In response to the documented addictive and harmful health effects of tobacco use, governments worldwide and at the local, state, and federal levels in the United States have adopted various policies to reduce or eliminate tobacco use. Common measures in the past decades have included high taxes on tobacco products and bans on advertising. Tobacco use, notably the smoking of cigarettes, has declined because of these efforts, but worldwide there are still more than 1 billion people who regularly use tobacco, including many who purchase their products illicitly. Illicit tobacco markets can undermine public health efforts to reduce tobacco use. These markets can also deprive governments of revenue; in the United States, these losses are especially incurred by the states.
In comparison with other consumer products, cigarettes are currently subject to high taxes in the United States and in most other countries. The high rates of taxation and the large tax differentials between jurisdictions increase incentives for tax evasion and tax avoidance and contribute to existing illicit tobacco markets. Tax evasion means illegal avoidance of tobacco taxes and is done by individuals or criminal networks or other entities; tax avoidance means legal activities and purchases—mostly by individual tobacco buyers—that are in accordance with customs and tax regulations.
In the future, nonprice regulation of cigarettes—such as product design, formulation, and packaging—could, in principle, contribute to the development of new types of illicit tobacco markets if the incentives for such illicit trade are not controlled or mitigated. Although the U.S. Food and Drug Administration (FDA) does not have taxation power or the authority
to enforce tax compliance, the Family Smoking Prevention and Tobacco Control Act of 2009 gave the FDA significant authority to regulate the manufacturing, marketing, and distribution of tobacco products. The FDA cannot ban nicotine entirely, but it can prohibit or restrict allowable levels of the constituents and additives in tobacco products, which could include the reduction of nicotine to a subaddictive threshold. The FDA can also regulate tobacco packaging and messaging. These restrictions may create illicit markets for banned products, and as the FDA considers possible regulations for tobacco products, it is important to understand the potential effects of any such regulations on the illicit tobacco market.
As part of its consideration of possible regulations, FDA asked the National Research Council (NRC) and the Institute of Medicine (IOM) to assess the international illicit tobacco market, including variations by country; the effects of various policy mechanisms on the market; and the applicability of international experiences to the United States. The FDA also asked for recommendations for research and data collection, though not for policy. The Committee on the Illicit Tobacco Market: Collection and Analysis of the International Experience was appointed by the NRC to carry out this task. Because the illicit tobacco trade largely coincides with the illicit trade in cigarettes, the committee report uses the terms “tobacco” and “cigarettes” interchangeably.
EXISTING ILLICIT MARKETS
The worldwide illicit tobacco trade comprises four main schemes: bootlegging, large-scale smuggling, illicit whites, and illegal production. Bootlegging refers to the legal purchase of cigarettes in one jurisdiction and their consumption or resale in another jurisdiction without the payment of applicable taxes or duties. Large-scale smuggling refers to the sale of cigarettes without the payment of any taxes or duties, even in the country of their origin. (It is important to note that “large-scale smuggling” refers not to the scale of the evasion activity, but, rather, to the systematic means by which it occurs.) Illicit whites are cigarettes that are legally produced under unique brand names or no brand name at all and that are destined primarily or exclusively for illicit distribution. Illegal production comes in two main forms: the unlicensed or underreported production of legitimate tobacco products, and counterfeiting, which refers to the production of cigarettes with brand labels that are used without the permission of the trademark owner.
In the United States, the illicit tobacco market has traditionally consisted of bootlegging from Native American reservations and low-tax states, such as Virginia, to high-tax states, such as New York. Large-scale smuggling does not appear to be a significant part of the U.S. illicit cigarette market.
Also largely absent from the U.S. market are illicit whites and illegal production, including counterfeiting. The illicit market in the United States is dominated by domestic sources. Several explanations have been offered for why, in comparison with other destination countries for contraband cigarettes, the United States appears to be less affected by large-scale smuggling of brand cigarettes and by counterfeit cigarettes and illicit whites: the effectiveness of general border controls; the relative attractiveness of alternative avenues for illicit trade inside the United States (e.g., bootlegging); and the preferences of U.S. consumers for certain kinds of cigarettes.
