Introduction: Cigarette Taxes andThe Law of Unintended Consequences
Arbitrage is a simple concept. It can be defined as the practice of taking advantage of a price differential between two or more markets. The same principle of buying an item in a lower priced market and reselling it in a higher priced one applies just a equally in the worlds of high finance with stocks, bonds, options, and currencies as it does in placing sports bets or selling collectibles on eBay.
Arbitrage applies to cigarettes as well. For decades, U.S. cigarette taxes were far lower than those in Canada, leading to a high volume of cigarettes heading Northbound with Canadian travelers. On an individual level, smokers have an incentive to take advantage of the tax disparity by purchasing lower taxed and lower-priced cigarettes in neighboring states. Literally, by driving a few miles or, in many cases, by simply crossing the street, they could save themselves $10 or $20 per carton. However, academic studies have shown that for most smokers, convenience outweighs economics. The fact is that approximately two-thirds of all of all cigarettes sold in the United States are sold by the single pack. For instance, a recent study by researchers from the University of California found that after Californias 50 cent per pack tax increase, fewer than five percent of the states smokers attempted to evade the heightened tax by purchasing their cigarettes online, from nearby state s, or on an Indian reservation (where cigarettes can legally be sold tax-free).
In the U.S., while there is a federal excise tax of 39 cents levied on each pack of cigarettes, the majority of cigarette taxes are imposed at the state level. And in this decade, states have significantly increased their cigarette taxes. In fact, in the past five years alone, the average state cigarette tax has risen from 43.4 cents per pack to $1.02 a pack. In addition, major cities, such as Chicago, New York City, and Anchorage are increasingly adding their own taxes on cigarettes. In fact, the total cigarette taxes in each of these locales exceed $3 per pack! Thus, the disparity in state cigarette taxes is large, ranging from a high of $2.57 per pack in New Jersey to just 7 cents per pack in South Carolina (for reference, Louisiana's cigarette tax stands at 36 cents per pack, making it the seventh lowest of all fifty states). The disparities are especially stark when you consider that in several instances, the cigarette taxes of one state can be often double, triple or m ore than that of its neighboring states. Consider that North Carolinas tax of 35 cents per pack is five times that of neighboring South Carolina, and that New York States tax rate of $1.50 per pack is more than four times that of North Carolinas (and more than twenty times that of South Carolina. The city cigarette taxes even exacerbate these cigarette price disparities, in New York City, the municipal tax of $1.50 per pack doubles the effective tax rate on cigarettes bought there versus in other parts of the state.
These tax increases have been generally popular with the public at least with the non-smoking majority, who see cigarette taxes as a means to provide a stable source of tax revenue, while working to help curb youth smoking by making smoking less affordable. Academic studies have shown that while cigarette tax increases do decrease overall smoking rates slightly, state tax revenues still increase with each tax increase, as the core group of smokers has an almost inelastic demand for the product. Perhaps most importantly, by reducing the smoking rate in society, the tax increases should in the long-term decrease the health care costs attributable to the treatment of smoking-related illnesses and concerns (causing less government spending on health services down the road). Yet, even with todays average price for a pack of cigarettes running at $4.28, health experts have calculated that the total health care and productivity costs attributable to smoking at over ten dollars p er pack!
The Booming Business of Cigarette Smuggling
The price disparity between these markets has not been lost on entrepreneurial types in both the legitimate and illegitimate business world. Online cigarette sales have been a flourishing business, with estimates on Internet sales of cigarettes reaching into the billions. Also, the many Indian tribes in the United States have aggressively promoted tobacco sales on their tribal lands as a major attraction, both in their own right and to promote sales of other items and visits to tribal casinos. While cigarette taxes are set by the individual states, the interstate transport and sale of cigarettes is governed by a 1949 federal law known as the Jenkins Act . This statute prohibits the sale or transfer of cigarettes across state lines unless the proper taxes are paid in the receiving state. Thus, trafficking of cigarettes across state lines makes the products contraband, and in most instances, Internet retail outlets and Indian tribal sellers are not paying the proper taxes. Thi s means what are legal sales can become illegal when state lines are crossed. It also means that states lose tremendous amounts of tax revenue, estimated to be upwards of one and a half billion or more dollars annually in a recent report from the federal Government Accountability Office (GAO).
