Tobacco Taxes: Large Disparities in Rates for Smoking Products Trigger Significant Market Shifts to Avoid Higher Taxes

In 2009, CHIPRA increased and equalized federal excise tax rates for cigarettes, roll-your-own tobacco, and small cigars. Though CHIPRA also increased federal excise tax rates for pipe tobacco and large cigars, it raised the pipe tobacco tax to a rate significantly below the equalized rate for the other products, and its large cigar excise tax can be significantly lower, depending on price. Treasury collects federal excise taxes on tobacco products.

Also passed in 2009, the Family Smoking Prevention and Tobacco Control Act (Tobacco Control Act) granted FDA regulatory authority over tobacco products. This act directed GAO to report on trade in tobacco products, including the effects of differing tobacco tax rates. This report (1) reviews the market shifts in smoking tobacco products since CHIPRA; (2) examines the impact of the market shifts on federal revenue and Treasury’s actions to respond; and (3) describes differences in FDA’s regulation of various smoking tobacco products. GAO interviewed agency officials, industry members, and public health representatives. GAO analyzed tax and revenue data and reviewed relevant literature.

Large federal excise tax disparities among tobacco products, which resulted from the Children’s Health Insurance Program Reauthorization Act (CHIPRA) of 2009, created opportunities for tax avoidance and led to significant market shifts by manufacturers and price sensitive consumers toward the lower-taxed products. Monthly sales of pipe tobacco increased from approximately 240,000 pounds in January 2009 to over 3 million pounds in September 2011, while roll-your-own tobacco dropped from about 2 million pounds to 315,000 pounds. For the same months, large cigar sales increased from 411 million to over 1 billion cigars, while small cigars dropped from about 430 million to 60 million cigars. According to government, industry, and nongovernmental organization representatives, many roll-your-own tobacco and small cigar manufacturers shifted to the lower-taxed products after CHIPRA to avoid paying higher taxes.

While revenue collected for all smoking tobacco products from April 2009 through fiscal year 2011 amounted to $40 billion, GAO estimates that federal revenue losses due to market shifts from roll-your-own to pipe tobacco and from small to large cigars range from about $615 million to $1.1 billion for the same period. The Department of the Treasury (Treasury) has limited options to respond to these market shifts. Treasury has attempted to differentiate between roll-your-own and pipe tobacco for tax purposes but faces challenges because the definitions of the two products in the Internal Revenue Code of 1986 do not specify distinguishing physical characteristics. Treasury also has limited options to address the market shift to large cigars and faces added complexity in monitoring and enforcing tax payments due to the change in large cigar tax rates.

Unlike cigarettes and roll-your-own tobacco, pipe tobacco and cigars are not currently regulated by the Food and Drug Administration (FDA) and thus are not subject to the same restrictions on characterizing flavors, sales, or distribution. In 2011, FDA indicated its intent to issue a proposed rule that would deem products meeting the statutory definition of “tobacco product” to be subject to FDA’s regulation. However, FDA had not issued the proposed rule as of March 2012. FDA officials told GAO that developing the rule was taking longer than expected.

As Congress continues its oversight of CHIPRA and Tobacco Control Act implementation, it should consider equalizing tax rates on roll-your-own and pipe tobacco and, in consultation with Treasury, consider options for reducing tax avoidance due to tax differentials between small and large cigars. Treasury generally agreed with GAO’s conclusions and observations.

Tobacco use is the leading cause of preventable death, disease, and  disability and a significant contributor to health care costs in the United  States. The Centers for Disease Control and Prevention reports that  smoking and exposure to secondhand smoke account for over 440,000  premature deaths per year and cost the United States an estimated $193  billion annually in health care expenditures and productivity losses.  Federal and state legislation has aimed to discourage tobacco use and  raise revenues by increasing excise taxes on tobacco products. The most  recent federal increase occurred in 2009 when Congress passed the  Children’s Health Insurance Program Reauthorization Act of 2009  (CHIPRA), which amended the Internal Revenue Code of 1986 (IRC) by  raising excise tax rates on tobacco products. The Department of the  Treasury (Treasury) is responsible for collecting these taxes. In addition,  in order to reduce tobacco use and protect public health, in June 2009,  Congress passed the Family Smoking Prevention and Tobacco Control  Act (Tobacco Control Act), which granted the Food and Drug  Administration (FDA) authority to regulate the manufacture, distribution,  and marketing of tobacco products.

Title III of the Tobacco Control Act directed GAO to report on various  aspects of trade in tobacco products, including the effects resulting from  the differing tax rates applicable to tobacco products. This report  examines the federal revenue effects resulting from different federal  excise tax rates on various smoking tobacco products and differences in  FDA’s regulation of these products. Specifically, we (1) review the market  shifts among smoking tobacco products since CHIPRA went into effect on  April 1, 2009; (2) examine the impact of these market shifts on federal  revenue and Treasury’s actions to respond; and (3) describe differences  in FDA’s regulation of various smoking tobacco products. Our review  includes smoking tobacco products that are subject to federal excise tax:  cigarettes and four other tobacco products—roll-your-own tobacco  (sometimes called RYO), pipe tobacco, small cigars, and large cigars.  However, in analyzing the market shifts among these products, we  focused solely on the four smoking tobacco products other than  cigarettes.

To address the three objectives in this study, we reviewed documents  and interviewed agency officials from Treasury’s Alcohol and Tobacco  Tax and Trade Bureau, FDA, and the Centers for Disease Control and  Prevention, as well as tobacco industry members, representatives of  public health and other nongovernmental organizations, and academics,  to obtain information on tobacco legislation and regulations, tobacco  product sales trends, and consumption patterns. We also reviewed  studies analyzing the relationship between tobacco tax increases and  smoking, including among youth. We analyzed Treasury removals data to  identify sales trends across the different tobacco products. As used in this  report, for smoking tobacco products, “removals” means the amount  removed for distribution in the United States from the factory or released  from customs. In this report, we consider removals to be equivalent to  sales and use the term sales. In addition, we collected and analyzed data  on federal excise tax rates for these tobacco products and the revenues  generated from their sale. We estimated what the effect on tax revenue  collection would have been if the sales trends for roll-your-own and pipe  tobacco and for small and large cigars had not been affected by  substitution between the products but had been affected by the increase  in price due to the tax—in other words, if the market shifts resulting from  the substitution of higher-taxed products with lower-taxed products had  not occurred. In this report, we refer to this estimated effect on federal tax  revenue collection as revenue losses. Our analysis takes into account the  expected fall in quantity demanded due to the price increases resulting  from higher federal excise tax rates that CHIPRA imposed on all four of  these smoking tobacco products. See appendix I for more information on  our objectives, scope, and methodology.

We conducted this performance audit from March 2011 to April 2012 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.

Cigarettes continue to dominate the smoking tobacco product market,  accounting for approximately 91 percent of sales in 2011. However, the  use of other smoking tobacco products has increased over the past 10  years. Between 2001 and 2011, combined sales of roll-your-own tobacco,  pipe tobacco, and small and large cigars grew from 3 percent of the  smoking tobacco market to 9 percent. Although cigarette use in the  United States is declining, it is partially offset by growing use of other  smoking tobacco products. (See app. II for data on U.S. sales of smoking  tobacco products from fiscal year 2001 through fiscal year 2011.)

Increasing the price of tobacco products by raising excise taxes is widely  recognized as an effective policy for reducing smoking prevalence across  socioeconomic and racial groups. Public health and economic studies  have found that adolescents are more responsive than adults to tobacco  tax and price increases because they have less disposable income.  However, the impact of tax increases on reducing overall smoking  prevalence is likely to be weaker if smokers can turn to tobacco products  that can be used as functional equivalents of factory-made cigarettes and  cost significantly less, according to public health officials and academics.

Smoking tobacco products are broadly defined in the IRC. Roll-your-own  tobacco and pipe tobacco are defined by such factors as the use for  which the product is suited and how they are offered for sale, as indicated  by their appearance, type, packaging, and labeling. Cigars are  differentiated from cigarettes by their wrapper and whether the product is,  for a number of reasons, likely to be offered to, or purchased by,  consumers as a cigarette. The tax rate for cigars is categorized into small  and large cigars, which are differentiated by a weight threshold alone— small cigars are defined as weighing 3 pounds or less per thousand  sticks. The definitions found in the IRC characterize five types of  smoking tobacco products that are relevant to our discussion, as shown  in table 1.

