With the growth of the Internet, websites offering cigarettes for sale online have spread enormously. A General Accounting Office (GAO) report specifically identified the some 147 such sites in 2002 and said that there might be 400 or more such sites in existence (GAO, 2002). With names like www.taxfreecigarettes.com, www.notaxsmokes.com and www.0taxcigs.com, it is clear that vendors are aware of the opportunities the Internet provides for tax evasion. Virtually all of the online merchants are physically located either on American Indian reservations (and thereby need not remit state excise taxes) or in states like North Carolina, Kentucky, or Virginia, where the state cigarette excise tax is very low.
While these sites make it easy for consumers to circumvent state excise taxes (which are usually remitted by the wholesaler and reflected in the retail price), they do not eliminate the legal obligation to do so. By state law, an individual is supposed to pay the excise tax on any cigarettes they consume in their state of residence, even if the cigarettes were purchased elsewhere or received by mail. They are supposed to do this by filling out a Cigarette Use Tax form. In reality, of course, almost no one does that.
Given the variation in tax rates on cigarettes around the country and the difficulties with enforcing use taxes, it isn't surprising that cross-border shipments would proliferate or that there would be laws designed to contain it. The Jenkins Act, a federal law, requires anyone that sells cigarettes for a profit to a customer across state lines (other than to a licensed distributor) to report the brand and quantity of the sale as well as the name and address of the customer to the buyer’s state's tobacco tax authority. If online merchants did that, of course, it would be much easier for states to enforce taxes on Internet sales.
Violating the Jenkins Act, however, is only a misdemeanor and the penalty cannot exceed a $1000 fine (or 6 months in prison). Further, enforcement of the act is left to the Department of Justice and the FBI, who have not actively pursued such cases. The GAO reported that, of the websites they examined, almost 80 percent either claimed (falsely) that the Jenkins Act did not apply to them, or that they refused to comply and would keep all customer information secret (illegally). Another law, the Contraband Cigarette Trafficking Act of 1978, makes it a federal crime to transport more than 60,000 cigarettes (i.e., 300 cartons) across state lines without proof that state taxes have been paid but, apparently for this reason, most of the online sites specifically limit purchases to less than 300 cartons. Again, enforcement is difficult and the key matter for the online merchants.
Because the states do not have enforcement authority regarding the federal Jenkins Act, there is little they can do, as described in the existing GAO reports (GAO, 2002; 2003). New York has tried banning the delivery of cigarettes ordered online and began enforcing that ban in 2003 by threatening fines for delivery companies and by threatening to close down merchants within the state, many of which are operated on the Seneca Indian lands in upstate New York (Business Review, 2003). California has tried to notify Internet merchants and California residents directly. From May, 1999 to September, 2001 they notified 167 Internet vendors and 23,500 residents, but collected only $1.4 million in taxes, penalties, and interest (GAO, 2002). The federal government is also concerned about the issue. Recent legislation proposed in Congress would strengthen reporting requirements, raise violations of the Jenkins Act to a felony and reduce the number of cigarettes required to qualify as contraband to 10,000 (Glasner, 2003).
There is little information, however, on the most basic of issues such as the volume of online sales of cigarettes. Forrester Research (2001) has estimated that online sales of cigarettes will exceed $5 billion by 2005, equal to about 14 percent of total sales, causing $1.4 billion in lost state cigarette excise tax revenue. We have two other pieces of evidence on the question. The first comes from survey data on individuals. Surveys in 2002 found 2.2 percent of smokers had bought online in Oregon and 6.7 percent in New Jersey. The second is indirect and comes from the frequency with which people use search engines to look for sites related to online cigarette sales. Search engines like Google and Yahoo sell advertisements whose prices depend on the number of consumers that search on a given term. Using Overture's Keyword Selector Tool, we computed the number of searches conducted in March, 2004 for terms associated with buying cigarettes online. The results indicated that at Overture, there were about 350,000 searches for the month (4.2 million at an annual rate) using the basic search definitions and 734,000 searchers using a broader definition of the search terms (8.8 million annually). Scaling these numbers up by Overture's estimated market share implies that there are between 13 to 28 million searches per year for terms related to buying cigarettes online. We do not know how many of these searches turned into purchases nor how many searches a typical customer might do in a year, but these numbers are large and might even understate the true magnitude if only because people that purchase online from a merchant may return directly to that merchant in the future rather than going back through the search engine. To be sure, such estimates are only suggestive. Virtually all expert observers agree, however, that online cigarette sales have been growing very rapidly in the last several years.
It is easy to understand why demand would be high for online cigarettes if most or all of the tax savings associated with online sales are passed on to consumers, rather than being captured by online merchants through higher pre-tax prices. To check this, in the fall of 2003 we gathered data on in-store retail prices from several merchants in Ann Arbor, Michigan and compared them to the prices available at the top five domestic cigarette sites listed at Google for the search phrase "tax free cigarettes." We did this for the top ten cigarette brands, as identified by Advertising Age (2002). Weighting the ten brands by their national sales volume, we found that prices online were $27.33 a carton and pre-tax prices in the stores were $25.83. At that time Michigan taxes (including sales tax) amounted to $14.80 per carton, so the average online site was apparently passing about 90 percent of the tax savings through to the consumer. This is likely to be a lower bound on the cost savings, because with even a minor amount of search online one can find lower prices for any particular brand (using the minimum price among the online sites yielded prices actually lower than the pre-tax prices in the retail stores, i.e., prices were lower by more than 100% of the tax rate), and because a significant fraction of locally-purchased cigarettes are actually bought one pack at a time, at a higher per-pack price than would apply if buying by the carton. So it seems clear that online sites are, indeed, a way that non-taxpaying customers might save money when buying cigarettes and may very well increase the price sensitivity of taxed sales.
