[Senate Hearing 113-648]
[From the U.S. Government Publishing Office]
S. Hrg. 113-648
TOBACCO: TAXES OWED, AVOIDED, AND EVADED
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HEARING
before the
COMMITTEE ON FINANCE
UNITED STATES SENATE
ONE HUNDRED THIRTEENTH CONGRESS
SECOND SESSION
__________
JULY 29, 2014
__________
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Printed for the use of the Committee on Finance
______
U.S. GOVERNMENT PUBLISHING OFFICE
94-638-PDF WASHINGTON : 2015
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COMMITTEE ON FINANCE
RON WYDEN, Oregon, Chairman
JOHN D. ROCKEFELLER IV, West ORRIN G. HATCH, Utah
Virginia CHUCK GRASSLEY, Iowa
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
DEBBIE STABENOW, Michigan PAT ROBERTS, Kansas
MARIA CANTWELL, Washington MICHAEL B. ENZI, Wyoming
BILL NELSON, Florida JOHN CORNYN, Texas
ROBERT MENENDEZ, New Jersey JOHN THUNE, South Dakota
THOMAS R. CARPER, Delaware RICHARD BURR, North Carolina
BENJAMIN L. CARDIN, Maryland JOHNNY ISAKSON, Georgia
SHERROD BROWN, Ohio ROB PORTMAN, Ohio
MICHAEL F. BENNET, Colorado PATRICK J. TOOMEY, Pennsylvania
ROBERT P. CASEY, Jr., Pennsylvania
MARK R. WARNER, Virginia
Joshua Sheinkman, Staff Director
Chris Campbell, Republican Staff Director
(ii)
C O N T E N T S
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OPENING STATEMENTS
Page
Wyden, Hon. Ron, a U.S. Senator from Oregon, chairman, Committee
on Finance..................................................... 1
Hatch, Hon. Orrin G., a U.S. Senator from Utah................... 2
WITNESSES
Manfreda, John J., Administrator, Alcohol and Tobacco Tax and
Trade Bureau, Washington, DC................................... 4
Gootnick, Dr. David, Director, International Affairs and Trade,
Government Accountability Office, Washington, DC............... 6
Bernstein, Ronald J., president and CEO, Liggett Vector Brands
LLC, Morrisville, NC........................................... 15
Patel, Rocky, owner, Rocky Patel Premium Cigars Inc., and board
member, Cigar Rights of America, Naples, FL.................... 16
Tynan, Michael, policy officer, Oregon Public Health Division,
Portland, OR................................................... 18
Drenkard, Scott, economist and manager of State projects, Tax
Foundation, Washington, DC..................................... 20
ALPHABETICAL LISTING AND APPENDIX MATERIAL
Bernstein, Ronald J.:
Testimony.................................................... 15
Prepared statement with attachments.......................... 29
Responses to questions from committee members................ 72
Drenkard, Scott:
Testimony.................................................... 20
Prepared statement........................................... 74
Responses to questions from committee members................ 84
Gootnick, Dr. David:
Testimony.................................................... 6
Prepared statement........................................... 85
Responses to questions from committee members................ 110
Hatch, Hon. Orrin G.:
Opening statement............................................ 2
Prepared statement........................................... 113
Manfreda, John J.:
Testimony.................................................... 4
Prepared statement........................................... 115
Responses to questions from committee members................ 129
Patel, Rocky:
Testimony.................................................... 16
Prepared statement........................................... 141
Responses to questions from committee members................ 148
Tynan, Michael:
Testimony.................................................... 18
Prepared statement with attachments.......................... 151
Responses to questions from committee members................ 171
Wyden, Hon. Ron:
Opening statement............................................ 1
Prepared statement with attachments.......................... 176
Communications
Center for Regulatory Effectiveness.............................. 183
National Association of Convenience Stores (NACS)................ 221
Small Business Cigar Coalition................................... 228
TOBACCO: TAXES OWED, AVOIDED,
AND EVADED
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TUESDAY, JULY 29, 2014
U.S. Senate,
Committee on Finance,
Washington, DC.
The hearing was convened, pursuant to notice, at 10:06
a.m., in room SD-215, Dirksen Senate Office Building, Hon. Ron
Wyden (chairman of the committee) presiding.
Present: Senators Cardin, Warner, Hatch, Grassley, Crapo,
and Thune.
Also present: Democratic Staff: Jocelyn Moore, Deputy Staff
Director; David Berick, Chief Investigator; Chris Arneson, Tax
Policy Advisor; and Anne Dwyer, Professional Staff Member.
Republican Staff: Chris Campbell, Staff Director; Kimberly
Brandt, Chief Healthcare Investigative Counsel; and Nicholas
Wyatt, Tax and Nominations Professional Staff Member.
OPENING STATEMENT OF HON. RON WYDEN, A U.S. SENATOR FROM
OREGON, CHAIRMAN, COMMITTEE ON FINANCE
The Chairman. The Finance Committee will come to order.
Today the Finance Committee will examine a classic case of
tax evasion; specifically, how dozens of companies making
tobacco products are able to dodge taxes owed under current law
by changing only a few words on the packaging labels. This
evasion fleeces American taxpayers out of billions of dollars,
and it means children and teens are more easily hooked on
tobacco.
The tax evasion tale goes like this. In 2009, the Congress
renewed the Children's Health Insurance Program, which
currently provides insurance coverage to more than 8 million
children each year. To pay for that coverage, the Congress
raised excise taxes on certain types of tobacco products,
including cigarettes and loose roll-your-own tobacco. The tax
rate on tobacco for pipes and some large cigars, however,
remained lower.
So, immediately after the law was enacted, companies pried
open a big loophole. They started changing the labels on their
packaging. Products that would have been labeled ``roll-your-
own tobacco'' one day were labeled ``pipe tobacco'' the next,
and the tax bill on them plummeted. Companies also stuffed
small cigars with a few extra grams of tobacco. That way they
could be considered large cigars and be taxed at a lower rate.
Now, the numbers show just how big this loophole has
become. Sales of pipe tobacco have skyrocketed more than 10-
fold in just 5 years. It just seems implausible that so many
more Americans would suddenly start smoking pipes.
Today the Finance Committee is going to inquire as to why
it is so easy to skirt the law. Clearly there has been a lapse
in good government. After 5 years, the Treasury Department's
Alcohol and Tobacco Tax and Trade Bureau, or TTB, still has not
drawn a meaningful distinction between tobacco products.
Instead, they have ignored everything except for the words on
the package: ``roll-your-own'' or ``pipe.'' All it takes to
exploit this loophole is some ink on the label, and the
committee is going to see that demonstrated today. No muss, no
fuss, no teams of tax lawyers poring over legal documents.
Unfortunately, the financial burden this loophole inflicts
on American taxpayers is enormous. The committee is going to
hear today that the tobacco loophole has cost taxpayers more
than $2 billion over the last 5 years--more than $2 billion.
Furthermore, the loophole seriously undermines the effort to
discourage smoking among America's children and our teens.
According to the Surgeon General, evidence shows that raising
the cost of cigarettes is a factor in stopping kids from
smoking, but when tobacco is cheap because of a blatant
loophole, young people are more likely to buy it.
TTB has had ample time to solve this problem, but it has
not followed through. So today the Finance Committee is going
to inquire why that is the case. Is it a lack of resources
needed to mount an adequate enforcement effort? TTB has four
criminal agents at this point to enforce the law for the entire
country. Could it be that one hand does not know what the other
hand is up to? When the Food and Drug Administration was
dragged into the situation, it made matters worse by actively
allowing companies to continue using the loophole. The Food and
Drug Administration even sent letters to companies giving them
the green light.
My bottom line, as we begin this inquiry, is that this
loophole hurts taxpayers, it hurts kids, and it needs to be
closed. As has been our practice, we are going to work on this
important issue, we are going to work on it in a bipartisan
way, and I am very pleased to yield to Senator Hatch for his
comments.*
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* For more information, see also, ``Present Law and Background
Relating to Tobacco Excise Taxes,''Joint Committee on Taxation staff
report, July 25, 2014 (JCX-93-14), https://www.jct.gov/
publications.html?func=startdown&id=4659.