Figure 1 shows a sample of different cigarette and cigar products. Several  of the products closely resemble each other in size and shape. The three  on the left are cigarettes. The first is a roll-your-own cigarette made by  hand with roll-your-own tobacco. The second is a roll-your-own cigarette  made in a commercial roll-your-own machine with pipe tobacco. And the  third from the left is a factory-made cigarette. The three products on the  right are cigars, which can vary widely in size, shape, flavor, and aroma.  According to industry representatives, a nongovernmental organization,  and government officials, traditionally, cigars are hand-rolled, wrapped in  a tobacco leaf, large in size, and their smoke is not meant to be inhaled.  However, they indicated that many small and large cigars now have  filters, are wrapped in a type of paper made with tobacco, and can be  similar in size and appearance to cigarettes.

While the enactment of CHIPRA in 2009 represents the most recent  increase in federal excise taxes on tobacco products, Congress has taxed  tobacco products since its inception as a means to raise revenue. Of the  smoking tobacco products that we discuss in this report, Congress taxed  only cigarettes, small cigars, and large cigars prior to 1989. Congress  began taxing pipe tobacco on January 1, 1989, and roll-your-own  tobacco on January 1, 2000. As the danger of tobacco became better  known, congressional debates surrounding tobacco taxes expanded from  increasing revenue to protecting the public from health risks of tobacco.

Figure 2 shows the tax rates for four smoking tobacco products from 1951  to 2010.

The federal excise tax rates on different tobacco products are calculated  in different ways. Cigarettes and small cigars are taxed on a unit basis— number of sticks. Roll-your-own and pipe tobacco are taxed by weight.  Table 2 provides information on the different federal excise tax rates for  cigarettes, roll-your-own tobacco, pipe tobacco, and small cigars before  and after CHIPRA.

Before CHIPRA, the federal excise tax rate on cigarettes was higher than  the rates on roll-your-own tobacco, pipe tobacco, and small cigars.  However, CHIPRA significantly raised the tax rates on these four  products and equalized the rates on cigarettes, roll-your-own tobacco,  and small cigars (see fig. 3). Congress equalized the tax rates on roll- your-own tobacco and small cigars with the cigarette tax rate in part in  response to concerns that smokers had been using these two products as  substitutes for higher-taxed factory-made cigarettes, according to  nongovernmental organizations. CHIPRA also raised the federal excise  tax rate on pipe tobacco, but to a rate that is considerably lower. Prior to  CHIPRA, the tax rate on roll-your-own tobacco and pipe tobacco was the  same.

CHIPRA significantly changed the federal excise tax rate on large cigars.  Large cigars are unique among tobacco products in that the tax rate is ad  valorem—a percentage of the manufacturer’s or importer’s sale price per  thousand sticks—up to a maximum tax per thousand sticks. Before  CHIPRA, large cigars were taxed at 20.72 percent of the manufacturer’s  or importer’s sale price up to a maximum tax of $48.75 per thousand  sticks. After CHIPRA, the ad valorem rate increased to 52.75 percent of  the manufacturer’s or importer’s sale price, and the maximum tax per  thousand sticks increased to $402.60 (see table 3). According to an  industry association, the retail prices of premium handmade large cigars  range from $3 to $20. A public health organization noted that smaller  factory-made cigars that meet the legal definition of a large cigar can cost  as little as $0.07 per cigar.

Figure 4 illustrates the tax structure for large cigars, before and after  CHIPRA and includes three different scenarios. The sloped line  represents the ad valorem rate, which becomes flat when it reaches the  maximum tax per thousand cigars. The following are examples of the  federal excise taxes manufacturers and importers would have to pay for  differently priced large cigars, before and after CHIPRA (see examples  corresponding with fig. 4):  A.  If the manufacturer’s or importer’s sale price per thousand large cigars  is $100, before CHIPRA the ad valorem tax rate was $20.72 per  thousand; after CHIPRA it became $52.75 per thousand.

B.  If the manufacturer’s or importer’s sale price per thousand large cigars  is $500, before CHIPRA the tax rate was the maximum tax of $48.75  per thousand; after CHIPRA it became $263.75 per thousand based  on the new ad valorem tax rate.

C.  If the manufacturer’s or importer’s sale price per thousand large cigars  is $800, before CHIPRA the tax rate was the maximum tax of $48.75  per thousand; after CHIPRA it became $402.60, which is the new  maximum tax rate per thousand.

Treasury is responsible for administering and collecting the federal excise  tax on all tobacco products, among other things. In general, federal  excise taxes are collected when tobacco products leave the domestic  factory or, in the case of imports, when the products are released from  customs custody. Tobacco manufacturers and importers are required to  obtain a Treasury permit to operate and must comply with Treasury’s  recordkeeping, reporting, and other requirements. Tobacco product  wholesalers and distributors are responsible for paying state and local  excise taxes, but they are not required to obtain a Treasury permit and  are not subject to Treasury recordkeeping requirements. Figure 5 shows  the major steps in the tobacco supply chain, including the key points at  which taxes are paid.

In the Tobacco Control Act passed in June 2009, Congress amended the  Food, Drug, and Cosmetic Act by inserting a chapter governing tobacco  products and granting FDA authority to regulate the manufacture,  distribution, and marketing of tobacco products under that chapter. The  act aims to, among other things, reduce the use of tobacco products to  decrease health risks and social costs associated with tobacco-related  diseases. It recognizes that virtually all new users of tobacco products are  adolescents under the age of 18. According to the law, FDA’s regulation  of tobacco products is based, in part, on a public health standard rather  than the safety and effectiveness standard by which FDA regulates  pharmaceutical drugs and medical devices. For example, FDA can issue  restrictions on the sale, distribution, advertising, and promotion of a  tobacco product, if the public health standard is met. This standard  requires FDA to demonstrate that the proposed regulation is appropriate  for the protection of public health, based on a consideration of the risks  and benefits to the population as a whole, including users and nonusers  of tobacco products.

The act specifies that FDA’s authority over tobacco products under  Chapter IX of the Food, Drug, and Cosmetic Act shall apply to cigarettes,  roll-your-own tobacco, cigarette tobacco, and smokeless tobacco, as well  as any other tobacco products that the agency deems by regulation to be  subject to such authority. FDA does not at present regulate pipe tobacco  and small and large cigars. To implement the Tobacco Control Act, FDA  has established the Center for Tobacco Products.

Large Tax Disparities among Similar Tobacco Products Triggered Significant Market Shifts to Avoid Higher Taxes

Large federal excise tax disparities among tobacco products resulting  from CHIPRA caused sizable market shifts from higher to lower-taxed  products. According to our analysis and interviews with knowledgeable  sources, the tax disparities created incentives for price sensitive  manufacturers and consumers to substitute higher-taxed products with  lower-taxed products. The market for roll-your-own tobacco shifted to pipe  tobacco and the growth rate of the combined market increased after  CHIPRA. Roll-your-own tobacco manufacturers shifted to pipe tobacco  with minimal, if any, changes to the products, and consumers substituted  pipe tobacco for use in roll-your-own cigarettes. At the same time, the  cigar market shifted from small to large cigars, and the combined cigar  market continued to grow after CHIPRA.

Market Shifted from Roll- Your-Own Tobacco to Pipe Tobacco after CHIPRA

Market trends for roll-your-own and pipe tobacco changed immediately  after CHIPRA, with sales of pipe tobacco rising steeply while sales of roll- your-own tobacco plummeted. According to government officials and  representatives of industry and nongovernmental organizations,  manufacturers and consumers switched to lower-taxed pipe tobacco to  make roll-your-own cigarettes. After CHIPRA, the federal excise tax on  roll-your-own tobacco was over $20 per pound more than the tax on pipe  tobacco, whereas before CHIPRA, the taxes on both products were the  same. Figure 6 shows the market shift through monthly sales of roll-your- own and pipe tobacco from fiscal year 2001 through fiscal year 2011.  Total annual sales of pipe tobacco grew from approximately 3.2 million  pounds in fiscal year 2008, the last year before CHIPRA, to 30.5 million  pounds in fiscal year 2011, representing an increase of about 869  percent. Over the same period, total annual sales of roll-your-own  tobacco declined from approximately 19.7 million pounds to 5.2 million  pounds, a decrease of about 74 percent. According to the representatives  of industry and nongovernmental organizations we interviewed, the shift  can be mostly attributed to consumers switching from using roll-your-own  tobacco to pipe tobacco in roll-your-own cigarettes, rather than to a  sudden increase in pipe smoking.