Internationally, nonprice factors are at least as important as price factors in the illicit tobacco trade. Those nonprice factors include weak governance, political corruption, the ease and cost of operating in a country, and the availability of retail distribution networks. Countries with high measured levels of corruption have higher levels of tax evasion and tax avoidance than do countries with low measured levels of corruption.
The behaviors of participants in the illicit tobacco market—on both the supply and demand side—shape and drive the illicit trade. Evidence from Europe suggests that the structure of illicit tobacco networks and the methods involved in the illicit tobacco trade (especially bootlegging) are generally relatively simple. In addition, the people involved in all segments of the distribution process of the illicit tobacco trade generally do not have serious criminal records, and the illicit tobacco market is not associated with violence. Although many claims have been made regarding the relationship between the illicit tobacco trade and terrorism, the link between the U.S. illicit tobacco market and terrorism appears to be minor, and there is also no systematic evidence of sustained links between the global illicit tobacco trade and terrorism.
The involvement of the tobacco industry in the illicit market is complicated. Although counterfeit cigarettes result in financial losses for tobacco companies, the tobacco industry can still benefit from other aspects of the illicit tobacco trade, such as by abetting the smuggling of legally manufactured cigarettes as a way of introducing a company’s products to new markets or to lower the price, thus expanding its share in existing markets. Studies of internal industry documents, as well as legal investigations and agreements, have shown that tobacco companies at a global level have promoted and facilitated the smuggling of legally manufactured cigarettes. However, there is no evidence that the tobacco industry is currently involved in the illicit trade in the United States. In some cases, manufacturers have provided training and support to U.S. law enforcement agencies to help combat counterfeit cigarette trade and bootlegging.
On the demand side, the consumption of illicit tobacco carries little social stigma (compared with smoking in general), particularly in places where smoking is generally socially acceptable. Individuals with low socio-
economic status and limited education tend to purchase illegal cigarettes locally, while people with higher income and education tend to purchase online or to travel to another location to avoid high taxes on cigarette purchases. Heavier smokers and those less interested in quitting are also more likely to engage in tax avoidance and tax evasion.
Youth access to tobacco in the United States represents a special situation, since the sale of tobacco to people under the age of 18 is illegal in every state. For this study, however, the only relevant circumstance is when youths engage in the same illicit transactions as do adults, and not on the underage—and by definition, illegal—purchase of tobacco products. In this context, a reasonable estimate is that youth purchases constitute about 1 percent of the illicit market. Though small, these transactions are of particular public health concern.
SIZE OF THE U.S. ILLICIT TOBACCO MARKET
It is difficult to measure the size of the illicit tobacco market precisely. Multiple methods have been used to estimate its size, including trade gap analysis; differences in self-reported consumption and tax-paid sales; econometric modeling; population surveys; empty pack collections; pack observation, return, and swap studies; and expert opinion. These methods are not easily comparable: they differ in sample sizes, time periods covered, and scientific rigor, and they yield different estimates and have different sources of error. Another limitation is the difficulty of separating tax avoidance from evasion, a distinction that is important for law enforcement and policy purposes.
In order to estimate the size of the illicit tobacco market in the United States, the committee considered a wide range of studies and carried out its own comparison of self-reported consumption and tax-paid sales. The committee’s calculation provides just one estimate of the size of the illicit market. As with other methods, the committee’s approach has strengths and limitations. For this reason, multiple methods should be used in order to obtain the most comprehensive picture of the scale of the illicit tobacco market for a specific location and time.
Using its own estimate and plausible estimates from other methods, the committee determined that the percentage of the total market represented by illicit sales in the United States is between 8.5 percent and 21 percent. This range represents between 1.24 to 2.91 billion packs of cigarettes annually and between $2.95 billion and $6.92 billion in lost gross state and local tax revenues. Note, however, that for almost all of these cigarettes, the federal tax has been paid.