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[The prepared statement of Chairman Wyden appears in the
appendix.]
OPENING STATEMENT OF HON. ORRIN G. HATCH,
A U.S. SENATOR FROM UTAH
Senator Hatch. Well, thank you, Mr. Chairman. According to
written testimony we received today, the Alcohol and Tobacco
Tax and Trade Bureau collected approximately $23 billion in
taxes in fiscal year 2013, making it the third-largest tax
collection agency in the U.S. Government. This amount is even
more significant when you consider the number of tobacco-
related transactions undertaken and that millions of Americans
are represented somewhere in that $23 billion. Of that amount,
around $14 billion came from collecting taxes on tobacco
products. It seems that there is some truth to the quip
attributed to former House Majority Leader Thomas Foley that
``if you don't drink, smoke, or drive a car, you're a tax
evader.'' [Laughter.]
Now, because of the large sums of money involved in this
issue and because of the number of people and businesses
affected, it is important that Federal excise taxes are
administered accurately and fairly. In fact, Senator Kennedy
and I made the tobacco tax the basis for the Children's Health
Insurance Program and the State Children's Health Insurance
Program, otherwise known as SCHIP.
But, as with the income tax and our tax system as a whole,
compliance needs to be based on a belief that clear rules are
constantly enforced in a way that does not put taxpayers at a
disadvantage to those who do not follow the rules. We also need
to keep in mind--and this is true for all tax policy--that tax
avoidance and tax evasion are very different behaviors. The tax
code should consist of clear rules, and people will either
follow them or they will not. To the taxpayer, the tax code is
not a bill for a government program or a claim on whatever
someone might consider to be the patriotic amount, it is a set
of rules for arriving at a specific and definite number.
During today's hearing, we will specifically discuss two
market shifts in tobacco products that seem prevalent since the
passage of the Children's Health Insurance Program
Reauthorization Act, or CHIPRA, in 2009, which increased
tobacco taxes. One of these is an apparent shift from roll-
your-own tobacco to pipe tobacco, as the chairman has
suggested, which is taxed at a lower rate. As one of our
witnesses noted in his written testimony, one tobacco
manufacturer has ``acknowledged that there was no real
difference between its roll-your-own tobacco and its pipe-cut
tobacco.'' Given the fact that roll-your-own tobacco is taxed
at around 10 times the rate of pipe tobacco, this market shift
deserves our attention. Another market trend that I expect to
be highlighted in this hearing concerns an apparent shift from
what the Internal Revenue Code defines as ``small cigars'' to
``large cigars,'' which results in tax savings if the
manufacturer's price is below a certain amount.
In addition to these recent market shifts, we need to be
mindful of more longstanding issues that clearly deal with tax
evasion. For example, smuggling of counterfeit or diverted
products where Federal taxes have not been paid is a serious
problem, possibly costing the U.S. billions of dollars in tax
revenue every year.
Finally, since we are discussing tobacco, the health
component of this issue is also important. Evasion,
counterfeiting, and black markets, in addition to denying
Federal, State, and local governments revenue, also side-step
health-related requirements along with restrictions intended to
reduce the appeal of tobacco to minors.
I hope this hearing sheds light on how we can improve tax
administration by ensuring that our tax laws are being enforced
appropriately. I also hope that it will help us understand if
the laws themselves have not been written in a way to
accomplish what was intended. And, though we are talking about
a specific set of Federal excise taxes on a product that is
controversial, that should not distract us from the
fundamentals of good tax policy. One of the things I have
always worried about in taxing tobacco is that we have to be
careful how we do that, because you are going to have an
underground economy doing things that we will not be able to
control. So I am very concerned about how we approach this.
I appreciate the chairman's interest in trying to do what
is right here, and we will see what we can do. I have to tell
you, Mr. Chairman, I can only stay for a few minutes and then I
have to leave, but I appreciate your leadership.
The Chairman. Well, Senator Hatch, first of all, I want
everyone to understand that one of the reasons it is so
important to get this right is that you have led this fight
with respect to children and the Children's Health Insurance
Program for years. You and Senator Kennedy--and I think we know
our colleague Senator Rockefeller--have been partners in this
effort. I so appreciate the advocacy on behalf of children that
you have engaged in for many, many years. I think it drives
home why both of us are committed to getting this right, and I
look forward to working with you.
[The prepared statement of Senator Hatch appears in the
appendix.]
The Chairman. Our hearing today is going to consist of two
panels. The first panel will include two government witnesses
from the Alcohol and Tobacco Tax and Trade Bureau, known as
TTB, and the Government Accountability Office. Our second panel
includes industry members and experts on the cost of tobacco
tax evasion. We are going to, therefore, have six witnesses, so
we would like our guests to limit their testimony to 5 minutes.
Our first witness will be Mr. John Manfreda, the
Administrator of the Alcohol and Tobacco Tax and Trade Bureau
that is part of the Department of the Treasury. Our second
witness will be Dr. David Gootnick, Director of International
Affairs and Trade at the Government Accountability Office. We
thank both of you for your cooperation and for coming. Your
prepared statements are going to be made a part of the record.
We will start with you, Mr. Manfreda.
STATEMENT OF JOHN J. MANFREDA, ADMINISTRATOR, ALCOHOL AND
TOBACCO TAX AND TRADE BUREAU, WASHINGTON, DC
Mr. Manfreda. Mr. Chairman, Ranking Member Hatch, and
distinguished members of the committee, thank you for the
opportunity to testify about TTB's tobacco enforcement
activities. We greatly appreciate your interest in our bureau.
The Internal Revenue Code imposes Federal excise taxes on
tobacco products and establishes a comprehensive framework to
protect the revenue. Under this authority, we collected over
$14 billion in tobacco excise taxes in fiscal year 2013. Our
tax authority also extends to alcohol products, firearms, and
ammunition, under which we have collected an additional $9
billion last year.
Our tax enforcement strategy involves the development and
application of multiple tools and skills to ensure compliance
with the Internal Revenue Code and to detect and address tax
evasion. Our specialists evaluate permit applications to ensure
that only qualified persons operate in the tobacco industry,
and we investigate high-risk applicants prior to approval.
Through the use of risk models and other intelligence, our
analysts identify diversion schemes and refer cases for further
field work. Our auditors and investigators then apply advanced
investigative techniques to pursue these leads, deploying teams
with diverse skill sets for large, complex investigations. As
these cases develop, if there are indications of criminal
activity, they are referred to our special agents for
investigation and potential referral for prosecution. We also
operate a tobacco laboratory which ensures the appropriate tax
classification of products and provides analytical support for
audits, investigations, and rulemaking.
The Children's Health Insurance Program Reauthorization Act
increased the tax rate for all tobacco products and equalized
the tax rate for cigarettes, roll-your-own, and small cigars.
The tax rate for pipe tobacco was also increased, but to a
significantly lower rate. These tax changes resulted in
increased tobacco tax collections, although the amount of the
increase has decreased steadily since fiscal year 2010, the
first full year following CHIPRA. Overall, however, tobacco tax
collections remain higher than they were pre-CHIPRA. The tax
rate differentials resulting from CHIPRA created new incentives
for manufacturers, importers, and consumers of certain tobacco
products.
Since CHIPRA increased the tax on small cigars and small
cigarettes, we have not found evidence of widespread
misclassification of cigarettes as cigars under the Internal
Revenue Code. We have, however, seen a notable shift in the
cigar market. Although CHIPRA raised the tax on both small and
large cigars, it created an incentive to shift production to
the large cigar category because, depending on price, the tax
rate on a large cigar can be significantly lower than the tax
on small cigars. Large cigars are the only tobacco product for
which the excise tax is based on the manufacturer's or
importer's sale price.