CHIPRA’s increase in the federal excise tax for roll-your-own tobacco did  not dampen the overall sales of roll-your-own and pipe tobacco. Instead,  the combined sales of roll-your-own and pipe tobacco increased because  of the rapid growth in pipe tobacco sales following CHIPRA. Before  CHIPRA, from October 2000 through March 2009, the combined average  monthly growth rate was 0.63 percent; after CHIPRA, the combined  average monthly growth rate increased to 2.00 percent. See Figure 7 for  the trends in combined sales of roll-your-own and pipe tobacco from fiscal  year 2001 through fiscal year 2011.

According to government officials, representatives of nongovernmental  organizations, and industry, after CHIPRA many manufacturers of roll- your-own tobacco switched to producing pipe tobacco in order to avoid  higher taxes. According to these representatives and government  officials, the new pipe tobacco products have minimal, if any, differences  from roll-your-own tobacco. Roll-your-own tobacco and pipe tobacco are  defined in the IRC by such factors as the use for which the product is  suited and how they are offered for sale, as indicated by their  appearance, type, packaging, and labeling. To meet the definition of pipe  tobacco in the IRC and Treasury’s regulations, a product must be clearly  labeled as pipe tobacco and not indicate other uses. The definitions of  tobacco products in the IRC do not specify physical characteristics that  would differentiate pipe tobacco from roll-your-own tobacco.  Representatives of industry and nongovernmental organizations provided  examples of current pipe tobacco brands that had been roll-your-own  brands prior to CHIPRA, with minimal differences in the packaging and  the appearance of the tobacco itself. We also found examples of Internet  retailers signaling to customers in their marketing that pipe tobacco was  suitable for smoking in roll-your-own cigarettes. One manufacturer of pipe  tobacco had designed its label with three-letter markings, to indicate to  customers the product’s similarity to brand-name cigarettes. For example,  the marking MRD indicated Marlboro Red and CML indicated Camel  Light.

We approached 15 pipe tobacco manufacturers to ask about their  companies’ actions in response to the CHIPRA tax changes. Each of the  three tobacco manufacturers that agreed to speak with us explained that  their companies switched from selling higher-taxed roll-your-own tobacco  to lower-taxed pipe tobacco in order to stay competitive. One company  changed the cut of its roll-your-own tobacco and labeled it as pipe  tobacco, although a company representative acknowledged that there  was no real difference between its pipe-cut tobacco and its roll-your-own  tobacco. A representative from another company that switched from  selling roll-your-own tobacco to selling pipe tobacco stated that she was  not aware of any difference in the two products other than the federal  excise tax rate.

Data show that the total number of companies exclusively manufacturing  pipe tobacco increased significantly since CHIPRA, while the number of  companies exclusively manufacturing roll-your-own tobacco decreased  sharply. Treasury emphasized that it is unclear whether these  manufacturers modified their roll-your-own tobacco beyond reclassifying it  as pipe tobacco. Data also show the number of companies producing  both roll-your-own and pipe tobacco has slowly increased since 2007  (see fig. 8).

The rise in pipe tobacco sales coincided with the growing availability of  commercial roll-your-own machines. Treasury officials stated that there  has recently been significant growth in commercial roll-your-own  machines. These machines enable customers to produce a carton of  cigarettes using pipe tobacco and cigarette-paper tubes with filters. By  using pipe tobacco instead of roll-your-own tobacco, customers are able  to save almost $9 per carton in federal excise taxes. A common  commercial roll-your-own machine can produce a carton of cigarettes in  less than 10 minutes, providing a significant time saving compared with  making roll-your-own cigarettes by hand.

During our visit to a tobacco outlet store in Maryland, we used a  commercial roll-your-own machine to make a carton of 200 cigarettes  using pipe tobacco in about 8 minutes. We made a video showing this  machine being used to make cigarettes (See  http:www.gao.gov/multimedia/video#video_id=589493). The carton we  made in Maryland cost about $25, which included state and federal  excise taxes. The total price of $25 for our carton was about half the price  of a carton of discount cigarettes in nearby stores that sold tobacco (see  fig. 9).

CHIPRA’s 2009 changes in federal excise tax rates on tobacco products  also resulted in an immediate shift in the cigar market, with sales of lower- taxed large cigars rising sharply while sales of higher-taxed small cigars  dropped. Figure 10 shows the market shift through monthly sales of small  and large cigars from fiscal year 2001 through fiscal year 2011. Total  annual sales of large cigars increased from approximately 4.8 billion  sticks in fiscal year 2008 to about 10.3 billion sticks in fiscal year 2011,  representing an increase of about 116 percent. For the same period, the  total annual sales of small cigars declined from 5.3 billion sticks to 0.8  billion sticks, a decrease of 85 percent. According to government officials  and representatives of nongovernmental organizations, because weight is  the only characteristic that distinguishes small cigars from large cigars,  many cigar manufacturers made their small cigars slightly heavier to  qualify for the large cigar tax rate and avoid higher taxes levied on small  cigars after CHIPRA. Figure 10 shows an increase in large cigar sales in  the months immediately prior to the tax change. Treasury officials stated  that although they have not specifically investigated the cause of this  increase, there was an incentive for retailers and wholesalers to purchase  and stockpile large cigars after the date CHIPRA was signed into law  (February 4, 2009) and before the tax increase went into effect (April 1,  2009). In addition, these officials noted that a floor stocks tax is typically  imposed to prevent stockpiling just before a tax increase, but the floor  stocks tax imposed by CHIPRA did not apply to large cigars.

The combined sales for small and large cigars continued to increase after  CHIPRA, though at a slightly lower rate. Before CHIPRA, from October  2001 through March 2009, the combined average monthly growth rate  was 0.75 percent, compared with a 0.17 percent growth rate from April  2009 through September 2011. See figure 11 for trends in overall cigar  sales from fiscal year 2001 through fiscal year 2011.

Market Shifts to Avoid Taxes Have Reduced Federal Revenue, and Treasury Has Limited Options to Respond

While tax revenue collected for all smoking tobacco products from April  2009 through the end of fiscal year 2011 amounted to $40 billion, we  estimate that the market shifts from roll-your-own to pipe tobacco and  from small to large cigars reduced federal revenue by a range of  approximately $615 million to $1.1 billion for the same period. We  estimated what the effect on tax revenue collection would have been if  the sales trends for roll-your-own and pipe tobacco and for small and  large cigars had not been affected by substitution between the products  but had been affected by the increase in price due to the tax—in other  words, if the market shifts resulting from the substitution of higher-taxed  products with lower-taxed products had not occurred. In this report, we  refer to this estimated effect on federal tax revenue collection as revenue  losses. Although Treasury has taken steps to respond to these market  shifts, it has limited options. For example, Treasury has pursued  differentiating between roll-your-own and pipe tobacco for tax collection  purposes but faces challenges because the definitions of the two  products in the IRC do not specify distinguishing physical characteristics.  Furthermore, Treasury also has limited options to address the market  shift to large cigars.

Estimated Federal Revenue Losses from Market Shifts after CHIPRA Range from $615 Million to $1.1 Billion

We estimated that federal revenue losses due to the market shifts from  roll-your-own to pipe tobacco and from small to large cigars range from  $615 million to $1.1 billion. This range includes combined tax revenue  losses for the roll-your-own and pipe tobacco markets, as well as the  small and large cigar markets. We conducted analyses of data from  Treasury and the Bureau of Labor Statistics to estimate tax revenue  losses in these markets. Our methodology takes into account the  expected fall in demand for a product following a price increase, holding  other variables constant. To calculate the range of federal revenue  losses, we included high and low estimates based on assumptions about  the effect of a price increase on projected sales. Economic studies show  that, when the price of a product increases, the quantity demanded for the  product will adjust downward, decreasing at an estimated rate based on  the quantity demanded for the product, that is, price elasticity. Based on  our interviews with government officials and academics and our literature  review, we determined that the price elasticity for the smoking tobacco  products ranges from -0.6 to -0.3 for the low and high revenue estimates,  respectively. Our projections also take into account the historic sales  trends for these products and the tax component of the price. Appendix  I contains more information on our methodology for developing these  estimates.

Treasury collected $573 million in tax revenue from roll-your-own and  pipe tobacco from April 2009 through September 2011. We estimate  that during the same period the market shift from roll-your-own to pipe  tobacco reduced federal revenues by between $255 million and $492  million (see fig. 12).

