$4 billion that is not appearing on its top-line. ^[3]

The State Regulator’s Perspective

The Commission on Illegal Tobacco was established by the Commonwealth of Massachusetts in part to report on the illegal tobacco market in the state in 2013. This was the same year that Massachusetts increased its state excise tax on cigarettes from $2.51 per pack to $3.51. This made Massachusetts’ excise tax on cigarettes the second highest in the U.S. Neighboring New York comes in first with $4.35 a pack. The Massachusetts tax rates are, however, well above those of three other neighboring states: New Hampshire, Vermont, and Maine. ^[2]

Massachusetts Department of Revenue economists have predicted that the latest tax increase will raise $150 million a year in revenues for the state. As regards illegal cigarettes, they estimated that prior to the raising of taxes, between 7% and 20% of the cigarettes consumed in the state was untaxed. With the tax increase it is expected to go upto between 8.3% and 27.5%. The broad range reflects the uncertainty due to lack of availability of necessary data and unreliable nature of available data. For other tobacco products, such as cigars and moist tobacco, the economists have not been able to estimate these figures at all. ^[2]

Counterfeiting Less Of A Threat In Massachusetts

Of the two ways of taking advantage of the higher tax, namely smuggling and counterfeiting, the former has been estimated to be a greater threat in Massachusetts. This is due to the prevalence of lower taxes in neighboring states, which induces smuggling across state borders. ^[2] Counterfeiting, on the other hand, was found to be less prevalent in Massachusetts. Altria Group embarked on a program to collect discarded cigarette packs from Boston. They found that less than 0.1% of such packets collected were counterfeits of their brands such as Marlboro and a similar small number had counterfeit tax stamps. ^[2] International smuggling on the other hand is believed to be a greater threat as 3.4% of the packs gathered were non-domestic packs. ^[2] Whether these packs were brought in by individual overseas travelers or by organized smugglers is uncertain.

Implications For The Altria Group

The economists have estimated that the increase in taxes will increase the incidence of tax avoidance between $12 million and $49 million. These figures are much lower than the estimated increment in tax collection, which is almost thrice the highest figure in the range. ^[2] This could have two important implications for Altria Group. Firstly, since smuggling, unlike counterfeiting, does not deprive Altria of its revenues, lower tax revenue losses from tax avoidance does not benefit Altria. We are assuming here that cigarettes smuggled across state lines have been purchased legally in the low tax states. Hence Altria stand only to lose from reduced consumption due to increased tax inclusive prices of cigarettes. A pack of Marlboro is priced a little under $10 in Massachusetts. ^[4] This means that a tax increase of $1 if passed on to the consumer increases prices by 10%.

Following the Massachusetts Department of Revenue economists assumption of the price elasticity of consumption (% change in consumption due to a % change in price change) at between -0.3 and -0.5, the tobacco industry stands to lose between 3% and 5% of its sales in the state. ^[2] If a $1 hike in taxes per pack of cigarette adds revenue of $150 million annually to the state, then the number of packs sold in a year in the state is 150 million. Assuming half of these are Altria products priced around $10, then Altria’s cigarette sales revenues from Massachusetts is $750 million. Loss of between 3% and 5% of these revenues implies a loss of between $22.5 milion and $ 37.5 million of lost sales.

The second implication of the tax rate hike for Altria Group is the effect it will have on the approach of regulators in other states. If Massachusetts manages to increase its revenues from higher taxes to the extent they have forecast, it would mean that the current rates of tax on cigarettes is not at the peak of the Laffer curve (The Laffer curve suggests that if taxes are increased continuously, after reaching a peak high value, the revenue generated from the tax begins to fall due to tax avoidance). ^[5] This could motivate other states to follow suit in hiking cigarette taxes. It will effectively throw one of the major arguments of big tobacco, i.e., the rise in tax avoidance offsetting the incremental revenue from increased taxation, out of the window.

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1. Excise Tax Increases [↩] [↩] [↩]
2. Report Of Commission On Illegal Tobacco [↩] [↩] [↩] [↩] [↩] [↩] [↩] [↩]
3. Altria Boosted By Higher Cigarette Prices [↩]
4. Massachusetts Minimum Retail Prices [↩]
5. The Laffer Curve [↩]