The arbitrage window is also open for smugglers as well, with both small time and large scale operators to take advantage of the price disparities between state jurisdictions. From the perspective of John D'Angelo of the Bureau of Alcohol, Tobacco, Firearms and Explosives (ATFE), There is no doubt that there's a direct relationship between the increase in a state's tax to an increase in illegal trafficking. Indeed, there have been an increasing number of cases of cigarette smuggling (officially called cigarette diversion) in the United States since the rapid rise of tobacco taxes, beginning in 2000. There is also an increasing sophistication in these trafficking operations, with the increasing involvement of both organized crime elements and terrorist organizations in these black market operations. As the Irish Republican Army has been involved with cigarette smuggling in Europe for decades, in the past few years, cases have been uncovered in the U.S. mainland involving know n international terrorist groups, including Hamas, Hezbollah, Islamic Jihad, PKK (the Kurdish Workers Party), and Al Qaeda. Now, the U.S. faces the very real prospect that not only are we facing not only a tax problem, but an increasing threat from terrorism, funded significantly by a growing black market trade in cigarettes coming to our shores.
Indeed, what is occurring in the U.S. is the long reach of a global epidemic of cigarette smuggling. To a lesser extent, the U.S. is also seeing the tax burden on cigarettes sparking growth in the illegal importation of counterfeit cigarette products from China and a variety of other countries around the world . In fact, according to the most recent data available, the U.S. Customs and Border Protection seized approximately $25 million worth of counterfeit imported cigarettes in 2003, which represents almost one-fifth of all imported commodities seized for violations of intellectual property rights. According to the World Health Organization (WHO), more than a quarter of all cigarettes are smuggled, and the U.S. Bureau of Alcohol, Tobacco, Firearms, and Explosives has found that Russian, Armenian, Ukrainian, Chinese, Taiwanese, and Middle Eastern (mainly Pakistani, Lebanese, and Syrian) organized crime groups are highly involved in the trafficking of contraband and counterfe it cigarettes. Finally, sales of cigarettes through the black market work around the prohibitions against the sale of tobacco products to minors (under 18 or even up to 21 in some states). Thus, the World Health Organization has taken the position that the burgeoning sale of contraband cigarettes serves to significantly counteract the efforts to curb youth smoking.
Using RFID Technology to Combat Organized Cigarette Smuggling (and You, Yes You, Buying Your Smokes at the Indian Casino!)
RFID is a new, old technology using radio wave technology to identify objects as opposed to manual or bar-code based optical scanning. It is being utilized in a wide variety of industries today, everywhere from retail to pharmaceuticals to animal science to aerospace, as the cost of the technology is making it practical for routine use. In contrast, todays cigarette tax technology dates back to the early 1950s, with tax stamps on packs of cigarettes being mandated by the Jenkins Act. These have proven easily counterfeited and subject to fraud on a massive scale. Indeed, there is a rampant black market just in the sale of counterfeit and stolen tax stamps themselves. California is the only state thus far to use a new generation of machine readable tax stamps, incorporating encryption technology that gives law enforcement the ability to scan stocks of cigarettes to verify that the proper taxes have been paid. With these new, high tech tax stamps, California has seen a signif icant rise in cigarette tax revenue well in excess of $100 million in the past two years since the new requirements went into effect. And with all states struggling with declining tax revenues due to the current economic situation, recapturing tax revenues will be an especially important subject for legislators and tax enforcement agencies over the next few years.
In mid-February 2007, then Sen. Ted Kennedy (D-Massachusetts) and Rep. Henry Waxman (D-California) introduced The Family Smoking Prevention and Tobacco Control Act (S.625 in the Senate and H.R. 1108 in the House). Their bills would for the first time grant the U.S. Food and Drug Administration (FDA) the power to regulate the manufacture, sale and advertisement of most tobacco products, including cigarettes and smokeless tobacco. The bill specifically authorizes the use of special codes or devices on tobacco product labels for the purpose of tracking or tracing the tobacco product through the distribution system. While the proposed legislation do not now specifically call for an RFID mandate, industry and political analysts believe that this could be the case when the bills reach their final form, or, when passed in the implementing regulations. According to a recent RFID Journal analysis, Congress, while not naming RFID specifically, could become the first legislative cat alysts for the technology's use in government regulation.
A Wall Street Journal editorial dubbed the proposed legislation The Marlboro Preservation Act, as the bill through advertising restrictions and other barriers to entry would help to protect the market dominance of the major tobacco companies, making it harder and most costly for smaller manufacturers to compete. In fact, tobacco industry analysts from Morgan Stanley and Citigroup believe that the legislation would work in favor of the incumbent, large tobacco companies. This is because the increased regulatory burden and advertising limitations would limit the ability of smaller competitors to make inroads into the cigarette market, while also serving to narrow the price gap between premium and low-cost brands.