Treasury collected $1.7 billion in tax revenue from small and large cigars  from April 2009 through fiscal year 2011. We estimate that during that  same period the market shift from small to large cigars reduced federal  revenue by between $360 million to $559 million (see fig. 13).

Differentiating between roll-your-own and pipe tobacco for tax collection  purposes presents challenges to Treasury because the definitions of the  two products in the IRC are based on such factors as the use for which  they are suited and how they are packaged and labeled for consumers  and do not specify distinguishing physical characteristics. Treasury  officials and representatives of nongovernmental organizations we spoke  with stated that because the two products were taxed at the same rate  prior to CHIPRA, there was no revenue-related reason to clarify the  differences between the two products beyond the existing statutory  definitions. However, according to Treasury comments in the Federal  Register, the large differences in tax rates resulting from CHIPRA created  an incentive for industry members to present roll-your-own tobacco as  pipe tobacco products, thus enabling them to pay a lower tax rate.

After the CHIPRA tax changes and the market shift from roll-your-own to  pipe tobacco that immediately followed, Treasury took steps through  rulemaking notices in an effort to more clearly differentiate the two  products for tax collection purposes. However, Treasury has not yet  issued a final rule to distinguish the two products based on physical  characteristics. The tobacco industry members’ comments on the June  2009 temporary rule and the July 2010 advance notice of proposed  rulemaking highlighted the complexity and difficulties in developing  objective standards that clearly differentiate the two tobacco products.  Treasury also issued a ruling determining that retail establishments that  make cigarette-making machines available for use by customers are  manufacturers of tobacco products. However, a U.S. District Court  enjoined Treasury’s enforcement of the ruling pending the outcome of a  court case on this ruling, which was still pending as of March 2012. Table  4 summarizes Treasury’s actions on roll-your-own and pipe tobacco  following CHIPRA, the resulting tobacco industry comments, and the  status of Treasury’s actions.    Temporary rule on packaging and labeling requirements: Following  the CHIPRA tax changes that took effect in April 2009, Treasury  published a temporary rule in June 2009, set to expire in June 2012,  that outlined new labeling and packaging requirements for roll-your- own and pipe tobacco to more clearly differentiate the two products.  The temporary rule required that, to be classified as pipe tobacco, the  packaging must clearly indicate the product type by bearing the words  “pipe tobacco” wherever the brand name appears, and that the  packaging cannot suggest a use other than as pipe tobacco. Treasury  also stated in the temporary rule that it was evaluating analytical  methods and other standards to differentiate between roll-your-own  tobacco and pipe tobacco, and it expected to publish rulemaking  proposals on this subject for comment in the future. In response to  this temporary rule, Treasury received comments from tobacco  industry members indicating that its new labeling and packaging  requirements were insufficient to prevent the misclassification of roll- your-own tobacco as pipe tobacco and that standards to further  differentiate the products were urgently needed. Treasury received  comments from industry members proposing alternative standards to  distinguish between roll-your-own and pipe tobacco based on physical  characteristics such as moisture content, cut, and variety of tobacco  used. The market shift from roll-your-own to pipe tobacco continued  despite Treasury’s issuance of this temporary rule.   Advance notice of proposed rulemaking on standards to differentiate  roll-your-own and pipe tobacco: In July 2010, Treasury published an  advance notice of proposed rulemaking issuing a request for public  comments on standards and characteristics proposed by commenters  to differentiate between roll-your-own and pipe tobacco, but it has not  issued a subsequent rule proposing the standards it would use. In the  notice, Treasury discussed the heightened need for more regulatory  detail to clarify the difference between the two products and stated its  primary concern that the standards be objective and enforceable. The  industry members’ comments to Treasury highlighted the complexity  and difficulties in developing objective standards that clearly  differentiate the two tobacco products. Industry members disagreed  on the standards and physical characteristics that should be  implemented, with some commenters noting that the two products  overlap greatly. Some industry commenters also expressed concerns  that proposed standards could easily be manipulated by consumers.

For example, a proposed standard for the cut width of pipe tobacco  could be compromised by a consumer using basic kitchen or  hardware appliances to grind wider cut tobacco into a smaller width  for use in cigarettes.

In August 2011, Treasury issued a second advance notice of  proposed rulemaking, thereby reopening the period for receiving  comments on the proposed standards. Treasury said it did so  because it had received an additional set of proposed standards after  the original comment period closed. Treasury received a number of  additional comments, many by the same companies that commented  on the earlier notices, and the comments continued to reflect  significant differences within the industry on standards that define and  distinguish roll-your-own tobacco from pipe tobacco. This second  comment period closed in October 2011. As of March 2012, Treasury  has not issued a subsequent rulemaking based on the comments  received, and no anticipated issuance date has been communicated.  Throughout this period, the market shift from roll-your-own to pipe  tobacco has continued, with negative impacts on federal revenue.  Appendix III contains a more detailed summary of the Federal  Register notices issued by Treasury related to differentiating between  roll-your-own and pipe tobacco and the industry comments in  response to these notices.    Ruling on commercial cigarette-making machines: Treasury also  issued a ruling in September 2010 determining that retailers who  make commercial cigarette-making machines available for use on  their premises are tobacco product manufacturers and are thus  subject to the permit and tax requirements of the IRC. In October  2010, RYO Machine Rental LLC, the maker of the RYO Filling  Stations, sued Treasury over this ruling. In December 2010, a federal  district court judge in Ohio ordered a preliminary injunction on the  enforcement of the Treasury rule, and the case is currently on appeal  in the U.S. Court of Appeals for the Sixth Circuit. During the period  that enforcement has been delayed, several organizations told us that  businesses continue to maintain these machines on their premises,  and the number of machines in use has increased. These machines,  which cost the retailer about $30,000 each, have also been the focus  of government regulation at the state level. A number of states are  taking action against commercial roll-your-own machines, including  Arkansas, Michigan, New Hampshire, and West Virginia. For  example, Arkansas passed a law prohibiting tobacco retailers  licensed, permitted, appointed, or commissioned under Arkansas  tobacco tax law from possessing or using the machines.

CHIPRA’s Changes to Tax Rates on Large Cigars Also Present Challenges to Treasury

CHIPRA’s changes to the federal excise tax rate on large cigars also  present challenges to Treasury. The first challenge resulted from  CHIPRA’s tax rate on the most inexpensive large cigars, which was  significantly lower than its rate for small cigars. This disparity in tax rates  provided an incentive for some small cigar manufacturers to make  minimal changes to their product to meet the legal definition of a large  cigar. The second challenge came about because CHIPRA’s rate for  large cigar taxes resulted in more large cigar manufacturers and  importers paying taxes based on the manufacturer’s or importer’s sale  price rather than simply paying the maximum set tax rate. This added  complexity to Treasury’s monitoring and enforcement of large cigar tax  payments and appears to have motivated some manufacturers and  importers of large cigars to restructure their market transactions to lower  the taxes they have to pay.

The first challenge resulted from CHIPRA’s changes to the federal excise  tax rate on large cigars, which created an incentive for small cigar  manufacturers to switch to making large cigars when the manufacturer’s  or importer’s sale price is less than $95.42 per thousand cigars. Before  CHIPRA, there was little incentive for small cigar manufacturers to alter  their product to meet the definition of a large cigar. Because small cigars  are taxed at a fixed rate, and large cigars are taxed at an ad valorem rate,  when CHIPRA raised the small cigar tax from $1.83 per thousand to  $50.33 per thousand, manufacturers of inexpensive small cigars had an  incentive to change their product to fit the lower-taxed large cigar  category. According to Treasury officials and other industry experts, prior  to CHIPRA, many small cigars weighed close to 3 pounds per thousand  sticks, which is the dividing line between small and large cigars set by the  IRC. Small cigars that weighed just under or exactly 3 pounds per  thousand sticks would be able to qualify as large cigars with minimal  changes. After CHIPRA, the same companies could use the same  machines to add a small amount of weight to their product, turning small  cigars into a product legally defined and taxed as large cigars. For  example, manufacturers could add weight by packing the tobacco more  tightly. Some manufacturers then changed their labels from “small cigars”  to “filtered cigars” or “cigars”—often with the same packaging and design.  For example, if a manufacturer sold cigars for $50 per thousand before  CHIPRA, by manufacturing small cigars instead of large cigars, it would  pay $1.83 per thousand in taxes, a tax savings of $8.53 per thousand.  After CHIPRA, the same manufacturer selling cigars for $50 per thousand  would pay $26.38 per thousand in taxes, a tax savings of $23.95 per  thousand, by manufacturing large cigars instead of small cigars (see fig.  14). Treasury officials stated that the agency lacks the authority to  remedy the tax revenue losses resulting from manufacturers’ legitimate  modifications of small cigars to qualify them for the lower tax rate on large  cigars.