Since CHIPRA, we have found that cigar manufacturers and
importers are structuring operations or sales to lower their
taxable sale price, resulting in a decrease in the average tax
collected per large cigar. We have also seen a significant
shift in removals of pipe and roll-your-own tobacco. Because
the two products can be similar, and because the tax on roll-
your-own tobacco was significantly increased as compared to
pipe tobacco, a portion of the roll-your-own tobacco market has
switched to pipe tobacco since CHIPRA. We believe that this
disparity, combined with the tax rate increase on cigarettes,
has resulted in an increase in the popularity of machines that
can make cigarettes from roll-your-own or pipe tobacco. These
issues will likely exist as long as incentives remain under the
Internal Revenue Code for manufacturers to reclassify products
or restructure transactions to achieve a lower tax by taking
advantage of rate differentials.
In addition, a 150-percent increase in the Federal excise
tax on cigarettes imposed by CHIPRA increased the incentive to
evade Federal taxes through tobacco diversion. We have seen
numerous diversion schemes and are addressing them through
multiple means, including criminal prosecution. Our Criminal
Enforcement Program is critical to our ability to effectively
curtail current illicit operations and deter others from
engaging in diversion activity.
I am proud of this bureau and what we have been able to
accomplish in the 11 years since we were established. Despite
our small size of about 465 employees, we have worked to
maximize the reach of our resources, collecting roughly $23
billion in fiscal year 2013, which represents a return of
approximately $450 for every dollar invested in TTB's revenue
collection activities.
I sincerely appreciate the opportunity to testify before
the committee today and would be happy to answer any questions
you have.
Thank you.
The Chairman. Thank you very much.
[The prepared statement of Mr. Manfreda appears in the
appendix.]
The Chairman. Dr. Gootnick?
STATEMENT OF DR. DAVID GOOTNICK, DIRECTOR, INTERNATIONAL
AFFAIRS AND TRADE, GOVERNMENT ACCOUNTABILITY OFFICE,
WASHINGTON, DC
Dr. Gootnick. Thank you, Mr. Chairman. Mr. Chairman and
members of the committee, thank you for asking GAO to
participate in this hearing.
As you know, Federal excise taxes on tobacco products have
long aimed to both raise revenue and discourage tobacco use. My
statement today will focus first on the market shifts among
smoking tobacco products that followed the 2009 changes to the
Internal Revenue Code, and second, on the impact of these
market shifts on tax revenues.
I will focus on the four tobacco products: roll-your-own
tobacco, pipe tobacco, small cigars, and large cigars.
Consumption of these four products has increased over the past
decade and now represents 12 percent of smoking tobacco sales
in the United States.
As Figure 2 from my written testimony shows, CHIPRA
eliminated certain tax disparities among these products and
created others, as we have been discussing. You can see here
the pre-CHIPRA rates and the post-CHIPRA rates, and you can see
that the rates on cigarettes, roll-your-own tobacco, and small
cigars were raised and made equivalent. However, you can also
see that the post-CHIPRA rate on pipe tobacco is now roughly
one-tenth of the rate of roll-your-own.
Unlike these products and not shown in the slide, the large
cigar tax, as has been mentioned, is calculated as a percentage
of the manufacturer or importer's sales price, up to a maximum.
This is the so-called ``ad valorem'' tax. The key point on
large cigars is that, after CHIPRA, inexpensive large cigars
are now taxed at a much lower rate than their counterpart small
cigars. So, as you would expect, the market shifted in response
to these changes. Manufacturers shifted their products to take
advantage of lower tax rates, and price-sensitive consumers
shifted their preferences.
As you can see in Figure 4, the sales of low-tax products
spiked after CHIPRA, and high-tax products plummeted.
Specifically in this figure, you see that sales of large cigars
more than doubled, while sales of small cigars declined by
nearly 90 percent. So the immediate spike in large cigars is
shown here on the heavy line, and the crash of the small cigar
market on the thin line. Likewise in Figure 3, you see sales of
pipe tobacco increasing over 7-fold, 744 percent, and sales of
roll-your-own tobacco declining by over 80 percent.
The key here is that manufacturers can shift their products
because the tax code differentiates roll-your-own and pipe
tobacco in large measure by their appearance, packaging, and
labeling, which allow firms to re-label their products with
minimal, if any, changes. Likewise, the tax code distinguishes
small and large cigars only by their weight, and at a
breakpoint of 3 pounds per thousand, a small cigar can undergo
minimal changes, as you have mentioned, to qualify as a large
cigar.
Regarding the revenue consequences of these shifts, we
modeled what tax revenues would have been if market shifts
resulting from the substitution had not occurred. Our analysis
used the long-term trends in consumption prior to CHIPRA and
the expected fall in demand due to higher tax rates. Thus, we
believe our estimates made conservative assumptions on the
magnitude of tax avoidance.
In the bottom line, we estimate the tax avoidance due to
the observed market shift to be in the range of $2.6 to $3.7
billion since the enactment of CHIPRA. Over the same interval,
actual post-CHIPRA revenue on these four products is roughly
$5.3 billion, so you can see that the tax avoidance, in both
magnitude and as a percentage, is significant.
As you have heard, TTB has limited options in response.
They have sought to curtail the growing availability of
unpermitted roll-your-own tobacco machines in commercial use
that emerged after CHIPRA; however, the core incentives towards
pipe tobacco remain. In addition, the Bureau has analyzed
proposals to differentiate roll-your-own and pipe tobacco based
on the physical attributes, but there is no real consensus on
what, if any, characteristics truly distinguish these two
products.
Finally, there are additional challenges with the ad
valorem tax on large cigars, which creates opportunities for
tax avoidance or evasion through intermediary transactions.
These transactions truly blur the line between tax avoidance
and tax evasion.
In conclusion, we maintain that Congress should consider
equalizing the tax rates on roll-your-own and pipe tobacco and,
with TTB, consider options for reducing tax avoidance due to
the gap between small and large cigars. Proposals in this
regard have included establishing a floor on the ad valorem tax
or increasing the weight threshold for large cigars.
Mr. Chairman, this completes my remarks. I am happy to
answer your questions.
The Chairman. Doctor, thank you very much.
[The prepared statement of Dr. Gootnick appears in the
appendix.]
The Chairman. Obviously, when you are talking about $2.6
billion to $3.7 billion being evaded in taxes, if anything, the
committee has understated this challenge. You are talking about
sums of money that are very substantial. Of course, the whole
point of this exercise, which Senator Hatch and Senator Kennedy
and Senator Rockefeller started, is to try to make sure that we
are taking steps to protect children.
Now, Mr. Manfreda, at this point we have 39 States asking
you to issue new rules to more clearly distinguish between
cigarettes and cigars. So that is the majority--well over the
majority--of our States that are asking for clarification on
this central point, which of course goes right to the tax
evasion that Dr. Gootnick is talking about.
Now, almost 8 years ago you all issued a Notice of Proposed
Rulemaking, but nothing happened. So let us start by having you
tell us why that is the case, that after 8 years and 39 States
asking for clarity on something that is right at the heart of
this tax evasion question, why it has not been done.
Mr. Manfreda. That is a fair question. Back in 2006, we did
do a Notice of Proposed Rulemaking regarding differentiating a
cigarette from a cigar. However, with CHIPRA equalizing the tax
rates between a small cigarette and a small cigar, the priority
for the revenue issue associated with that was pretty much
neutralized. What I mean is, they are now taxed the same way.
Given the fact that we are a very small agency, we have
very small resources, CHIPRA created other rather large
problems for us to address in regard to classification issues,
specifically roll-your-own tobacco versus pipe tobacco.
So we have been looking at and we have been going forward
with the research and the differentiation; however, it has not
had that big a priority from a tax collecting point of view as
roll-your-own tobacco or pipe tobacco does have. So we are in
the process. We have it on track as a rulemaking effort. Down
the road we will be coming out with rulemaking on that.
The Chairman. So when will that be? Because, as of right
now, the small cigars are getting through the loophole. So
when?
Mr. Manfreda. Well, small cigars are getting called a
loophole. What they are exercising their right to do is
increase the tobacco with regard to the weight of the small
cigar to make it a large cigar. That is a statutory line we
cannot change, sir. By that, when they are adding maybe 2 or 3
ounces of more tobacco to make it a large cigar, that is how
they are crossing the line.