The high end of the range (21 percent) is consistent with a pack return survey conducted in the United States. The low end of the range (8.5 per-
cent), which is the committee’s own estimate, reflects the net level of tax avoidance and evasion at the state level, aggregated nationally. According to the committee’s calculations, the net percentage of sales subject to tax evasion and tax avoidance has grown from 3.2 percent in 1992-1993 to 8.5 percent in 2010-2011.
For states with both positive and negative tax differentials with neighboring states, the difference between tax-paid sales and self-reported consumption will underestimate total cross-border illicit trade. Nevertheless, the committee’s estimate has a clear interpretation, the quantity that it is estimating can be defined precisely, and there are no issues with selecting a credible national sample of survey sites.
The committee’s state-level estimates show that the illicit tobacco market is not evenly distributed across the country. It may be as high as 45 percent in high-tax states, such as New York, while it is low in many other states and areas. The committee classifies 22 states and the District of Columbia as net exporters, and the remaining 28 states as net importers. Of the total tobacco taxes collected in 2011 by all states and localities of $17.65 billion, the net importing states lost an estimated $2.95 billion in state cigarette excise taxes; New York State accounts for nearly half of this total. The net exporting states gained an estimated $0.82 billion.
For comparison, the estimated revenue lost to the illicit tobacco market can be compared with the estimated loss in income taxes in the United States. For tobacco, the $2.95 billion loss (at the low end of the range) is roughly 10 percent of the total tobacco tax due; the estimates of the “income tax gap” are 17 percent at the federal level and 18 percent at the state level.
POLICY AND ENFORCEMENT INTERVENTIONS
Bootlegging, large-scale smuggling, illicit whites, and illegal manufacturing (including counterfeiting) are each linked to diversion at a particular phase in the legal supply chain of cigarettes, and opportunities exist at the preproduction, production, transit, wholesale, and retail stages for diversion to the illicit market. Opportunities also exist for the government to control the supply chain by imposing licensing and regulatory requirements on tobacco growers, manufacturers, distributors, wholesalers, and retailers.
Digital tax stamps with encrypted information and related tracking technologies also represent an approach to combating the illicit tobacco trade by monitoring and controlling the supply chain. Both methods have recently been adopted by a number of countries around the world, and California and Massachusetts require use of digital tax stamps. The main objective of tracking and tracing is to facilitate investigations into tobacco smuggling and to identify the points at which tobacco products are diverted into illicit markets. Although these technologies would not be able
to trace and investigate illegally manufactured or counterfeit products back through the supply chain, they could be used to identify such products as not having been properly taxed. In the United States, a track-and-trace system that is implemented across state borders would be better able to track and trace cigarettes through the licit distribution system and identify points of diversion into illicit markets. However, low-tax states that are the source of many bootlegged cigarettes have limited incentive to adopt such an approach.
Interventions can also seek to undermine the conditions that make illegal trade possible. For example, the enactment of a tax harmonization program, though politically challenging, would address one key cause of the domestic illicit trade: very different cigarette tax rates across states. Public education campaigns aimed directly at the illicit trade also show some promise for reaching lower socioeconomic populations who disproportionately participate in illicit tobacco markets.
Regulations and technologies to monitor and control the supply chain of tobacco products will have limited impact without enforcement efforts. Illicit tobacco is generally treated as an economic rather than a criminal problem, especially since the trade has been nonviolent and is only weakly opposed by social norms; law enforcement efforts to detect and investigate the illicit trade tend to be weak and uneven, and criminal prosecution of those involved is a low priority for prosecutors. Perhaps unsurprisingly, the committee was not able to obtain systematic, up-do-date information on measures of enforcement activity and success by agencies. Although the paucity of data makes it difficult to estimate the risks faced by tobacco smugglers, the available evidence strongly suggests that the risks of detection and prosecution are small.
Enforcement efforts against the illicit tobacco trade face two additional challenges: the dynamic and adaptive nature of illicit tobacco markets, and the need to coordinate across various agencies, participants, and levels of government. However, these challenges are not unique to the illicit cigarette trade, nor are they insurmountable.