The second challenge resulting from CHIPRA’s changes to tax rates on  large cigars is the complexity that has been added to Treasury’s efforts to  monitor and enforce tax payments because many more manufacturers  and importers must now determine the correct tax by applying the tax rate  to the manufacturer’s or importer’s sale price per stick (ad valorem) rather  than simply paying the maximum set tax rate. According to Treasury  officials, prior to CHIPRA, the majority of domestic manufacturers of large  cigars paid the federal excise tax at the maximum rate of $48.75 per  thousand cigars. Specifically, manufacturers or importers that sold large  cigars priced at $235.30 per thousand and above paid the set maximum  tax. The increase in the large cigar maximum tax after CHIPRA resulted  in many more manufacturers and importers of large cigars paying taxes  based on the ad valorem rate, according to Treasury officials. Currently,  the maximum tax rate does not apply until the manufacturer’s or  importer’s price is $763.22 per thousand or above, and then, the  maximum rate is $402.60 per thousand. For example, if a manufacturer  sold large cigars for $400 per thousand, before CHIPRA, it would pay  $48.75—based on the maximum tax. After CHIPRA, the manufacturer’s  tax would increase to $211 per thousand—based on the ad valorem rate.  If the manufacturer is able to lower its price for the large cigar product  from $400 to $300 per thousand, its tax would decrease to $158.25 per  thousand, a tax savings of $52.75 per thousand. Before CHIPRA, if the  manufacturer had lowered its price from $400 to $300, its tax rate would  have remained at the maximum rate of $48.75 (see fig. 15).

After CHIPRA, according to Treasury officials, some large cigar  manufacturers and importers began to restructure their market  transactions to lower the manufacturer’s or importer’s sale price for large  cigars in order to obtain the tax savings of a lower ad valorem rate,  creating enforcement challenges. These Treasury officials stated that  some manufacturers and importers are “structuring” or “layering” sales  transactions by including an additional transaction at a low price before  the sale to the wholesaler or distributor, and using this low initial price to  calculate the tax. This transaction is conducted with an intermediary that  may have a special contract arrangement with the manufacturer or  importer. A large markup may then be added to the intermediary’s  subsequent sale to the wholesaler or distributor. This added transaction  effectively lowers the manufacturer’s or importer’s sale price, and thus  reduces the taxes collected. According to Treasury officials, these layered  transactions have become more common after CHIPRA. Treasury  officials noted that manufacturers and importers of large cigars have  approached the agency for advice on different proposals to structure their  sales transactions to lower their taxes and still comply with the law. They  also stated that Treasury has not determined the legality of all of the  proposals under consideration, and that while Treasury can investigate  individual cases, its authority to enforce additional tax collection from  these kinds of large cigar transactions is limited. Officials stated that  Treasury is carefully examining the tobacco importer and manufacturer  pricing arrangements and taking corrective actions where appropriate on  a case by case basis.

The impact of the federal excise tax increases and the resulting actions  by industry to mitigate the CHIPRA tax increase on large cigars are  evidenced by large cigar pricing trends. Prior to CHIPRA, the average  manufacturer’s or importer’s sale price for large cigars was $244 per  thousand, Treasury officials stated. After the CHIPRA tax increases, the  average manufacturer’s or importer’s sale price dropped to $189 per  thousand. According to Treasury officials, since large cigar federal excise  taxes increased by a minimum of 155 percent, and the federal excise tax  is included in the sale price, large cigar manufacturer’s and importer’s  sale prices were expected to increase, not decrease.

FDA Currently Regulates Cigarettes and Roll-Your-Own Tobacco but Not Pipe Tobacco and Cigars

When the Tobacco Control Act amended the Food, Drug, and Cosmetic  Act in June 2009, it granted FDA immediate regulatory authority over four  tobacco products, including cigarettes and roll-your-own tobacco, but did  not specify authority over pipe tobacco and small and large cigars.  According to the law, FDA has the authority to deem by regulation any  other tobacco products, including pipe tobacco and small and large  cigars, to be subject to the tobacco provisions in Chapter IX of the Food,  Drug, and Cosmetic Act. Deeming additional products to be subject to  these tobacco provisions of the Food, Drug, and Cosmetic Act requires  FDA to go through the process of developing and issuing a regulation  (known as the rulemaking process).

Because FDA does not currently regulate pipe tobacco and small and  large cigars, these products are not subject to the tobacco product  provisions in Chapter IX of the Food, Drug, and Cosmetic Act or  regulations that FDA has issued since June 2009 to implement the  Tobacco Control Act. Some of act’s provisions and key FDA regulations  address, for example, (1) the use of characterizing flavors, (2) the sale  and distribution of tobacco products, and (3) the requirements for new  health warnings depicting negative health consequences of smoking:    Ban on the use of characterizing flavors: FDA implemented a ban on  cigarettes with characterizing flavors in September 2009 (with the  exception of tobacco or menthol). However, pipe tobacco and small  and large cigars—some of which look similar to cigarettes (see fig.  1)—are available in multiple flavors because this Tobacco Control Act  provision does not apply to these products. Smokers can make roll- your-own cigarettes with flavored pipe tobacco and buy cigars in  candy, berry, fruit, or other flavors. According to the U.S. Surgeon  General, the growing popularity of cigars among younger adults  (those under the age of 30) appears to be linked to the marketing of  flavored tobacco products, including cigars, that might be expected to  be attractive to youth.    Restrictions on the sale and distribution of cigarettes and smokeless  tobacco to protect children and adolescents: Pipe tobacco and small  and large cigars are not subject to FDA’s rule containing numerous  youth access and marketing restrictions that was issued in March  2010. One restriction generally prohibits the sale and distribution of  individual cigarettes or packs containing fewer than 20 cigarettes. In  contrast, cigars can be sold individually, and filtered cigars are often  sold in packs containing fewer than 20. A second restriction generally  requires that retail sales of cigarettes and smokeless tobacco be  conducted in a direct, face-to-face exchange. This restriction does  not apply to pipe tobacco and cigars, and these products are sold on  the Internet. A third restriction bans brand-name sponsorship of  sporting and cultural events by manufacturers, distributors, or retailers  of cigarettes and smokeless tobacco and does not currently apply to  pipe tobacco and cigars. A cigar company recently signed a multiyear  sponsorship deal for a major collegiate sporting event, but the deal  was canceled due to public pressure, as has been reported in the  press.   Requirements for new health warnings depicting negative health  consequences of smoking: Pipe tobacco and cigar packs are not  subject to FDA’s rule that requires each cigarette pack and  advertisement to bear one of nine new textual warning statements  accompanied by color graphics, issued in June 2011. According to  the law, the new warnings must cover the top half of the front and  back of cigarette packs and at least 20 percent of cigarette  advertisements and must contain color graphics depicting the  negative health consequences of smoking. FDA selected nine color  graphic health warning messages after reviewing relevant scientific  literature, 1,700 public comments, and the results of its experimental  18,000-person study to assess the effectiveness of the warnings.  While the Tobacco Control Act mandates that the warnings take effect  no later than 15 months after FDA issues regulations, that is, by  September 2012, pending litigation may impact implementation.

FDA indicated its interest in deeming additional tobacco products to be  subject to the agency’s tobacco product authorities in the four recent  issues of the U.S. government’s semiannual regulatory agenda. In the  spring and fall 2010 agendas, FDA announced that it planned to issue a  proposed rule that would deem cigars to be subject to the provisions of  the Food, Drug, and Cosmetic Act. In the spring and fall 2011 agendas,  FDA announced that it planned to broaden the proposed rule’s scope to  encompass all products that meet the statutory definition of “tobacco  product”under Chapter IX of the Food, Drug, and Cosmetic Act. The  fall 2011 announcement, the most recent, indicated that the proposed rule  would be issued in December 2011; however, FDA had not issued the  proposed rule as of March 2012, and FDA officials told us that developing  the rule is taking longer than they expected.