The U.S. would not be alone in looking to RFID in regulating the cigarette supply chain to specifically combat the trafficking of contraband products. The United Kingdom also has a sizeable problem with contraband cigarettes entering the British market. In fact, according to the Tobacco Manufacturers' Association (TMA), an estimated two billon counterfeit cigarettes well over a quarter of all cigarettes sold annually - are smuggled into the UK. This translates into a loss of approximately 3.5 billion in lost tax revenue for the British government from contraband cigarettes. To counteract this problem, HM Revenue & Customs (HMRC) announced in March that within six months, the British government would begin requiring the use of a covert security mark on all cigarette packets. Again, while not specifically naming RFID as the technology that would be utilized for the covert marking, analysts anticipate this to be the case, as the ministry desires to enable customs officials to be able to use small hand-held readers to verify the authenticity of cigarettes and that crown taxes had been properly paid.
Indeed, the WHO has recommended that countries take several steps to curb cigarette smuggling, from raising criminal penalties and licensing all parties involved in the cigarette trade who handle the product as it moves from the manufacturer through the distribution channels to the ultimate consumer. The WHO has also posited the value of having each pack of cigarettes given a serialized identification code, enabling track and trace capabilities to not only assure product authentication and provide a pedigree trail, but to ensure tax compliance as well. Again, while not suggesting an RFID-based solution specifically, it would appear that RFID would be the only technology capable of providing this level of security to the tobacco supply chain.
Analysis
Will we see wide-scale tagging of cigarettes using RFID in the near future? Noted RFID analyst, Dr. Peter Harrop, Chairman of IDTechEx Ltd., cautions that with the cost of RFID tags (presently at least a quarter per unit): No one in their right mind would put a conventional RFID chip in a cigarette packet. Yet, as tag prices fall and new chipless forms of RFID emerge, the prospect of tagging individual packs of cigarettes will become more practicable. Still, the major tobacco companies may come to see RFID tagging at the pack level as enhancing their competitiveness, both in fighting the damage to their brand from counterfeit cigarettes and in putting more costs on their smaller rivals. Thus, there is likely to be an unusual degree of industry-government cooperation to foster RFID tagging of cigarettes, due to the alignment of their mutual interest to protect the legal cigarette trade. We may also see more government action in this area along the lines of the recent British government announcement and the bill before the U.S. Congress, which stands a good chance of passage this year.
Yet, the question remains as to whether labeling can be made practical from a cost perspective? The answer lies in the level of tagging. Certainly, cigarettes qualify as one of the best candidate products for tagging, due to the ratio of the cost of the tag to the value of the item in question which is right up there with high cost items such as pharmaceuticals, electronics, and liquor. The unusual situation with cigarettes is that the key level of tagging might not be at either the individual item level (the pack) or the case level. Rather, cartons of cigarettes a packaging level unique to the tobacco trade - presents a compelling business case. A carton of cigarettes is an industry standard, containing 200 cigarettes (20 cigarettes in a pack, 10 packs to a carton). By tagging cartons of cigarettes, in addition to tagging the cases and pallets that contain them, the cigarette industry and governments could significantly cut the ability of individuals and outlets to trade in contraband cigarettes. In the process, they would effectively create the largest RFID mandate and with it, new demand for RFID tags and labels into the billions of tags - that would perhaps go a long way toward promoting the market growth that would drive unit tag prices significantly downward.
Finally, as we have seen in the U.S., there is that perfect storm developing where the interest of all parties is converging to work towards both national, and perhaps even multinational, solutions. While smoking rates are declining in the U.S., it is important to note that both legal and illicit cigarette sales are a burgeoning market globally. According to the most recent analysis from the World Health Organization, there are well over a billion smokers worldwide more than one-sixth of the global population consuming the approximately 5.5 trillion cigarettes produced annually by the tobacco industry. Thus, when talking about RFID and cigarettes, there is no blowing smoke theres surely a growth opportunity here for innovative companies ready for an innovative, effective RFID-based solution for the tobacco industry.
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David C. Wyld () is the Robert Maurin Professor of Management at Southeastern Louisiana University in Hammond, Louisiana. He is a management consultant, researcher/writer, and executive educator.
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