The broad-ranging interventions adopted by several countries are instructive for the United States insofar as they show that it is possible to reduce the size of the illicit tobacco market through the dedication of tobacco-specific enforcement resources, collaboration across jurisdictions, and comprehensive intervention strategies that encompass a variety of regulatory, enforcement, and policy approaches. For example, Spain reduced the share of its illicit market from 15 percent in 1995 to 2 percent in 2001 as the result of licensing and control measures, enforcement efforts, and legal agreements. The United Kingdom used stamping and marking requirements on cigarettes, agreements with tobacco manufacturers, enforcement efforts, and public education campaigns to reduce the size of its share of
the illicit market from 21 percent in 2000 to 9 percent in 2013. Canada reduced the illicit share of its market from nearly 30 percent in the early 1990s to between 7.6 percent and 14.7 percent in 2010 (by the committee’s estimate) through sweeping intervention efforts, including licensing, tax stamps, enforcement efforts, tax harmonization, tribal tax revenue agreements, legal agreements with tobacco manufacturers, and public education campaigns. The European Union has also taken an active approach to encouraging coordination among its member states to support implementation of a transnational track-and-trace system, tax harmonization policies, and enforcement efforts.
POTENTIAL EFFECTS OF PRODUCT CHANGES ON ILLICIT MARKETS
The existing illicit markets, both in the United States and most other countries, represent a response to price incentives created by different local, state, and national tax policies. In the future, however, illicit markets that may arise as a consequence of regulations of product design, formulation, or product packaging and marketing would be potentially very different in terms of both demand and supply determinants. Consideration of those determinants needs to recognize that both the legal tobacco market and the illicit tobacco trade are dynamic and adapt in response to regulatory changes.
One key question in trying to assess responses to potential regulations is how modification of tobacco products, notably cigarettes, might affect product appeal. Research in several countries has examined the effects of such modifications on smokers’ preferences and smoking habits. Two such modifications—reduced ignition propensity (i.e., the requirement that cigarettes extinguish when not actively puffed) and decreased filter ventilation—have been shown in experimental studies to have only modest effect on product appeal among U.S. smokers, at least when considered in isolation from other product features. In contrast, reductions in nicotine levels and mentholation have been shown in experimental studies in both the United States and the United Kingdom to have a stronger effect on reducing product appeal. In consumer research studies, product appeal has also been shown to be reduced by cigarette packs with large graphic warning labels or in plain packaging.
In countries that have required large graphic health warnings or plain packaging on cigarette packs, product appeal has been shown to be reduced, and it has promoted quitting behaviors. Some people who have continued to smoke have taken steps to conceal or avoid exposure to the graphic health warnings, for example, with the use of stickers or branded containers. While these strategies subvert the intent of the law (to reduce
the use of tobacco), they are an alternative to participation in the illicit tobacco market.
On the question of reducing menthol in cigarettes, the research has been limited to consumer surveys and short-term laboratory studies of U.S. smokers using nonmentholated products. That research suggests most smokers would consider legal alternatives, including switching to a nonmentholated cigarette or quitting. Some may choose some kind of self-mentholation technology if the option is available. This research also indicates that highly addicted smokers and daily users would be more likely than other smokers to seek mentholated cigarettes through the illicit market.
On the effect of reducing nicotine levels in cigarettes, studies have shown mixed results on smokers’ use and preferences for very low nicotine cigarettes. Some studies have found that most smokers indicate they intend to quit rather than to seek alternative products. Other studies have found that smokers are able to tolerate substantial reductions in nicotine with little to no change in individual cigarette consumption. There are several new research initiatives under way on this issue, and more definitive findings are anticipated.
When product appeal declines, consumers face three options: quit smoking, switch to a legal alternative, or seek a more appealing product from the illicit market. Unlike the current situation, in which the illicit U.S. market reflects only tax differences, a market in banned products would necessarily involve large-scale smuggling from outside the country or illegal domestic manufacturing. Little research has attempted to understand what factors motivate suppliers of illicit tobacco and what factors contribute to the mobilization of supply networks. Because aggressive policies on tobacco products are new in the countries that have adopted them, there have been few studies of their effects on illicit markets. Research on the emerging effects of regulatory actions in other countries, such as Brazil’s pending ban on tobacco additives (including menthol), could provide guidance for the United States.