A typical rulemaking process consists of three basic phases—initiation of  rulemaking actions, development of proposed rules, and development of  final rules—and involves internal review by the rulemaking agency,  external review by the Office of Management and Budget, and public  comments on proposed rules (fig. 16). In developing the proposed rule  deeming additional products, including pipe tobacco and cigars, to be  subject to the agency’s regulatory authority, FDA is in the second phase  of the process. FDA officials told us that, as of March 2012, the proposed  rule was undergoing review by the agency and the Department of Health  and Human Services and that FDA had not yet submitted the proposed  rule to the Office of Management and Budget. In a 2009 report on the  federal rulemaking process, we found—based on an analysis of 16 rules  at different federal agencies, including FDA—that the average time  needed to initiate, develop, and complete a rulemaking was about 4  years, with considerable variation among agencies and rules.

FDA will be able to exercise authority over the deemed products once the  rulemaking process is completed and the final rule is published in the  Federal Register. At that time, the deemed products will be subject to the  provisions of Chapter IX the Food, Drug, and Cosmetic Act that are  applicable to tobacco products in general. Examples of such provisions  include a requirement for annual registration with FDA of establishments  engaged in the manufacture of tobacco products, payment of user fees by  manufacturers and importers of specified classes of tobacco products, as  well as restrictions and penalties for misbranded products. However, if  FDA decides to expand the scope of its existing regulations applicable to  cigarettes and roll-your-own tobacco to encompass the deemed products,  it will have to amend those regulations through the rulemaking process.  For example, FDA would have to amend its rule covering the sale and  distribution restrictions for cigarettes and smokeless tobacco in order to  make it applicable to the deemed products.

Federal legislation has aimed to discourage tobacco use and raise  revenues by increasing excise taxes on tobacco products. In 2009,  Congress passed CHIPRA, which increased taxation on all smoking  tobacco products, but by different levels for pipe tobacco and for large  cigars. Also in 2009, Congress passed the Tobacco Control Act, which  gave FDA immediate regulatory authority over four tobacco products,  including cigarettes and roll-your-own tobacco, but did not specify  authority over pipe tobacco and small and large cigars.

In equalizing the federal excise tax rates on small cigars and roll-your- own tobacco with the tax rate on cigarettes, CHIPRA was responding to  concerns that these products were increasingly used as substitutes to  factory-made cigarettes. However, by introducing large tax disparities  between cigarettes, roll-your-own tobacco, and small cigars, on the one  hand, and pipe tobacco and large cigars, on the other, CHIPRA has  contributed to the substitution of higher-taxed tobacco products with  lower-taxed products. Sales of the lower-taxed pipe tobacco and large  cigars saw significant growth following CHIPRA, as manufacturers and  consumers sought to take advantage of lower-taxed products. We  estimate that this tax avoidance has resulted in between approximately  $615 million and $1.1 billion in lost federal revenue since 2009.

Treasury has not succeeded in addressing the continued tax avoidance  behavior reflected in the market shifts to pipe tobacco and to large cigars.  In the absence of legislative changes, Treasury has limited options for  effective action. First, roll-your-own and pipe tobacco are similar and, in  some cases, may be substitutable products, and the IRC lacks specificity  on how they should be distinguished based on physical characteristics.  Treasury is currently considering and analyzing various proposals to more  clearly and objectively differentiate the two products based on their  physical characteristics. However, the lack of consensus on which  characteristics or criteria truly define and differentiate roll-your-own from  pipe tobacco reveals the complexity and difficulty in attempting to develop  standards and tests to distinguish the products from each other. In  addition, there is the concern that products could easily be manipulated to  negate any newly established standards or tests.

Because small and large cigars are distinguished in the IRC only by  weight, and because many small cigars already weighed at or close to the  3 pounds per thousand threshold for classification as large cigars, many  small cigar manufacturers were able to legally shift to the lower-taxed  large cigar category with minimal changes to their products. In addition,  the large cigar tax structure, which consists of an ad valorem tax rate up  to a maximum rate, is complex and creates an incentive to lower the  manufacturer’s or importer’s sale price to avoid paying higher federal  excise taxes.

FDA, which implements the Tobacco Control Act, currently regulates  cigarettes and roll-your-own tobacco but does not regulate pipe tobacco  and small and large cigars. These regulatory disparities make pipe  tobacco and small and large cigars more accessible and attractive to  current and potential smokers. While FDA announced its intent to issue a  proposed rule that would subject additional products, including pipe  tobacco and small and large cigars, to its regulation, it had not issued the  proposed rule as of March 2012.

Disparities in tax rates on smoking tobacco products have negative  revenue implications because they create incentives for manufacturers  and consumers to substitute higher-taxed products with lower-taxed  products. In light of that fact, as Congress continues its oversight of  CHIPRA and Tobacco Control Act implementation, it should consider  modifying tobacco tax rates to eliminate significant tax differentials  between similar products. Specifically, Congress should consider  equalizing tax rates on roll-your-own and pipe tobacco and, in  consultation with Treasury, also consider options for reducing tax  avoidance due to tax differentials between small and large cigars.

We provided a draft of this report to the Secretary of the Treasury and the  Secretary of Health and Human Services for their review and comment.  We received technical comments from Treasury and the U.S. Department  of Health and Human Services, which we have incorporated in the report  as appropriate. We also received written comments from Treasury, which  are reprinted in appendix IV.

Treasury generally agreed with our overall conclusion that CHIPRA’s  introduction of large tax disparities between similar products contributed  to the substitution of higher-taxed tobacco products with lower-taxed  products. Treasury also agreed with our observation concerning  modifying tobacco tax rates to eliminate significant tax differentials  between similar products, which is consistent with our Matter for  Congressional Consideration.

Treasury noted our use of the term “revenue losses” and commented that  our estimates did not pertain to actual losses of revenues but rather were  estimates of revenue increases that would be realized if Congress were  to change the law to eliminate the tax disparities or had the market shifts  due to the disparities not occurred. We state in the report that our  analysis does not incorporate the hypothetical case of equal tax rates  among smoking products; rather, we estimate the revenues Treasury  would have collected under current law—but in the absence of the market  shifts from higher-taxed products to lower-taxed products. The difference  between the revenues collected under current law and our estimate of the  higher revenues that would have been due in the absence of the market  shifts is what we refer to as “revenue losses.”

In response to Treasury’s comment about the use of this term, we note  that Treasury’s Alcohol and Tobacco Tax and Trade Bureau developed its  own estimates of what it termed revenue losses stemming from the  market shifts involving these products, and we discuss these estimates in  our report. In addition, the Alcohol and Tobacco Tax and Trade Bureau’s  2011 Annual Report uses the term revenue losses when estimating the  effect of the market shifts since CHIPRA. Appendix I contains a more  detailed discussion of our methodology for developing our estimates.

We are sending copies of this report to the appropriate congressional  committees and to the Secretaries of Health and Human Services and  Treasury, and other interested parties. This report also is available at no  charge on the GAO website at http://www.gao.gov.

If you or your staff members have any questions about this report, please  contact me at (202) 512-3149 or gootnickd@gao.gov. Contact points for  our Offices of Congressional Relations and Public Affairs may be found  on the last page of this report. Individuals who made key contributions to  this report are listed in appendix V.

Appendix I: Objectives, Scope, and Methodology

The Family Smoking Prevention and Tobacco Control Act (Pub. L. No.  111-31) directed GAO to report on various aspects of cross-border and  illicit trade in tobacco products, including the effects of differing tax rates  applicable to tobacco products. In accordance with our agreement with  Senate Committee on Health, Education, Labor, and Pensions and House  Energy and Commerce Committee staff, this report provides information  on the federal revenue effects of differing tax rates applicable to tobacco  products. Our objectives for this report are to (1) review the market shifts  among smoking tobacco products since the Children’s Health Insurance  Program Reauthorization Act (CHIPRA) of 2009 went into effect on April  1, 2009; (2) examine the impact of these market shifts on federal revenue  and the Department of the Treasury’s (Treasury) actions to respond; and  (3) describe differences in regulation of various smoking tobacco products  by the Food and Drug Administration (FDA). Our review includes smoking  tobacco products that are subject to federal excise tax: cigarettes and  four other tobacco products—roll-your-own tobacco (sometimes called  RYO), pipe tobacco, small cigars, and large cigars. However, in  analyzing the market shifts among these products, we focused solely on  the four smoking tobacco products other than cigarettes.