The Chairman. The problem, however, is that cigarettes are
now in effect cigars, and that is the problem. I just keep
looking at all these proposals that you make, and the tax
evaders always seem to get around them. Then you say there is
some other reason that you cannot act.
So let us go then to the question of pipe tobacco after the
Children's Health Insurance Program Reauthorization. A number
of participants in the roll-your-own tobacco cigarette market
quickly shifted to labeling their products as lower-taxed pipe
tobacco. Then they got a wink and a nod from the retailers, to
direct consumers to the right bag, and the companies were able
to dodge $22-per-pound in tax by slapping pipe tobacco labels
on bags full of cigarette tobacco.
Now again, in 2010, you issued an Advanced Notice of
Proposed Rulemaking to deal with a problem that GAO has
spotlighted and I have spotlighted. But again, somehow the
regulation just was not issued. In fact, I gather there was not
even a formal proposed regulation, and GAO points out that
billions of dollars are being lost as a result of this
loophole. So what is the reason for the delay here?
Mr. Manfreda. Again, a fair question, sir. If you will
remember, we put out an Advanced Notice of Proposed Rulemaking
back in 2010. We extended that comment period in 2011, airing
industry proposals for differentiation.
In our airing, we looked at characteristics that could
differentiate these products, from cut size, moisture content,
residual sugar, the amount of black tobacco in a product, or
the amount of weight associated with flavors or other non-
tobacco products.
The Chairman. The bottom line is--because I want to ask one
other question--we do not have a regulation that will ensure
that we are not seeing tax law evaded. When is that regulation
going to come out? Can you give us a firm commitment now?
Mr. Manfreda. We are going to air a rulemaking in January.
The Chairman. Of 2015?
Mr. Manfreda. Of 2015.
Sir, the issue here, and what has made this so very
difficult is, if you go back and you look at our comments from
our 2011 rulemaking, we got an additional 170 comments, 32 of
which came from industry members. Those comments were so
diverse, and, when you dug into them, you actually got into the
point of, they were reflective of their own individual products
that were on the market. So what we are left with is, we are
trying to come up with an objective, measurable, not easily
manipulated standard that draws the line at the right place.
The Chairman. But of course an agency gets comments. To not
have issued even a proposed rule is, I just think--we have had
a classic case of tax evasion, and it seems like we are looking
at a classic case of foot-dragging, and we have to do better.
I want to ask you one other question, and my time is up.
That is, there of course is tremendous interest in the question
of e-
cigarettes. After decades of work, there has been an effort to
cut down on kids smoking, and fewer Americans pick up a
cigarette every day, but there has been an explosion in the use
of e-
cigarettes, especially among young people.
I am concerned about whether history is going to repeat
itself, because it was not very long ago when I was in the
House and I went down a row with tobacco executives and asked
whether nicotine was addictive and they all said no, and I am
very concerned about whether we are going to go down the same
route with people saying, let us study this and then we will
finally decide whether these nicotine delivery devices ought to
be taxed and regulated. So it would be very helpful to have on
the record whether or not TTB now has the authority to tax e-
cigarettes.
Mr. Manfreda. Sir, we do not, under the Internal Revenue
Code, have the authority to tax an e-cigarette that does not
contain tobacco. We have to have tobacco in the product to meet
an Internal Revenue Code definition of a tobacco product, so
currently we do not.
The Chairman. All right.
Let us go, next, to Senator Warner.
Senator Warner. Thank you, Mr. Chairman. Thank you for
holding this hearing. Let me also say I concur with you that it
appears, on these tax avoidance issues, the failure to have at
least a regulatory framework is losing the government revenue.
It is not fair; it is not right.
I was curious to hear comments about at least some level of
a floor, since it seems like your ability to manipulate a
little bit of tobacco in or out of a product puts you above or
below a threshold that could have a huge change in your
taxation. Obviously, I think the charts were pretty powerful
about how the market has diverged so much.
In Virginia we have a tradition of tobacco products. Most
of our companies are extraordinarily responsible in how they
deal with this. I do not think there should be such a wide
variety of tax consequences between products that may have
equal or similar health concerns.
What I want to ask the witnesses is, let's move a little
away from this question of straight avoidance, or manipulation
in a sense, to issues around just plain illicit activities. Mr.
Manfreda, I want to start with you, and then I will go to Dr.
Gootnick. My understanding is that, at this point, there is
little to no transparency regarding what entities actually hold
TTB permits, so investigative efforts are in many ways hindered
from their inception.
Without adequate enforcement--and I believe either in my
notes or in your testimony I read that you have only about four
enforcement agents--manufacturers without permits, that do not
have any authorization at all, are free to operate without fear
of enforcement of any laws. Often without that enforcement,
they avoid any payments at all of Federal or State excise tax.
I have heard actually some extraordinary and astounding
numbers. In some places, as much as half the cigarettes
consumed may be either totally non-taxed or under-taxed,
particularly in certain jurisdictions with very high-tax
components around cigarettes.
So, Mr. Manfreda, I understand that you are a small agency.
I want to associate myself with the chairman's remarks that I
do think we need to start this regulatory process sooner rather
than later. But when we are talking about just plain illicit
activities, how concerned are you about this? Can you talk
about efforts that your office is undertaking with State
enforcement agencies to deal with this illicit trade of
tobacco?
Mr. Manfreda. Yes, sir. Our criminal enforcement function
over the last 4 years has actually developed 72 cases, 70 of
which are presently accepted by U.S. Attorneys' Offices to
pursue as criminal cases. Out of that, we have identified over
$345 million in potential tax liability, and we have physically
seized over $121 million worth of merchandise as well. But
diversion is a real problem, especially with a commodity like
we are regulating. When the intrinsic value of the commodity is
dwarfed by its tax liability, it is a recipe for illegal
conduct.
Senator Warner. But is it safe to say that some of the
numbers that I have referenced, that in some States as much as
half of the tobacco products sold may be fully illicit and not
have even appropriate TTB permits, is that too high a number,
or is that in the range?
Mr. Manfreda. Sir, I do not have statistics on that. I am
unable----
Senator Warner. But you are the enforcement entity.
Mr. Manfreda. Yes, but diversion----
Senator Warner. It seems fairly stunning to me that you do
not have statistics, plus or minus 10 percent, or up to 50
percent of the tobacco products in a State like New York with a
high tobacco tax, are illicit.
Mr. Manfreda. Well, again, are we talking about Federal
excise tax or are we talking about State taxes that are covered
under the jurisdiction of ATF?
Senator Warner. Pick your poison.
Mr. Manfreda. We do not have jurisdiction over contraband
cigarette taxing. That is when you----
Senator Warner. But because there is a failure to have any
kind of transparency about which of these manufacturers that
are not following the rules at all in terms of TTB permits----
Mr. Manfreda. Well, we coordinate our efforts with State
authorities. We have ongoing dialogue with most States. We have
tax agreements to give us the ability to share tax information
with State authorities.
Senator Warner. Mr. Chairman, may I take one more moment to
ask one other question?
The Chairman. Of course.
Senator Warner. It just seems to me we should have concerns
about this agency, both in terms of the regulatory approach as
well as the fact that we do not seem to have a lot of good data
in terms of actual illicit activities that are also potentially
losing us revenue. That is where, Dr. Gootnick, I wanted to ask
you, can you talk in any detail about how the illicit trade is
affecting tax collection and how changes in CHIPRA may have
affected that positively or negatively?
Dr. Gootnick. Right. Start with the observation that, for a
pack of cigarettes, for example, more than 50 percent of the
retail sales price of a pack of cigarettes is taxes and fees.
That is the Federal excise tax the TTB is responsible for, plus
State excise taxes, local taxes in many cases, the master
settlement agreement, the tobacco buy-out. That set of taxes
and fees is over 50 percent of the price of a pack of
cigarettes. So, when you get a product where the profit margin
for illicit activity is high and the penalty is relatively low,
there is going to be a range of activities.