While these sites make it easy for consumers to circumvent state excise taxes (which are usually remitted by the wholesaler and reflected in the retail price), they do not eliminate the legal obligation to do so. By state law, an individual is supposed to pay the excise tax on any cigarettes they consume in their state of residence, even if the cigarettes were purchased elsewhere or received by mail. They are supposed to do this by filling out a Cigarette Use Tax form. In reality, of course, almost no one does that.
Given the variation in tax rates on cigarettes around the country and the difficulties with enforcing use taxes, it isn't surprising that cross-border shipments would proliferate or that there would be laws designed to contain it. The Jenkins Act, a federal law, requires anyone that sells cigarettes for a profit to a customer across state lines (other than to a licensed distributor) to report the brand and quantity of the sale as well as the name and address of the customer to the buyer’s state's tobacco tax authority. If online merchants did that, of course, it would be much easier for states to enforce taxes on Internet sales.
Violating the Jenkins Act, however, is only a misdemeanor and the penalty cannot exceed a $1000 fine (or 6 months in prison). Further, enforcement of the act is left to the Department of Justice and the FBI, who have not actively pursued such cases. The GAO reported that, of the websites they examined, almost 80 percent either claimed (falsely) that the Jenkins Act did not apply to them, or that they refused to comply and would keep all customer information secret (illegally). Another law, the Contraband Cigarette Trafficking Act of 1978, makes it a federal crime to transport more than 60,000 cigarettes (i.e., 300 cartons) across state lines without proof that state taxes have been paid but, apparently for this reason, most of the online sites specifically limit purchases to less than 300 cartons. Again, enforcement is difficult and the key matter for the online merchants.
Because the states do not have enforcement authority regarding the federal Jenkins Act, there is little they can do, as described in the existing GAO reports (GAO, 2002; 2003). New York has tried banning the delivery of cigarettes ordered online and began enforcing that ban in 2003 by threatening fines for delivery companies and by threatening to close down merchants within the state, many of which are operated on the Seneca Indian lands in upstate New York (Business Review, 2003). California has tried to notify Internet merchants and California residents directly. From May, 1999 to September, 2001 they notified 167 Internet vendors and 23,500 residents, but collected only $1.4 million in taxes, penalties, and interest (GAO, 2002). The federal government is also concerned about the issue. Recent legislation proposed in Congress would strengthen reporting requirements, raise violations of the Jenkins Act to a felony and reduce the number of cigarettes required to qualify as contraband to 10,000 (Glasner, 2003).
There is little information, however, on the most basic of issues such as the volume of online sales of cigarettes. Forrester Research (2001) has estimated that online sales of cigarettes will exceed $5 billion by 2005, equal to about 14 percent of total sales, causing $1.4 billion in lost state cigarette excise tax revenue. We have two other pieces of evidence on the question. The first comes from survey data on individuals. Surveys in 2002 found 2.2 percent of smokers had bought online in Oregon and 6.7 percent in New Jersey. The second is indirect and comes from the frequency with which people use search engines to look for sites related to online cigarette sales. Search engines like Google and Yahoo sell advertisements whose prices depend on the number of consumers that search on a given term. Using Overture's Keyword Selector Tool, we computed the number of searches conducted in March, 2004 for terms associated with buying cigarettes online. The results indicated that at Overture, there were about 350,000 searches for the month (4.2 million at an annual rate) using the basic search definitions and 734,000 searchers using a broader definition of the search terms (8.8 million annually). Scaling these numbers up by Overture's estimated market share implies that there are between 13 to 28 million searches per year for terms related to buying cigarettes online. We do not know how many of these searches turned into purchases nor how many searches a typical customer might do in a year, but these numbers are large and might even understate the true magnitude if only because people that purchase online from a merchant may return directly to that merchant in the future rather than going back through the search engine. To be sure, such estimates are only suggestive. Virtually all expert observers agree, however, that online cigarette sales have been growing very rapidly in the last several years.
It is easy to understand why demand would be high for online cigarettes if most or all of the tax savings associated with online sales are passed on to consumers, rather than being captured by online merchants through higher pre-tax prices. To check this, in the fall of 2003 we gathered data on in-store retail prices from several merchants in Ann Arbor, Michigan and compared them to the prices available at the top five domestic cigarette sites listed at Google for the search phrase "tax free cigarettes." We did this for the top ten cigarette brands, as identified by Advertising Age (2002). Weighting the ten brands by their national sales volume, we found that prices online were $27.33 a carton and pre-tax prices in the stores were $25.83. At that time Michigan taxes (including sales tax) amounted to $14.80 per carton, so the average online site was apparently passing about 90 percent of the tax savings through to the consumer. This is likely to be a lower bound on the cost savings, because with even a minor amount of search online one can find lower prices for any particular brand (using the minimum price among the online sites yielded prices actually lower than the pre-tax prices in the retail stores, i.e., prices were lower by more than 100% of the tax rate), and because a significant fraction of locally-purchased cigarettes are actually bought one pack at a time, at a higher per-pack price than would apply if buying by the carton. So it seems clear that online sites are, indeed, a way that non-taxpaying customers might save money when buying cigarettes and may very well increase the price sensitivity of taxed sales.