To address the three objectives in this study, we reviewed documents  and interviewed agency officials from Treasury’s Alcohol and Tobacco  Tax and Trade Bureau, FDA, and the Centers for Disease Control and  Prevention, as well as tobacco industry members, representatives of  public health and other nongovernmental organizations, and academics  to obtain information on tobacco legislation and regulations, tobacco  product sales trends, and consumption patterns. Tobacco industry  members that we spoke with included industry associations and individual  companies. We identified and contacted 15 pipe tobacco manufacturers  to ask about their companies’ actions in response to the CHIPRA tax  changes, and 3 of the manufacturers agreed to speak with us. We also  reviewed studies analyzing the relationship between tobacco tax  increases and smoking, including among youth. We also collected data  from Treasury, the Bureau of Labor Statistics, and the Department of  Agriculture and determined that they were sufficiently reliable for our  purposes.

We analyzed Treasury removals data to identify sales trends across the  different tobacco products before and after CHIPRA took effect. In  addition, we collected and analyzed price data and data on federal excise  tax rates for roll-your-own tobacco, pipe tobacco, small cigars, and large  cigars, as well as the federal tax revenue generated from their sale. We  estimated what the effect on federal tax revenue collection would have  been if the market shifts resulting from substitution of higher-taxed  products with lower-taxed products had not occurred once CHIPRA’s  higher tax rates went into effect. In this report, we refer to this estimated  effect on federal tax revenue collection as revenue losses. Our analysis  takes into account the expected fall in quantity demanded due to the price  increases resulting from the higher federal excise tax rates that CHIPRA  imposed on these smoking tobacco products.

To estimate federal tax revenue losses due to market shifts after  CHIPRA, we analyzed Treasury’s monthly sales and revenue data from  fiscal year 2001 through fiscal year 2011 for roll-your-own and pipe  tobacco and for small and large cigars. Our analysis compares the actual  tobacco tax revenue collected by Treasury with a counterfactual scenario.  Our counterfactual model draws from one used by Dr. Frank Chaloupka,  an economist who has investigated the effect of prices and taxes on  tobacco consumption in numerous publications. In particular, we follow  the methodology used in a paper from January 2011 in which Dr.  Chaloupka calculates the effect of raising cigarette taxes in the state of  Illinois. This methodology projects the effect of a future tax increase  based on the historic sales trend, the amount of the tax, and the effect of  a price increase on projected sales (that is, price elasticity of demand).  Our counterfactual model, then, projects post-CHIPRA sales of roll-your- own and pipe tobacco and small and large cigars according to the historic  sales trends for these products, adjusted downward to account for the fall  in demand due to the higher post-CHIPRA tax component of the price.  To calculate the impact on demand due to the higher taxes on these  products, we included high and low estimates for price elasticity. Based  on our interviews with experts and a review of the relevant literature, we  assumed that the price elasticity for the smoking tobacco products in our  analysis ranges from -0.6 to -0.3, which set, respectively, the low and  high boundaries of the estimated revenue losses.

Our analysis does not incorporate the hypothetical case of equal tax rates  among smoking tobacco products; rather, we estimate the revenues that  Treasury would have collected in the absence of the market’s substitution  of higher-taxed products with lower-taxed products. An analysis that  projected the impact of equal tax rates across all smoking tobacco  products would necessarily produce a much higher estimate of lost tax  revenues. We did not attempt to develop such a model, however,  because doing so was beyond the scope of our analysis. The reliability of  any such model would depend on the assumptions made, particularly with  regard to large cigars—the only tobacco product for which excise taxes  are calculated as a percentage of price. Compared with determining the  tax on all other tobacco products, according to Treasury, determining the  tax on large cigars is extremely complex. Modeling hypothetical  consumption trends for smoking tobacco products after equalizing tax  rates on them would require a complex set of assumptions not  necessarily grounded in reliable data.

We used data from two sources to build our counterfactual model  projecting post-CHIPRA sales of roll-your-own and pipe tobacco and  small and large cigars. The first source is Treasury’s data from fiscal year  2001 through fiscal year 2011 on smoking tobacco product tax revenues  and removals (the amount of tobacco removed for sale from the factory or  released from customs). The second data source is tobacco products  price data from the Bureau of Labor Statistics, which it uses to calculate  the Consumer Price Index for tobacco products. The Bureau of Labor  Statistics data contain retail price information collected each month  throughout the country; the prices include the cost of production, markup,  and excise taxes from federal, state, and local governments—shipping,  handling, sales tax, and fuel surcharges have been removed from the  data.

For roll-your-own and pipe tobacco and for small and large cigars, we  calculated an average taxable manufacturer’s or importer’s sale price for  the year before CHIPRA was enacted. We then estimated the post- CHIPRA price by adding the corresponding post-CHIPRA tax to the pre- CHIPRA price. Thus, our counterfactual model includes only the effect  of CHIPRA on tax revenue.

To calculate the average taxable manufacturer’s or importer’s sale price  for large cigars, we used Treasury’s revenue data and removals data.  Treasury collects revenue data for cigars but does not collect separate  revenue data for small and large cigars. However, Treasury’s removals  data are separated by small and large cigars, reporting the number of  sticks removed for sale from the factory or released from customs. After  CHIPRA, small cigars are taxed at $50.33 per thousand sticks, whereas  large cigars are taxed at 52.75 percent of the manufacturer’s or importer’s  price up to a maximum tax rate per thousand sticks. We calculated small  cigar revenue by multiplying the number of sticks reported in Treasury’s  removals data in each month by the tax rate. We then calculated large  cigar revenues by subtracting small cigar revenues from total cigar  revenues. Once we had calculated the large cigar revenues, we  estimated the average tax paid by dividing the large cigar revenues by the  number of large cigar sticks reported in the removals data for each month  and calculating the average price. From March 2007 through March 2009,  the average large cigar tax collected was 4.3 cents per stick. These  figures corroborate Treasury’s statement that a majority of manufacturers  were paying the maximum rate. CHIPRA raised this maximum rate from  4.8 cents to 40 cents per stick. We estimated that the average taxable  manufacturer’s or importer’s sale price before CHIPRA was 20.65 cents.  Hence, the average tax paid after CHIPRA using the new tax rate should  be 10.9 cents per cigar, and this is the number we used to estimate post- CHIPRA tax revenues in our counterfactual model. Treasury does not  maintain records of the manufacturers’ and importers’ sale prices of large  cigars where the manufacturer or importer paid the maximum rate,  thereby making it impossible to determine the magnitude of  underestimation in our model caused by the maximum rate.

To describe FDA’s regulation of tobacco products under Chapter IX of the  Food, Drug, and Cosmetic Act, we examined FDA’s regulatory actions  and announcements and interviewed officials from FDA’s Center for  Tobacco Products, including the Offices of Compliance and Enforcement,  Policy, Regulations, and Science.

We conducted this performance audit from March 2011 to April 2012 in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.

Appendix II: Sales of Smoking Tobacco Products in the United States, Fiscal Years 2001-2011

Treasury’s data on taxable removals (sales) show that the decline in  cigarette sales in the last decade has been partially offset by the  combined growth in sales of roll-your-own tobacco, pipe tobacco, small  cigars, and large cigars. Table 5 provides annual sales data for  cigarettes, roll-your-own tobacco, pipe tobacco, small cigars, and large  cigars from fiscal year 2001 through fiscal year 2011. Figure 17 uses the  same data to depict the concomitant decline in cigarette sales and growth  in combined sales of the other four smoking tobacco products.

From fiscal year 2001 through fiscal year 2011, sales of the smoking  tobacco products—cigarettes, roll-your-own tobacco, pipe tobacco, small  cigars, and large cigars—in the United States decreased by about 26  percent. Sales of cigarettes, which continue to dominate the market,  declined by 30 percent from about 414 billion sticks in fiscal year 2001 to  about 289 billion sticks in 2011. However, combined sales of roll-your- own tobacco, pipe tobacco, small cigars, and large cigars increased by  131 percent during the same period from about 12 billion sticks or  cigarette stick equivalents (for roll-your-own and pipe tobacco) in fiscal  year 2001 to about 29 billion sticks or cigarette stick equivalents. The  share of these four products grew from 3 percent of the smoking tobacco  market in fiscal year 2001 to 9 percent in fiscal year 2011.

