The unlikely link between tobacco taxes and regulations, criminal cartels, and terrorism

by Bob Gatty

The huge federal tobacco tax increases that took effect April 1 and potential new regulations and restrictions still to come are expected by some experts to spur increased sale of illegal cigarettes and other tobacco products, perhaps helping to finance much more sinister and dangerous criminal activities -- even terrorism.

    “The U.S. government needs to be very careful with its policies,” cautions UBS tobacco analyst Nik Modi, who says the combination of high taxes and tough regulations could encourage bootlegging, counterfeiting, and other illegal tobacco sales.

    “It’s a growing problem, one that will continue to grow because any sort of regulation has the implications of driving up prices,” cautions Patrick Fleenor, chief economist at The Tax Foundation, a Washington, DC-based nonpartisan educational organization. “New regulations will increase costs, and as with increased taxes, that will be a boon to bootleggers.”

    Trafficking in contraband cigarettes is a global problem and it is believed that cigarettes are the number-one illegally trafficked ‘legal’ commodity in the world, William Hoover, assistant director for field operations at the Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF), told the House Judiciary Committee during a hearing last year. He cited estimates that illicit trade in cigarettes accounts for some 11 percent of all cigarettes sold, about 600 billion cigarettes, with tax losses ranging between $40 and $50 billion per year.

    Hoover pointed out that the Government Accountability Office (GAO) in 2005 estimated that the state tax loss to states from cigarette trafficking was about $1 billion, with New York State losing $500 million and California $100 million annually due to the diversion of cigarettes. All of that, he said, is made possible by tax disparities between jurisdictions, creating “an opportunity for criminal networks to reap huge profits by avoiding federal and/or state excise taxes.”
    
Homeland security ‘issue’
Last July the Republican staff of the House Committee on Homeland Security published a report warning that illicit cigarette smugglers in New York State and elsewhere were sending large sums of cash to individuals with known terrorist ties.

    “This is a very serious homeland security issue, one that has gone unnoticed for far too long,” declared Rep. Peter T. King (R-NY), ranking Republican member of the committee. “Cigarette smugglers are able to generate millions of dollars in illegal profits, with a great deal of this wealth being sent to terrorist groups overseas—groups that would like nothing more than to inflict devastating harm on our country and its citizens.”

    That document came months before the new 62-cents-per-pack federal excise tax increase on cigarettes took effect April 1, sending prices – and the potential “margin” for bootleggers and counterfeiters – even higher.

    In April 2008, New York law enforcement authorities announced the arrest of Rafea al-Nablisi of Queens for smuggling 12,000 cartons of cigarettes a week.  “It was not the first such arrest, and thanks to New York’s latest cigarette tax hike, it will not be the last,” observed Fleenor in a Wall Street Journal op-ed.

    He pointed out that less than two weeks after Nablisi’s arrest was made public, Gov. David Paterson signed a $1.25 per-pack tax hike on top of the state’s $1.50 per-pack tax, which is in addition to New York City’s own $1.50 per-pack tax. As of July 1, 2008,  that meant that New York City smokers would be paying an average of $9 per pack for legal cigarettes – and that was before this year’s FET increase. Now the cost there exceeds $10 per pack.

    “If history is any guide,” Fleenor wrote, “most cigarettes sold will actually be trucked up from Virginia, or shipped in from China, by ‘butt’leggers’ who can make over $1 million on each tractor-trailer load of smuggled smokes. The blunt fact, which politicians of both political parties are determined to ignore, is that high cigarette taxes in New York have led to a bloody, decades-long smuggling epidemic.” He estimates that as much as 75 percent of cigarettes sold in New York City are on the black market.

    In Maryland, cigarette taxes were raised by $1 in 2008, and according to published reports, the state now is arresting more than double the number of people for illegal cigarette sales. Despite the tax increase, Maryland Comptroller Peter Franchot estimates tobacco tax receipts for this year will be down, with revenue predictions falling short again next year. The explanation? According to Fleenor, the black market is siphoning off revenue that had been anticipated in Maryland.

AWMA warns Congress
    In opposing both the FET increase legislation, AWMA President & CEO Scott Ramminger wrote to every member of Congress warning that such would be the case if taxes continued to rise.

    “What we are seeing here is something akin to “The Perfect Storm.”   We’ve seen an increase in the FET,  and many states are trying to put increases in their tobacco taxes into effect.  Into the middle of that environment drops the whole issue of  FDA regulating tobacco.  All you really have to do is think about what happened during Prohibition in this country – or at what has happened in Canada since that country put draconian restrictions on cigarette sales and marketing.   In Canada now, a huge proportion of the cigarettes – something like 30 percent – are illegally sold product,” Ramminger said.  “Aside from all of the government imposed restrictions, cigarettes are a fairly easy product to manufacture.  They are small, light, high value, and easy to make.  That – in conjunction with draconian government restrictions – creates a perfect opportunity for both counterfeiting and smuggling,” he added.