The regulatory task and the prediction of market response are complicated by the relatively recent emergence of electronic nicotine delivery systems (e.g., e-cigarettes), which are expected to eventually fall under the regulatory authority of the FDA. E-cigarettes have been promoted as a safer alternative for delivering nicotine to smokers than conventional products because they deliver nicotine to the user through vaporization of a nicotine solution rather than by burning tobacco. While they appear to be less harmful to one’s health than cigarettes, research is just beginning to investigate the impact of e-cigarettes on public health. The prevalence of e-cigarette use has grown rapidly, especially for adolescents, raising concerns about the public health implications of wide adoption of these products. At present, research about the efficacy and safety of e-cigarettes as an aid for smoking
cessation is limited to a small number of trials and small samples. Little is known about the possible impact of e-cigarettes as a gateway product to conventional cigarettes, and subsequent nicotine addiction, among youth or other nonsmokers. Similarly, little is known about the possible effects of the growing popularity of e-cigarettes on the existing or potential illicit tobacco market. However, e-cigarettes (and other emerging technologies for the delivery of nicotine) have the potential to be viable alternatives for some smokers in the future if there is a ban on menthol or if there are regulations that reduce nicotine in conventional cigarettes.
Overall, the limited evidence now available suggests that if conventional cigarettes are modified by regulations, the demand for illicit versions of them is likely to be modest. Some smokers may quit, and demand may also be diminished by the possibility that smokers will continue to use modified products or seek legal alternatives. Although some smokers may seek more appealing illicit products if available and accessible, this would require established distribution networks and new sources of product (which would either have to be smuggled from other countries or produced illegally) to create a supply of cigarettes with prohibited features. In addition to the possible difficulties of making such products available, the profit potential of a new type of illicit tobacco market would be limited by the availability and development of legal products that are close substitutes, as well as the robustness of enforcement.
In summary, however, there is insufficient evidence to draw strong conclusions about how the illicit tobacco market would adapt in response to permanent modifications to tobacco products as the result of any new regulations.
RECOMMENDATIONS FOR RESEARCH AND DATA COLLECTION
In order to better understand the nature of existing illicit tobacco markets and the ways in which they may evolve in the future, additional research and improved data are needed across a broad range of issues. The research and data collection recommendations listed below are numbered according to the report chapter in which they are presented and discussed.
RECOMMENDATION 2-1 Better information about the illicit tobacco market is needed to more accurately measure accounting profits of tobacco smugglers. For example, data could be systematically collected on the prices at which untaxed cigarettes are sold on the wholesale and retail levels, perhaps similar to the way in which the U.S. Drug Enforcement Agency collects information on heroin prices in large cities through its Domestic Monitoring Program, a component of the System to Retrieve Information from Drug Evidence (STRIDE) Program.
RECOMMENDATION 2-2 Research is needed on the extent to which consumer preferences explain why the United States appears to be less affected than other countries by large-scale smuggling of brand cigarettes and by counterfeit cigarettes and illicit whites. Research that directly tests the appeal and acceptability among U.S. consumers of a representative selection of non-American blend cigarettes, chosen from major international markets and Indian reservation producers, would shed light on this issue.
RECOMMENDATION 3-1 Research and data are needed about the individuals and criminal networks who traffic in illicit tobacco in the United States. A deeper understanding of these individuals and networks (criminal histories, motives, ties to organized crime, financing mechanisms, links to adjacent markets, etc.) would provide valuable knowledge about the supply chain and illicit procurement paths and the ways in which they may evolve in the future. Qualitative approaches should be complemented with quantitative approaches to measuring supply-side participation in illicit markets, such as surveys of retail store owners, wholesalers, and stamping agents; and systematic data collection (with the assistance of enforcement and regulatory agencies) on items such as the number of licensed and unlicensed sellers in a market, location of sellers, and numbers of violations. Specific questions could be asked about such topics as the nature of their sales and where, from whom, and for how much they purchase cigarettes for resale. Since sellers might be hesitant to reveal their participation in the illegal market, survey techniques aimed at soliciting true participation in stigmatized activities would need to be used.