Appendix III: Summary of Treasury’s Proposed Rulemaking Actions to Distinguish between Roll-Your-Own and Pipe Tobacco

Treasury published a temporary rule and request for public comments in  June 2009 that outlined new labeling and packaging requirements for roll- your-own and pipe tobacco to more clearly differentiate the two products  on those bases. Treasury also noted the need for additional rulemaking  on other standards and methods to differentiate the products. In response  to its June 2009 rulemaking notice, industry members proposed  standards to distinguish between roll-your-own and pipe tobacco based  on physical characteristics. For example, Treasury received comments  setting forth certain criteria for distinguishing between the products based  on whether the product met a certain number of factors, including  moisture content; cut width; percentage of weight consisting of reducing  sugars; and percentage of weight consisting of flavoring, casing, or other  nontobacco content.

In July 2010, Treasury published an advance notice of proposed  rulemaking issuing a request for public comments on these and other  standards proposed by commenters to differentiate between roll-your-own  and pipe tobacco. The industry members’ comments responding to  Treasury’s 2010 request highlighted the complexity and difficulties in  developing objective standards based on physical characteristics that  clearly differentiate the two tobacco products. Industry members  disagreed on the number of criteria that should be used and the specific  thresholds for differentiating between the products. For example, while  some industry members generally agreed that pipe tobacco traditionally  has had a thicker cut and greater moisture content than roll-your-own  tobacco, they disagreed on the specific cut width or moisture content that  defines pipe tobacco. Some comments noted that the physical  characteristics of the two products overlap greatly, emphasizing the  numerous types of roll-your-own and pipe tobacco products on the market  and various manufacturing methods, all of which make it difficult to  develop concrete definitions that clearly differentiate between the two  products. Other comments emphasized the challenges of conducting  tests to distinguish the two products as, for example, test results can be  influenced by factors such as the age of the sample used and the  temperature of the facility, potentially creating different results on tests of  the same tobacco products. Some industry members also proposed that  Treasury take into consideration the preexisting or established pipe  tobacco brands prior to CHIPRA and continue to classify them as pipe  tobacco through a grandfathering clause, regardless of how the tobacco  might fare in any tests based on objective standards. Other industry  members disagreed, however, stating that a grandfathering clause would  favor existing companies, reduce competition, and give some companies  the opportunity to introduce misclassified pipe tobacco into the market  without accountability.

Other industry members expressed concerns that the proposed standards  could easily be manipulated by consumers. For example, the tobacco cut  width standard for pipe tobacco could be compromised by a consumer  using a blender or coffee grinder to obtain a smaller width for use in  cigarettes. Additionally, the moisture content standard could also prove to  be ineffective because end users could dry out the moister pipe tobacco  for use in cigarettes.

After the initial public comment period closed in September 2010,  Treasury did not issue a subsequent rulemaking on clarifying standards.  Treasury said it received an additional proposal after the close of the  comment period and, as a result, issued a second advance notice of  proposed rulemaking in August 2011 reopening the period for receiving  comments on the standards proposed by commenters, including the new  proposal. Treasury received a number of additional comments, many by  the same companies that commented on the earlier notices, and the  comments continued to reflect significant differences within the industry  on standards that define and distinguish roll-your-own tobacco from pipe  tobacco. This second comment period closed in October 2011, and  Treasury has not issued a subsequent rulemaking as of March 2012.

Within the 2011 notice, Treasury also published the results of the  preliminary analysis conducted by its laboratory on a sample of roll-your- own and pipe tobacco products. For this analysis, Treasury purchased a  sample of products labeled as roll-your-own and pipe tobacco from local  retail vendors in Maryland. These samples were purchased just prior to  the CHIPRA tax increases going into effect. Treasury officials  emphasized that their sample was not a representative market sample  and thus not generalizable. Treasury officials stated that the purpose of  the preliminary analysis was to investigate what could be learned about  the initial proposed standards rather than to complete a definitive test  differentiating the products or attempting to determine whether the  products were roll-your-own or pipe tobacco, as they were labeled.  Treasury tested for several of the proposed standards, including total  reducing sugars and moisture content. Treasury’s results, in some cases,  appeared to show a lack of a clear distinction between the roll-your-own  and pipe tobacco samples.

Appendix IV: Comments from the Department of the Treasury

Appendix V: GAO Contact and Staff Acknowledgments

In addition to the individual named above, Christine Broderick, Assistant  Director; Sada Aksartova; Pedro Almoguera; David Dayton; Etana  Finkler; Jeremy Latimer; Grace Lui; and Alana Miller made key  contributions to this report. In addition, Barbara El Osta, Joyce Evans,  Marc Molino, Theresa Perkins, Jena Sinkfield, and Cynthia S. Taylor  provided technical assistance.

Question: What market shift prompted a federal revenue loss from from FY2009-FY2011?

Answer: While revenue collected for all smoking tobacco products from April 2009 through fiscal year 2011 amounted to $40 billion, GAO estimates that federal revenue losses due to market shifts from roll-your-own to pipe tobacco and from small to large cigars range from about $615 million to $1.1 billion for the same period.

Question: Why is it challenging for the Department of Treasury to respond to such market shifts?

Answer: The Department of the Treasury (Treasury) has limited options to respond to these market shifts.

Question: What exactly has the Treasure attempted and how has this been a challenge for them?

Answer: Treasury has attempted to differentiate between roll-your-own and pipe tobacco for tax purposes but faces challenges because the definitions of the two products in the Internal Revenue Code of 1986 do not specify distinguishing physical characteristics.

Question: How does the change in large cigar tax rates affect Treasury's ability to address the market shift?

Answer: Treasury also has limited options to address the market shift to large cigars and faces added complexity in monitoring and enforcing tax payments due to the change in large cigar tax rates.

Market Shifts to Avoid Taxes Have Reduced Federal Revenue, and Treasury Has Limited Options to Respond

Estimated Federal Revenue Losses from Market Shifts after CHIPRA Range from $615 Million to $1.1 Billion

CHIPRA’s Changes to Tax Rates on Large Cigars Also Present Challenges to Treasury

Question: Why aren't pipe tobacco and cigars not subject to the same FDA restrictions as cigarettes and roll-your-own tobacco?

Answer: Unlike cigarettes and roll-your-own tobacco, pipe tobacco and cigars are not currently regulated by the Food and Drug Administration (FDA) and thus are not subject to the same restrictions on characterizing flavors, sales, or distribution.

Question: How would the FDA ideally regulate tobacco according to a 2011 proposed rule?

Answer: In 2011, FDA indicated its intent to issue a proposed rule that would deem products meeting the statutory definition of “tobacco product” to be subject to FDA’s regulation.

Question: What was the status of the proposed rule as of March 2012?

Answer: However, FDA had not issued the proposed rule as of March 2012.

Question: What was the reason for why the FDA hadn't proposed the rule?

Answer: FDA officials told GAO that developing the rule was taking longer than expected.

FDA Currently Regulates Cigarettes and Roll-Your-Own Tobacco but Not Pipe Tobacco and Cigars

Question: What action did CHIRPA take against cigarettes, roll-your-own tobacco, and small cigars?

Answer: In 2009, CHIPRA increased and equalized federal excise tax rates for cigarettes, roll-your-own tobacco, and small cigars.

Question: What other tax initiatives has CHIRPA launches with regards to tobacco?

Answer: Though CHIPRA also increased federal excise tax rates for pipe tobacco and large cigars, it raised the pipe tobacco tax to a rate significantly below the equalized rate for the other products, and its large cigar excise tax can be significantly lower, depending on price.

Question: What is Treasury's role in CHIRPA's tobacco tax acts?

Answer: Treasury collects federal excise taxes on tobacco products.

Background
Tobacco Products Have Broad Definitions

Question: What did FDA receive from the Tobacco Control Act?

Answer: Also passed in 2009, the Family Smoking Prevention and Tobacco Control Act (Tobacco Control Act) granted FDA regulatory authority over tobacco products.

Question: What did the Tobacco Control Act require GAO to do?

Answer: This act directed GAO to report on trade in tobacco products, including the effects of differing tobacco tax rates.

Question: What did the GAO report on?

Answer: This report (1) reviews the market shifts in smoking tobacco products since CHIPRA; (2) examines the impact of the market shifts on federal revenue and Treasury’s actions to respond; and (3) describes differences in FDA’s regulation of various smoking tobacco products.

Question: How did GAO collect information for this report?

Answer: GAO interviewed agency officials, industry members, and public health representatives. GAO analyzed tax and revenue data and reviewed relevant literature.

Appendix I: Objectives, Scope, and Methodology