Last September, a California man was sentenced to 42 months in prison and ordered to pay nearly $1 million in restitution to the state for his role in a ring that was trafficking counterfeit cigarettes and cigarettes bearing counterfeit California tax stamps. According to court documents, the ring’s activities deprived the state of more than $43 million in tax revenues.

    Daniel Araya had previously pleaded guilty to trafficking contraband cigarettes and smuggling goods into the U.S. He was one of 13 defendants charged in connection with the scheme through which he distributed more than 1 million packs of cigarettes bearing counterfeit tax stamps. Some of the smokes were counterfeits smuggled into the U.S from China, according to the U.S. Attorney’s Office in California.

    In March, the FBI charged two Brooklyn, NY, men with buying 15 cases of cigarettes from a New Jersey undercover agent who told the men the smokes were stolen. Each case held about 600 packs on which no state tax had been paid.

    Charles Potts, an auditor with the Camden, NJ, ATF office, was quoted on Philly.com as saying running cigarettes is easy and can result in a big payoff.

    “Do it right and it’s like free money,” Potts said. “It’s the best thing since Prohibition.”

    That, of course, is an important argument advanced by AWMA in opposing the higher federal taxes as well as legislation giving the Food and Drug Administration (FDA) authority to regulate tobacco. Prohibition of alcohol resulted in booze being bootlegged by organized crime, and de facto prohibition of tobacco would have a similar result.

    Last year in a letter to Congress opposing the FDA legislation, since approved by the House of Representatives and at press time nearing a vote in the Senate, AWMA cautioned that granting FDA the power to regulate tobacco could result in “such onerous restrictions on the distribution, promotion, advertising and sale of tobacco products that wholesalers and retailers would be unable to comply…and…would be forced to discontinue offering tobacco products to American consumers.”

    The FDA legislation, “The Family Smoking Prevention and Tobacco Control Act,” gives FDA authority to regulate the manufacturing, marketing and sale of tobacco products. Key features include:
 

• Restrictions on marketing and sales to youth.
• Granting to FDA specific authority to restrict tobacco marketing.
• Requiring detailed disclosure of ingredients, nicotine and harmful smoke constituents.
• Allowing FDA to require changes to tobacco products to protect the public health, including changing nicotine yields.
• Regulating “reduced harm” products, including prohibiting such descriptors as “light,” “mild,” and “low” to characterize a product on labels or in advertising.
• Requiring larger, more specific health warnings on packs.
• Funding FDA’s activities through a user fee on manufacturers, allocated by market share.

    In May, during the organization’s Day on the Hill lobbying event, AWMA members urged lawmakers to oppose the FDA bill, and encouraged, instead, consideration of an alternative, “science-based” measure that would create a Tobacco Harm Reduction Center to focus on cessation programs and combating underage smoking and development of reduced risk products.

The anti-tobacco culture
    However, at press time, final passage of the FDA bill appeared to be inevitable, a development welcomed by President Obama’s new FDA Commissioner, Margaret “Peggy” Hamburg, a key figure in Washington’s growing “anti-tobacco” culture.

    “Tobacco products are unlike any other products on the market in that they are unusually lethal, but yet not highly regulated,” she told the Senate panel May 7 as lawmakers considered her nomination. “This is a critical moment, I think, to take a more aggressive look at how we regulate tobacco products…and to reduce the risks of tobacco products to the American people. I think the FDA is the appropriate agency to regulate tobacco. They have the scientific expertise.”

    Hamburg is not the only tobacco opponent named to highly influential positions by the President.

    In January, just days before taking his oath of office, the President-elect announced the nomination of William V. Corr, executive director of the Campaign for Tobacco-Free Kids, to be the number-two official at the Department of Health and Human Services.

    In May, the President announced the selection of Dr. Thomas R. Frieden, New York City’s health commissioner, as director of the Centers for Disease Control and Prevention. During his seven years as New York’s top health official, Dr. Frieden, an infectious disease specialist, led the crusade to ban smoking in city restaurants and bars.  He was quoted by the New York Observer as calling tobacco industry executives “mass murderers.”

    Meanwhile, both Modi and Fleenor caution that lawmakers and regulators in the U.S. should pay attention to developments in Canada that have occurred in direct correlation to exceedingly high cigarette taxes and tough regulations on marketing and merchandising that were imposed in recent years as a deterrent to smoking.

    There, stark, scary health messages warning of dire consequences are required on cigarette packs, and the merchandising of cigarettes is controlled to the point where product must be hidden behind doors or curtains – out of view by customers.

    According to a study published by AWMA last year, the unintended result has been “the growing availability of illicit cigarettes that are cheap, unregulated, of poor quality and distributed by organized crime; the same people that run guns and drugs.”   
 
   Meeting with lawmakers during the Day on the Hill event, Ramminger pointed out that in Canada some 30 percent of tobacco sales are of contraband product.

    “That takes jobs away from law-abiding people and gives the proceeds to terrorists,” he said. “Is that what we want to do?”

Bob Gatty writes regularly for Distribution Channels magazine and is a contributing editor.  He also is founder of G-Net Strategic Communications.