RECOMMENDATION 3-2 Because youths under the age of 18 are of particular concern to policy makers, research is needed about the extent to which they purchase cigarettes in the illicit market and how easily they do so. The National Youth Tobacco Survey should add items that would clarify the nature of the “other commercial sources” that have become more prevalent in recent years.
RECOMMENDATION 4-1 The Tobacco Use Supplement to the Current Population Survey should be expanded in both the number of questions and specificity of questions currently asked regarding tobacco use and illicit tobacco market participation. The survey should continue to include questions that garner information about price paid and location and place of purchase; it should add questions on frequency of purchase at certain locations, last purchase location and price, and nature of the purchase (i.e., licit or illicit). Other questions that should
be added would cover the particular factors contributing to one’s seeking out lower-priced products and what price levels might influence a consumer’s decision to switch between the legal and illicit markets.
RECOMMENDATION 4-2 A large-scale pack swap survey that is representative of the U.S. population should be conducted. This survey could be integrated into a current nationwide survey capable of also providing state-level estimates, such as the Tobacco Use Supplement to the Current Population Survey, so that questions regarding a customer’s last purchase would be coupled with a pack swap component that would allow researchers to examine stamps and markings to determine if appropriate taxes were paid, and conduct an analysis of the product’s design characteristics and chemistry in order to determine if counterfeits or illicit whites had entered the market.
RECOMMENDATION 4-3 Methods should be improved in order to better differentiate between tax evasion and tax avoidance. More accurate estimates of the size of the illicit market separately attributable to tax avoidance and tax evasion could be obtained by combining more systematic data collection on discarded packs in states with significant illicit trade with (1) an expansion in the number and specificity of questions currently asked in representative population surveys regarding tobacco use and illicit tobacco market participation and (2) a large-scale pack swap survey that is similarly representative of the U.S. population.
RECOMMENDATION 6-1 Because an appropriately scaled and well-targeted enforcement effort against the illicit tobacco trade requires systematic data on the array of current efforts, the U.S. federal government should assemble and publish a periodic report on indicators of the extent of bootlegging, international smuggling, and illicit production, together with indicators of enforcement activities by the relevant federal agencies. The federal government should also consider developing a voluntary reporting system by state and local governments.
RECOMMENDATION 6-2 Systematic evaluations should be conducted of existing and future enforcement interventions in the illicit tobacco trade in the United States. State- and local-level efforts, such as the tobacco task force led by the New York City Sheriff’s Office, should be evaluated by independent researchers.
RECOMMENDATION 8-1 Research is needed to examine how smokers respond to the permanent loss of specific product features that they have previously found desirable, as a result of bans and restric-
tions on key constituents and additives as well as changes to packaging. Research should assess consumers’ intentions to seek products with banned features through the illicit market in comparison with other options, such as quitting and using alternative products. Factors that promote individual variation in response should also be examined.
RECOMMENDATION 8-2 Research is needed on the relationship between the use of e-cigarettes and the use of conventional tobacco products and on the role of e-cigarettes as an alternative to participation in the illicit tobacco market. Longitudinal studies are needed to understand the dynamics of the relationship and to determine the extent of full substitution of e-cigarettes compared with dual use or reversion to conventional products. Such work will require improvements to sources of data, including unique coding for e-cigarettes in international commerce. Furthermore, although some current surveys include questions on e-cigarette use and awareness, more detailed questions are needed on factors that affect use and their relationship to the use of conventional cigarettes.
RECOMMENDATION 8-3 The paucity of studies on the supply side of the illicit tobacco market presents challenges for research, and creative methodologies will be needed. One potential source of needed information may come from reviews of analogous markets, perhaps in other countries, where existing products have been removed from the market, but similar or related products continue to be available in legal commerce, to determine what factors influenced the emergence of illegal supply.