Those activities range from true smuggling across
international boundaries to diversion of product that is deemed
for export but is reintroduced into the domestic market absent
the Federal excise tax, to what I think you are talking about,
which is movement of cigarettes from, say, Virginia, a low-tax
State, to New York, a high-tax State. In addition, there are
Internet sales that do not pay required taxes.
There have been estimates that the magnitude of diversion
on State excise taxes is in the range of $5 billion annually. I
do not know how reliable those numbers are. It is inherently
difficult to quantify what is covert and what is an underground
activity.
Senator Warner. Mr. Chairman, I guess my final point--and I
appreciate you giving me a little bit of extra time here--is
that it seems like there may be two buckets here. One bucket,
which I think you focused appropriately on, is, do we have a
floor? How do we make sure that there is not an ability to game
the system somehow within the, at least quasi-legal, context of
roll-your-own or moving from small cigar to large cigar, these
kind of manipulations which affect us in terms of a lot of
revenue?
There is also this other bucket of activities which we have
heard referenced of up to 50 percent full tax evasion or fully
illicit manipulation, or failure to even have any kind of
registration. Those just seem to be out-and-out wrong actions.
I believe we need to take action in both areas.
Again, I appreciate the chairman giving me this extra time
and having this very important hearing.
The Chairman. The Senator from Virginia is being too
logical. Heaven forbid that logic should break out on this, but
I very much appreciate your separating those two considerations
out. I look forward to working with you to pursue that.
Let us move on again to kind of stay with this question of
what is behind the inaction. Dr. Gootnick, you have reviewed
the roll-your-own tobacco issue, the shift to large cigars. You
have said that the problem is getting worse, this effort to
circumvent the higher taxes, and it has gotten worse since you
last looked at it.
Now, given all that, the committee, back in 2012, included
a provision in the Highway Bill that required roll-your-own
machines offered for use at retail locations--we would be
talking about convenience stores, tobacco shops--to be
registered as commercial cigarette manufacturers. It was the
point of the committee back then that this provision would stop
the use of these machines for tobacco tax evasion and reduce
the use of mislabeled roll-your-own tobacco.
My sense is that that has not happened, and that is pretty
much what you have said. But what is your sense of why the
transportation bill provision has not worked? I mean, why has
that not been an effective tool to close the loophole and block
the bleeding of these enormous sums of money?
Dr. Gootnick. Right. I would say, in a nutshell, it is
because the incentive remains to switch from roll-your-own to
pipe tobacco. But you are very correct that the transportation
legislation in 2012 made clear that roll-your-own machines in
commercial use were to be considered manufacturers of tobacco
and should be taxed accordingly.
The use of commercial roll-your-own machines went
underground a little bit more than it had been. Insofar as
these roll-your-own machines still exist, they do not
necessarily as frequently exist right inside a retail tobacco
outlet, but they do exist right next door.
So we have observed--I had a team go, in this local area
within 20 to 30 miles from here, to retail outlets and observe
one retail outlet that formerly had a roll-your-own machine on
its premises. Now there was a wall between the roll-your-own
machine and the tobacco outlet where an individual could buy
the pipe tobacco and the tubes, go around the corner to the
roll-your-own machine. We actually observed an individual walk
in, join the club for $10, and then provide them with their
tobacco and walk out with a carton of cigarettes. Using roll-
your-own tobacco, they saved easily 10 bucks on a carton of
cigarettes. So the incentives remain, and the process still
goes on.
The Chairman. And, Mr. Manfreda, what is your response to
that? I mean, again, we have a substantial question of
enforcement, where it seems like the government is just behind
those who would try to skirt the laws and rules. What is your
response to exactly what Dr. Gootnick just said?
Mr. Manfreda. I would concur with him that the major
incentive here is the tax differentiation between the products.
I would tell you that, at present, we have over 72
investigations under way regarding cigarette-making machines.
All but six of those have raised issues of whether or not a
social club is exempt from the liability as a manufacturer.
We have not seen any representation where a social club
would fall within the exemption from being considered a
manufacturer of tobacco products. Some of the issues associated
with finding this--and I do agree with the doctor that these
have gone underground--when MAP-21 * was issued, we sent out
over 1,467 letters to locations where we knew these machines
were.
---------------------------------------------------------------------------
* The Moving Ahead for Progress in the 21st Century Act of 2012.
---------------------------------------------------------------------------
The problem is, we have no jurisdiction over these machines
or their operators, they are not required to keep records, and
they are not required to cooperate with us. They are really
easily moveable. So enforcement of this becomes a very
difficult problem.
I do know that, out of the 72 investigations we have under
way, the liability associated with any one location is about
$54,000. So it is time-consuming. They do not cooperate with
us. Even the manufacturers of the machines have an incentive
not to cooperate with us. So, it is a very difficult problem to
put to bed, because they are mobile and they hide.
The Chairman. Fourteen hundred machines, 72 investigations,
and still--unless I am missing something--no actual enforcement
actions. Part of my concern is that, when there are no
enforcement actions, it basically says to those who try to
skirt the laws, you are home free.
I mean, the whole point of enforcement, especially with
scarce resources--and I am aware that you all are pressed in
terms of resources--is, if you do not have some enforcement
actions where you go the distance, it just sends the worst
possible message, because those who would try to make money and
exploit these loopholes to take advantage know they are home
free. That is what I am so troubled about.
I want to move on to one other area where I need to know
whether new legislation is actually needed, and that is the
question of processed tobacco and the diversion of it. Now, in
2009 the Congress expanded your authority to address this
issue, the shipment of untaxed processed tobacco, so that the
agency could get a better handle on whether or not the
manufacturers were paying the right taxes.
Now, you all have asked for additional authority in this
area because of your concern that untaxed processed tobacco
shipments are being diverted through intermediaries and your
ability to track the shipments is being lost. So why was the
authority in the Children's Health legislation inadequate on
this point, so we know exactly why you need the additional
authority that you are talking about?
Mr. Manfreda. In the President's budget, we proposed that
any transfer to a non-permittee would be regarded as a removal
of roll-your-own tobacco. The reason the current framework is a
problem is that, when a manufacturer or processed manufacturer
ships to a non-permittee, the first shipment is required to be
reported to us, but what we have seen is there are multiple
shipments after that that are not required to be reported to
us.
The ability to follow that shipment is at the whim of the
persons we are going to, who are not required to report to us,
keep records, or do anything like that, so the audit trail
becomes almost impossible to follow without cooperation. That
is why we would want to limit the transferability of processed
tobacco to non-permittees.
The Chairman. Did you want to add anything to that, Dr.
Gootnick?
Dr. Gootnick. I was just going to say that processed
tobacco is really, I think, a straightforward example of an
intermediate good being treated as a consumer item. So the
intention under the definition of processed tobacco is that it
is used as a factor in the making of a consumer good, but
indeed it is just simply being used, and can be used with
minimum modification in, for instance, these commercial roll-
your-own machines to make cigarettes.
The Chairman. Thank you very much, Dr. Gootnick.
I am going to excuse you both at this time, but I want it
understood that, with the problem now more serious even than we
had originally assessed, Mr. Manfreda, we need some clear
rules. The idea that 39 States, as I stated, wait around for
years and years, and there are proposals, it kind of reminds me
of the marquee at the old movie house where it says ``coming
soon'' and it never gets there.
I mean, you all make these proposals, and year after year
after year goes by, as those who would try to skirt the laws
get more inventive and more and more creative, and the
combination of the lack of clear rules--for reasons that I am
still not clear on--plus the fact that we cannot even have a
handful of enforcement actions to send a message of deterrence,
I think is a prescription for trouble. So at this point I am
going to ask----
Senator Crapo is here, and I will just make a unanimous
consent request, and then see if my colleague has questions.
At this point I am going to ask unanimous consent to
include in the record two analyses prepared by the TTB
analyzing the number of tobacco companies that switched their
small cigars to large cigars and roll-your-own cigarette
tobacco to pipe tobacco. The identity of the individual
companies is not included in these analyses because the
information is considered protected under section 6103 of the
Internal Revenue Code. These analyses were provided to and were
discussed with minority staff. Without objection, they will be
made part of the record.
