Black Market Cigarettes

When I was a child, my father smoked. He smoked in the house and he smoked in the car. I don’t remember if he cracked the window open when he smoked, but I doubt it. People used the ash trays in their cars. Everyone owned ash trays even if they didn’t smoke. There were no restrictions on smoking in bars, restaurants and many other public places. Pregnant women smoked and no one cared.

It’s a different world today. We now know the health effects of smoking. There’s a lot of anti-smoking sentiment. It’s very hard to be a smoker today. The smokers from the business across the street from my office have to leave their building, go across the parking lot and cross the street to smoke next to our driveway.

Smoking is costly, especially in New York State. Cigarettes have federal and state excise taxes, state and local sales taxes and sometimes local cigarette-specific taxes. 

In July of 1862, the United States Congress passed excise tax on many items including tobacco to fund the Civil War. After the war, many of the excise taxes were repealed, but not the tobacco tax. There’s been a federal excise tax on cigarettes since that time.

State excise taxes followed much later. In 1921, Iowa passed the first one. Other states followed quickly and by 1950 40 states and Washington D.C. had taxes on cigarettes in addition to the federal excise tax.

Recently, there have been two drivers to increased cigarette taxes. It is widely recognized that increasing the tax on cigarettes reduces the smoking rate. Public health officials support cigarette tax increases for that reason. One study shows that every ten percent increase in the price of a pack of cigarettes reduces youth smoking rates by seven percent. (www.medicalnewstoday.com/articles/137936.php)

The second driver is that these taxes are such effective revenue raisers. Lawmakers have been using cigarette taxes to reduce budget deficits. New York’s legislature passed a bill in June of last year to increase cigarette taxes to the highest in the country. It was part of an emergency budget measure to keep the government running. That law added another $1.60 of tax to every pack of cigarettes making the average price about $9.20. New York City imposes its own additional tax of $1.50.

Unless you’re a smoker, all these cigarette taxes sound like a win-win situation. They reduce the smoking rate and help us keep our budgets balanced. 

Actually, there’s a dark side to cigarette taxes. The taxes have encouraged layers and layers of fraud, and a black market that’s so lucrative that criminal activity has increased exponentially as the taxes have gone up.

“Diverting” is the crime of avoiding the federal and state taxes on cigarette sales. Manufacturers pay federal excise tax on their shipments of cigarettes. By underreporting shipments, less tax is paid and the manufacturer gets a competitive advantage by lowering their costs. There’s about a million dollars of profit in one tractor trailer load of diverted cigarettes. It’s a complicated fraud requiring false invoices, bank, and tax records.

Smugglers buy cigarettes in low tax or no tax (Indian Reservations) jurisdictions and sell them in high tax jurisdictions like New York. Each state sets its own tax on the retail sale of a pack of cigarettes. Some states charge a few cents and others charge several dollars. The bigger the difference between the two taxing jurisdictions the higher the profit. All that profit represents excise and sales tax fraud. It’s uncollected revenue for the states which is usually earmarked for local services including education.

Cigarette trafficking is such a problem that there are task forces, undercover operatives and long-term undercover investigations. New York State is collaborating with the federal Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF) to crack down on the cigarette black market. The black market diverts billions of dollars a year from legitimate businesses and governments to criminals.

Two months ago the FBI announced Operation Secondhand Smoke. This was a massive fraud in the cigarette industry with a nationwide network of retailers, wholesalers, distributors, importers, and manufacturers who were avoiding cigarette taxes to make millions in profits. Six subjects have pled guilty so far to a variety of federal charges. This scheme was so profitable that subjects had mansions, vacation properties, boats, and airplanes. During the execution of one search warrant agents seized $12 million in cash and certificates of deposit that were “just lying around.”

The New York Association of Convenience Store Owners estimates as many as half of all cigarettes consumed in New York lack proper tax stamps.

The sale of cigarettes in New York State is regulated by federal, state, and local law. It’s enforced by the New York State Department of Taxation and Finance. Finance is very actively enforcing the law. Recently, they received purchase and shipping records of various internet cigarette dealers as part of a legal settlement with those companies. They have billed the customers of those internet sites and collected over $3 million through January of this year. This is an ongoing effort.

New York officials say the tax is worth it. It’s an incentive for smokers to quit, and the higher taxes do make up for the black market losses.

I’m not so sure. I’m just glad I don’t smoke, and neither does my Dad anymore.

Gina Bliss, CPA, CFE, is a senior manager at EFP Rotenberg, LLP, Certified Public Accountants and Business Consultants, who specializes in internal audit, fraud audit, and forensic accounting. She may be reached at (585) 295-0536 or by e-mail at gblissefprotenberg [dot] com