June 2001

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State Taxes 

By James P. Sweeney

In California, a black and gray market in tobacco products already was costing the state an estimated $50 million when voters approved Proposition 10, an initiative that more than doubled the tobacco tax rates.

SACRAMENTO - A little more than a year ago, state agents made a startling discovery, an outbreak of counterfeit tobacco tax stamps unlike anything they had ever seen in California.

The sophisticated frauds, designed to dodge the state's relatively steep tariff on cigarettes and other tobacco products, since have turned up in 17 counties and investigators fear more are out there.

"We have found counterfeit stamps on cigarettes throughout the state and it seems to be a growing problem," said Monte Williams, chief of investigations for the State Board of Equalization.

The phony stamps are merely the biggest piece of a black and gray market that authorities say has flourished since California more than doubled its tobacco tax in 1998.

The underground, Internet and mail-order trade already may exceed a half-billion dollars a year in cigarette sales, one state specialist estimated.

Unless checked, that could send more than $200 million a year up in smoke. Much of that projected tax revenue is earmarked for public health and children's programs.

But some prominent public health advocates remain skeptical, fearful that hyperventilating over a black market they don't believe exists will spur efforts to roll back the tobacco tax rate.

"They're trying to explain what they see as an unusual drop in consumption data by saying there hasn't been a change in smoking prevalence and there has been a huge change in the amount people are smoking," said Dr. John Pierce, a professor of cancer prevention at the University of California, San Diego.

Dr. Pierce said he found no evidence of a significant black market in a massive cigarette consumption study he recently completed for the state. But he said his data was collected in 1999, and did not attempt to measure any counterfeiting, which was discovered in February 2000.

"If they're arguing that there are a lot more counterfeit stamps, that's out of our field," he said.

Consumption of cigarettes, measured by taxable sales reported to the state, has been sliding since the 1980-81 fiscal year. But it has never dropped as sharply as it did in the two years since the last big tax increase, state data shows.

The situation has moved at least one lawmaker to suggest it's time to license tobacco retailers. Otherwise, the potential fallout has not aroused much concern, apparently because it has yet to cut deeply into the revenue stream.

Officials at the state Department of Finance and a new state children's commission dependent on tobacco taxes say they have not seen a sharp dropoff in revenue.

But both rely largely on the Board of Equalization, one of the state's primary tax collectors, for their information.

"We have about nine active investigations on counterfeit stamps and the proportions would probably boggle our minds," said Dennis Maciel, chief of the board's excise taxes division.

The federal Bureau of Alcohol, Tobacco and Firearms has ramped up enforcement efforts aimed at bootleg cigarettes and is working with the state on some investigations, a spokeswoman confirmed.

"We've got a couple cases that we're looking into right now that are fairly significant," the ATF's Marti McKee said.

Because the investigations are ongoing, state and federal officials refused to say what cities or counties are involved.

On top of illegal sales, more Californians are buying cigarettes legally over the Internet and at Indian reservations, where state taxes are not collected.

Reflecting the industry's historic political clout, California's tax on cigarettes was just 10 cents a pack before 1988, when voters approved a 25-cent increase for public health purposes.

Ten years later, voters added another 50 cents, a 137 percent hike that pushed the state bite on each pack of cigarettes to 87 cents. That's the nation's fourth highest rate, behind only Alaska and Hawaii, $1 each, and New York, $1.11.

About the time Hawaii raised its tax from 60 cents a pack, Ronald Randall, the state's tax compliance chief, said he received a warning from a counterpart in New York.

Counterfeits had been found in New York the day after tobacco stamps were introduced, Randall said.

"They knew what the stamps were going to look like before they got to the store."

In California, a black and gray market in tobacco products already was costing the state an estimated $50 million when voters approved Proposition 10, an initiative that more than doubled the tobacco tax rates.

In the two years since, illegal and other untaxed sales have mushroomed, state and federal officials said.

"Told you so," said Ned Roscoe, president of the Cigarettes Cheaper! chain. Mr. Roscoe and his family financed Proposition 28, a failed initiative that would have repealed the 50-cent increase.

Mr. Roscoe had a load of cigarettes stolen several months ago. When they were recovered, they had counterfeit stamps.

"It's clear across the country that the amount of tax is related to the amount of tax evasion," he said.

In addition to thefts, cigarettes are smuggled in from other states such as Nevada, where the tax is 35 cents a pack, across the Mexican border and from abroad.

The Board of Equalization's Maciel and Williams say the state's losses are approaching $150 million a year, and could be higher. That is more than 12 percent of the $1.2 billion in tobacco taxes California collected in the last full fiscal year, 1999-2000.

And it doesn't include lost sales and income taxes, or the 34-cent federal tax on each pack of cigarettes.

The combined loss, state officials say, is well in excess of $200 million a year.

That may not sound like much for a state burning through $50 million a day to keep the lights on, but it could be painful for scores of health and children's programs that rely almost exclusively on tobacco taxes.

Proposition 10 generates nearly $700 million a year for spending on children age 5 and younger. It has fostered the creation of children's commissions in every county of the state.

In Los Angeles County, the Proposition 10 windfall - $165 million in the first year - has financed expanded and enriched child care, health care and initiatives aimed at improving parenting skills.

There have been no indications that the Los Angeles commission will face anything more than a normal projected falloff of up to 4 percent in fundings, said spokeswoman Lizanne Fleming.

"Proposition 10 was established with the idea that there would be some attrition as people stop smoking, so we plan our budgets with that caveat," Ms. Fleming said.

At the Capitol, Assembly Member Herb Wesson, a powerful Culver City Democrat, was pondering legislation to license tobacco retailers when he heard about the magnitude of the black market. It has only sharpened his resolve to push ahead.

"Retailers would then be required to obtain their tobacco product from licensed distributors," and inventories could be traced, Mr. Wesson explained.

Mr. Maciel, chief of the state's excise taxes division, said a licensing system would establish a valuable database on who is selling cigarettes. But he suggested it would do little to curb Internet and mail-order sales, which have pushed beyond an estimated $60 million a year.

Cigarettes that cost upward of $40 a carton in California can be purchased online for less than $20 a carton. Federal law requires out-of-state tobacco vendors to identify their customers to states that ask, but most ignore the law, Mr. Maciel said.

The Board of Equalization bills those few customers who are reported. About half respond. Mr. Maciel doesn't even attempt to conceal the futility of the situation.

"If you order from an Internet site, and that site told the state who they sold to, and the state sent you a letter, would you ever buy from that Internet site again?"