[The analyses appear in the appendix on p. 178.]
The Chairman. So let me recognize my friend and colleague
Senator Crapo for any questions he has for the first panel.
Senator Crapo. Senator, I have no questions for the first
panel, and I look forward to moving on to see what the next
panel has.
The Chairman. Very good. Gentlemen, you are excused.
Our next panel will be Mr. Ronald Bernstein, president and
CEO of Liggett Vector Brands of Morrisville, NC; Mr. Rocky
Patel, owner of Rocky Patel Premium Cigars and board member of
Cigar Rights of America in Naples, FL; Mr. Michael Tynan,
Policy Officer, Oregon Public Health Division in Portland, OR;
and Mr. Scott Drenkard, economist and manager of State
projects, Tax Foundation of Washington, DC.
Gentlemen, if you all will come forward. All right. I am
very pleased that we have this panel, and let us begin with
you, Mr. Bernstein.
STATEMENT OF RONALD J. BERNSTEIN, PRESIDENT AND CEO, LIGGETT
VECTOR BRANDS LLC, MORRISVILLE, NC
Mr. Bernstein. Chairman Wyden, Ranking Member Hatch, and
members of the committee, my name is Ron Bernstein, and I am
president and CEO of Liggett Vector Brands. Liggett is the
fourth-largest cigarette manufacturer in the United States and
has been operating since 1873. Thank you for inviting me to
testify today.
Seventeen years ago, Liggett became the first tobacco
company to break ranks with the industry and settle tobacco-
related litigation. We also were the first, and remain the
only, company to state that smoking is addictive on our
packaging and to voluntarily list ingredients on our cartons.
These actions reflect Liggett's longstanding cooperative
relationship with Congress, the public health community, and
regulators. With that backdrop, we are here today to shine a
light on illegal conduct that is costing the U.S. billions in
tax revenues.
In 2009, Congress raised tobacco taxes to help fund the
State Children's Health Insurance Program. The taxes on
cigarettes, roll-your-own tobacco, and on little cigars were
raised to the equivalent of $10.07 per carton. At the same
time, Congress only marginally raised the tax on pipe tobacco
to $1.15 per carton equivalent. That means the Federal excise
tax on cigarette tobacco is roughly 10 times that on pipe
tobacco. Before the ink was dry on the legislation, certain
tobacco manufacturers embarked on a campaign to evade the tax
increase by relabeling roll-your-own tobacco as pipe tobacco.
For example, what a smoker would have found in a store
before the tax increase was called Kentucky Select cigarette
tobacco. The product made available after the tax increase is
called Kentucky Select pipe tobacco. The chief differences
between these products are the label and a substantially lower
tax rate.
Here is a bag of Desperado. Astoundingly, this company
pasted on a label that says ``All Natural Pipe Tobacco'' and
used tape to cover the statement ``Makes approximately 500
cigarettes'' on the back. Everyone knows that this is cigarette
tobacco. The manufacturer knows, the consumer knows, and I
know. I know because I tried smoking it in a pipe and it was
not a pleasant experience.
We met with representatives from TTB in 2010 and showed
them that all of the growth in the category was coming from
mislabeled pipe tobacco rather than genuine pipe tobacco. TTB
advised they were aware and had expected this problem when
Congress failed to equalize the tax on pipe tobacco with roll-
your-own tobacco and cigarettes in 2009.
Since the existing tax code definition of RYO included
anything sold as cigarette tobacco or roll-your-own tobacco,
TTB already had clear authority to enforce the law, especially
since the manufacturers of the product knew exactly what they
were doing and were using a variety of tactics to inform
consumers that the product was really roll-your-own tobacco.
We were pleased to learn shortly after the meeting that TTB
had issued a statement on its website indicating that specific
guidance would be forthcoming in the near future. Four years
later, we are still waiting for that guidance. Meanwhile, sales
of pipe tobacco have grown by over 700 percent, while roll-
your-own has declined by over 80 percent, and cigarettes have
declined by over 20 percent.
This chart--which is included in my written statement--
looks very similar to the one that GAO put up and really tells
the whole story. None of the manufacturers of genuine pipe
tobacco have seen any real growth during this period, nor are
we aware of any growth in the sale of pipes. Yet products
labeled as pipe tobacco have grown in sales from less than 1
percent of the total cigarettes equivalent market to over 6
percent, or more than 18 billion cigarette equivalents. Despite
this, TTB has issued no specific guidance, and over $3 billion
in excise taxes have been lost by the Federal Government.
Even after a GAO report clearly demonstrated that the
explosion of pipe tobacco sales was entirely due to roll-your-
own tobacco sales and had admissions from manufacturers to this
fact, TTB still failed to act. Under the definition of
cigarette tobacco in the Tobacco Control Act, FDA also has
clear authority to treat mislabeled pipe tobacco as misbranded
and to require it to be properly labeled and regulated as
cigarette tobacco, but they too have allowed two markets to
exist, one regulated and properly taxed, the other not.
Additionally, since 2009 the renegade tobacco industry has
also relabeled little cigars as filtered cigars. Here is an
example, which you can see looks exactly like a pack of
cigarettes and also contains menthol, which is not typically
found in real cigars. This has created another tax dodge that
has cost the Federal Government close to $900 million. Together
with mislabeled pipe tobacco, these products now comprise over
8 percent of the cigarette market.
We welcome the attention that Congress is once again
bringing to this issue and look forward to working with you to
address the problem. Thank you for your attention.
The Chairman. Mr. Bernstein, thank you. I just am struck by
the fact that, 2 decades ago when I asked tobacco executives
whether nicotine was addictive and they were under oath, they
said ``no,'' and you have come here today and in effect given
us real candor as to what is going on in the marketplace. I
very much appreciate it, and we will have some questions for
you in a moment.
Mr. Bernstein. Thank you, Mr. Chairman.
[The prepared statement of Mr. Bernstein appears in the
appendix.]
The Chairman. Mr. Patel, welcome.
STATEMENT OF ROCKY PATEL, OWNER, ROCKY PATEL PREMIUM CIGARS
INC., AND BOARD MEMBER, CIGAR RIGHTS OF AMERICA, NAPLES, FL
Mr. Patel. Thank you, Chairman Wyden, Ranking Member Hatch,
and members of the committee, for granting me this opportunity
to testify before this committee. My name is Rocky Patel, and I
am the owner and CEO of Rocky Patel Premium Cigars, founded in
Naples, FL.
The 20 million premium cigars we handle each year embody
the values of artisan craftsmanship, strict quality control,
and the use of the finest aged tobaccos. While not defined
under the tax code, premium cigars are made from a 100-percent
wholly tobacco wrapper, are made by hand with 100-percent
tobacco binder and filler containing no filter, tip, or non-
tobacco mouthpiece, and weigh in at at least 6 pounds per
thousand. These are considered to be high-grade tobacco
products. The closest approximation to a premium cigar in the
tax code is the large cigar, which weighs at least 3 pounds per
thousand. As a result, there are physical weight differences
between what we consider a premium cigar and what is considered
a large cigar under the code.
The premium cigar culture is also unique and is rooted in
the social nature of premium cigar consumption, often used in
celebrations. The typical cigar shop is a family-owned brick-
and-mortar store that is the modern-day equivalent of a general
store or barbershop where men and women who share a passion for
premium cigars can enjoy each others' company, share common
interests, and discuss the issues of the day in a relaxed,
comfortable environment. Many of these experienced tobacconists
have spent years visiting my farms and factories so as to
provide the superior expertise their customers expect. Premium
cigars occupy a niche within the overall cigar and tobacco
market, serving an adult consumer base with a complex palate
and appreciation for high-quality tobacco products.
Since the 1970s, cigars have been classified as either
small or large based upon weight and taxed differently based
upon this classification. Premium cigars are lumped into the
large cigar category under the code. In 2009, the enactment of
CHIPRA transformed tobacco taxation by significantly raising
the Federal excise taxes on both small and large cigars, along
with other tobacco products including cigarettes, pipe tobacco,
and roll-your-own tobacco.
Before CHIPRA, premium and large cigars were taxed at a
greater amount of either 20.719 percent per cigar or not more
than 4.875 cents per cigar. After CHIPRA, these rates rose to
the greater amount of either 52.75 percent per cigar and 40.26
cents per cigar, respectively. This resulted in as much as a
726-percent tax increase on premium cigars per thousand, one of
the highest increases in the history of the U.S. tax code.
However, taxes on small and large cigarettes only increased by
approximately 158 percent per thousand sticks after CHIPRA.
The 2012 GAO report highlighted that price-sensitive
manufacturers and consumers began substituting higher-taxed
products with lower-taxed ones. Some industry participants took
steps to avoid taxes by reclassifying their products by adding
weight to small cigars in order to qualify as large cigars. Our
solution to this issue would be to define premium cigars in the
code to distinguish between non-premium cigars and premium
cigars. A premium cigar could be defined according to several
unique factors, including that premium cigars are unfiltered
products that are hand-wrapped, are 100-percent leaf tobacco,
and weigh more than 6 pounds per thousand.
These differences would make it impossible to game the
definition of premium cigars based on weight alone, allowing
Congress and the regulators to focus on the differences between
small, large, and premium cigars and reduce the opportunity and
incidences of tax avoidance. We also support a lower flat tax
for premium cigars, which should have the added benefit of
simplicity and certainty, reducing the compliance burden on the
premium cigar industry and the enforcement burden on the TTB.
Such a flat tax could, and should, be lower than the
current rate applied to large cigars to more appropriately
calibrate the relative differences between the tax rates. We
also believe that the policies adopted in the response to the
GAO report should focus on key sources of revenue loss and not
focus on tobacco products that are not the source of tax
avoidance. Importantly, cigars represented less than 4 percent
of the Federal excise tax revenue from all tobacco products in
2012.
Thank you again for this opportunity to testify before the
committee. I would be pleased to answer any questions.
The Chairman. Thank you very much, Mr. Patel. We will have
questions in a moment.
[The prepared statement of Mr. Patel appears in the
appendix.]
The Chairman. We are glad to see Oregon well-represented
here today. Mr. Tynan, please proceed.
STATEMENT OF MICHAEL TYNAN, POLICY OFFICER,
OREGON PUBLIC HEALTH DIVISION, PORTLAND, OR
Mr. Tynan. Thank you, Chairman Wyden, Ranking Member Hatch,
and members of the committee. My name is Michael Tynan. I am
the Policy Officer for the Public Health Division in the Oregon
Health Authority. Prior to that, I was at the Centers for
Disease Control and Prevention's Office on Smoking and Health.
I have been invited here to talk to you today about studies I
published on changes that have happened since the Federal
excise tax increased in 2009, but before that, since I am the
only public health voice, I want to talk about the dangers and
health effects of smoking.
Tobacco use is the leading cause of death and disease in
the United States. Each year, 480,000 people die from smoking
and exposure to second-hand smoke, and CDC estimates that 18.1
percent of adults in the United States are smokers. The good
news is, we know how to end the tobacco use problem in this
country. Ending the tobacco use problem is a political
question, not a scientific one.
We know what works. Increasing the price of tobacco,
establishing smoke-free environments, warning about the dangers
of
second-hand smoke with aggressive media campaigns, and
increasing access to cessation are the tools available to
public health that can significantly reduce smoking and tobacco
use.
Increasing the price of tobacco is the most effective
tobacco prevention tool available for public health. Simply
put, the more cigarettes cost, the less people will smoke.
Every 10-percent increase in the price of cigarettes results in
a 4-percent decline in consumption and can have an even greater
impact on youth.
Dr. Gootnick already spoke to you about reports published
by GAO concerning changes in the tobacco use patterns and
product design since 2009, and my full testimony contains a
summary of the papers that I have published, and my colleagues
at CDC and in Oregon, on this topic. I will summarize those by
saying that our papers reached complementary conclusions to
what GAO reported to you earlier today. Our papers included an
estimate of Federal revenue loss, and, although we used
different timelines and slightly different methodologies, we
found that, through June 2013, Federal tax receipts on the
pipe/roll-your-own switching alone reduced Federal tax receipts
by $2.3 billion. There were additional losses to State
governments in lost excise taxes and lost State revenue.
But let me walk you through what this means practically for
a smoker. This, as you have seen earlier, is a 1-pound bag of
roll-your-own tobacco. However, as you can see, it has a pipe
label on it. This bag can be purchased online for about $10. I
went to my neighborhood roll-your-own shop on Sunday. I walked
to it. I did not ride my bike, but I walked to it, Senator, and
it cost me $16. So, because it has a pipe label on it, that is
why it is so inexpensive. Had it had a roll-your-own label on
it, it would have been at least $22 more.
But the interesting thing was, even though the store's name
is Roll-Your-Own Mart, they do not even sell roll-your-own
tobacco. All of the tobacco they sell there is pipe tobacco.
The clerk told me that roll-your-own tobacco is too expensive,
so they do not carry it. They sell pipe tobacco instead.
This $16 bag will make approximately 500 cigarettes. That
is about 2\1/2\ cartons of cigarettes. So for comparison, a
single carton of cigarettes in Oregon costs $45. Two hundred
cigarettes for $45, or you can make 500 for $16--if you were a
smoker and your taxes went up, which product would you buy?
The public health community is concerned about this,
because, instead of quitting in response to the 2009 Federal
cigarette tax increase, it appears that some smokers have
switched to pipe tobacco, allowing them to maintain their
addiction to tobacco products. Also, as you heard earlier, the
changes do not stop at pipe tobacco. There have been changes to
the type of cigars people smoke, or at least in the way that
those cigars are taxed.
So this is a machine-made cigarette, which you saw earlier,
made by Cheyenne Tobacco. This is a small cigar made by
Cheyenne Tobacco. They are identical. The difference is, this
one is wrapped in white paper, this one is wrapped in tobacco
leaf. That is how this is classified as a small cigar. Then
what manufacturers did after 2009 is, they took these products,
still sold in a pack of 20, that were small cigars, made them a
little bit heavier, and classified them as large cigars. In
some cases, as you mentioned, Senator, that was done by adding
a little bit more tobacco to the product. It has also been done
by adding kitty litter to the filter to make them heavier.
So again, the public health concern is that smokers who
might have otherwise quit have instead switched to products
that have allowed them to maintain their addiction to tobacco
products. Public health is also concerned because the morbidity
and mortality effects of all forms of combustible tobacco are
the same. If you smoke a cigar the way you smoke a cigarette,
it does not matter how it is taxed, there are going to be
health effects.
Changing how these products are classified also does not
just result in lost revenue, but also changes how these
products are regulated by the Food and Drug Administration.
These products are now available in candy flavors and with
misleading descriptors like ``Lite,'' ``Mild,'' and ``Low,''
even though those practices are banned by the Food and Drug
Administration and by Congress in the Tobacco Smoking Act.
So at least two policy approaches exist that can address
these tax and policy loopholes. First, as was discussed
earlier, the objective characteristics could be identified that
could classify these products separately from one another.
Second though, and more importantly, tax parity for combustible
tobacco is the direct way to impact this practice.
Congress was wise in 2009 when it created tax parity for
cigarettes and small cigars and roll-your-own to discourage
switching between these products. The issue we are discussing
today, Senators, is an unfortunate consequence of tax inequity
between pipe tobacco, large cigars, and other combustible
tobacco. Simply put, tax parity would expand the public health
benefit of the 2009 Federal tax increase.
The Chairman. I want to make sure I heard that right, but I
thought you said that clay in kitty litter was added to the
filter to make the small cigar heavier. Is that true?
Mr. Tynan. There are some instances where that has been
done. Yes, Senator.
The Chairman. Could you get us that for the record? I had
not heard that before.
Mr. Tynan. Yes.
[The prepared statement of Mr. Tynan appears in the
appendix.]
The Chairman. All right. Let us hear from Mr. Drenkard.
STATEMENT OF SCOTT DRENKARD, ECONOMIST AND MANAGER OF STATE
PROJECTS, TAX FOUNDATION, WASHINGTON, DC
Mr. Drenkard. Thank you, Chairman Wyden and members of the
committee. I appreciate the opportunity to speak today. In our
77 years since our founding in 1937, the Tax Foundation has
monitored tax policy trends at the Federal and State levels,
and our data and research are heavily relied upon by
policymakers, the media, and the general public.
Tobacco taxes today are the highest they have ever been in
the United States. The Federal rate currently stands at $1.0066
cents per pack of cigarettes, and State and local rates can add
as much as an additional $6.16 per pack, as in Chicago, IL.
These combined rates are equivalent to a tax in excess of 200
percent in some locales. Now, these taxes have a really
substantial effect on the price of cigarettes as well. The most
recent survey I found is that a pack of cigarettes costs $14.50
in New York City.
The high tax burden on tobacco results in de facto
prohibition on the products, bringing with it all the
undesirable outcomes associated with the alcohol prohibition in
the 1920s. The largest of these is cigarette smuggling. Our
research shows substantial empirical evidence of tobacco
smuggling from low- to high-tax jurisdictions, with criminals
pocketing the profits that would otherwise go to State revenue
coffers.
The Mackinac Center for Public Policy estimates that 57
percent of the cigarettes consumed in New York State in 2012
were smuggled into the State from other locales. Other States
with substantial smuggling problems include Arizona at 51.5
percent, New Mexico at 48.1 percent, Washington at 48 percent,
and Wisconsin at 34.6 percent.
On top of that, the news stories surrounding the black
market for tobacco are shocking. We have uncovered instances of
violent crime, like one disturbing episode in California where
criminals sacked a distribution center, rounded up the
employees at gunpoint, and made off with $1 million in
cigarettes, and most importantly, the tobacco tax stamps. We
have seen crime rings that involve corruption of law
enforcement officers--this happened in Maryland--and even one
instance of a crime ring running cigarettes from Charlotte to
Detroit which was funding operations of the terrorist
organization Hezbollah.
In addition to smuggling authentic cigarettes from low- to
high-tax jurisdictions, criminals sometimes skirt the legal
market altogether with counterfeit name-brand products and
tobacco tax stamps. Counterfeiting is highly profitable. It is
an international business that exposes consumers to products
with increased levels of dangerous chemicals like lead and
thallium. Various sources report finding insect eggs, dead
flies, mold, and human feces in counterfeit cigarettes. One
source estimates that the Chinese counterfeit cigarette
business produces 400 billion cigarettes per year to meet
international demand.
This problem is far more pervasive than people are aware
of, and even I am surprised by it sometimes. Last week when I
was preparing for this testimony, I thought it might be
interesting to see how quickly I could buy a pack of improperly
stamped cigarettes, and I kid you not, the very first store I
walked into in the District of Columbia to try to do this sold
me a pack of cigarettes with a Virginia tax stamp. This is
illegal.
I brought along a few visual aids to help me make my point
today. The first map--Figure 1 in my written statement--shows
the large amount of the cigarette smuggling problem. Some
States are outflow States, and those tend to be places where
taxes are low, or at least relatively low compared to
neighboring States. Other States are a lot higher, and New York
is the most shocking, with the rate of 57 percent of the
cigarette market being under the table.
The second chart--Figure 2--is a scatter plot where each
dot represents a State's cigarette tax rate and their
corresponding smuggling percentage. As you can see, as the
taxes go up, the rates of smuggling go up in a pretty clear
fashion.
Then finally--on the last page of my written statement--is
a picture of a car, what an apprehended smuggler looks like. As
you can see, the smugglers are capable of fitting hundreds of
cartons into just one regular-sized vehicle. In fact, the
Virginia Crime Commission estimated in 2012 that a well-
structured crime ring could pocket $4 million if they could fit
a 16-wheeler with contraband cigarettes.
This is not what sound tax policy looks like. Subjecting
certain products, even unhealthy ones, to wildly prohibitory
rates has damaging unintended consequences. In 1994, the
Canadian government found that smuggling rates were so high and
crime was so senseless that they cut the Federal excise tax
rate from $16 to $11 per carton. Many provinces followed suit,
and smuggling rates declined in response. Canadian tax rates
have since, unfortunately, crept up little by little, and
smuggling rates have grown with them. The point here is that
cigarette taxes are not a good revenue source and the products
are currently over-taxed.
Any conversation of raising rates needs to have a realistic
expectation of how consumers will respond. We have learned from
these panels that consumers will shift their purchases to
lower-tax options because it is cheaper. It is our
responsibility to make sure that we are not giving them
incentives to shift them to the black market instead. Thank
you.
The Chairman. Thank you, Mr. Drenkard. We will have some
questions in a moment.
[The prepared statement of Mr. Drenkard appears in the
appendix.]
The Chairman. Let me start with you, Mr. Bernstein, because
it is a pretty rare event in America when a major corporation
like your company asks to come to Washington, DC and say to the
government, we need to meet with you and talk about better
oversight and better regulation. But as far as I can tell, that
is what you all did. You asked to come to Washington to meet
with the Treasury Department over this issue. Why did your
company take this step in terms of asking to come to Washington
to meet with Treasury officials?
Mr. Bernstein. Well, Senator, thank you. This is a big
issue. We obviously operate on the street and we know what is
going on, and we are able to see things quickly that the
regulatory agencies may not be able to register as quickly.
So we went to make them aware--and, at that point, the lost
revenue was not as dramatic as it is today, because it has
gradually increased over the 5 years. But at that time we could
see that clearly there were two markets that were developing:
one that was properly regulated and taxed and the other not.
We felt it was appropriate to bring that to their
attention. As I said in my comments, we were pleased to find
out that they were, in fact, aware of it. We think we may have
enlightened them on a few aspects of it that they had not seen,
particularly the proliferation of the cigarette machines that
had started at that time. We were hopeful when we left the
meeting that there would be quick action. Unfortunately, as
this hearing has indicated, that has not happened.
The Chairman. And so they told you what at the meeting?
What did they tell you they were going to do?
Mr. Bernstein. They did not tell us they were going to do
anything. What they did was, they indicated that they were not
surprised, that they were aware that it was a problem, that
they had been aware that it would be a problem from the time
that pipe tobacco was not raised to the same level as
cigarettes and roll-your-own in 2009.
Just one other comment: our primary objective was to assure
that the playing field is the same for everybody in the tobacco
business.
The Chairman. That is what I wanted to ask you about next,
because we are looking today at Federal tobacco excise taxes,
but there are additional incentives to mislabel and convert the
cigarette-type products and the lower-tax pipe and cigar
products because you can get around some State and local taxes
as well.
When you add all of this up, how big a price advantage do
the firms that deliberately mislabel and convert their products
to low-tax products have compared to firms like yours that are
trying to comply with what the Congress at least intended?
Mr. Bernstein. Well, I think as was indicated by your
gentleman from Oregon, you can go and buy 2\1/2\ packs of
cigarette equivalent in pipe tobacco for about $15, $16,
whereas you cannot get a pack of legitimate and properly taxed
cigarettes for under $30. I am using national averages when
considering State excise tax variations. But if you look at it,
I mean, the gap can be anywhere from $15 to $40 or $50 when you
are talking about premium cigarettes.
The Chairman. All right. Let us move on to Mr. Tynan. We
thank you for coming, Mr. Tynan. We are glad to have you.
As I pointed out in my opening statement, the
reauthorization of the Children's Health Insurance Program
tried to establish the principle that all cigarette-type
products would be taxed at the same rate, especially small
cigars. When it became clear that there were those who were
going to try to circumvent that principle by using these
rolling machines, Congress passed legislation to try to shut
that particular loophole. Your research indicates that all of
these dodges together cumulatively have meant that the 2012
legislation has not had any real impact. In your view, why is
that the case?
Mr. Tynan. We do not know why that is the case. The
machines do not appear to be in the stores anymore, at least
not anecdotally in the stores we have gone into in Oregon. But
that does not mean that they have not gone underground or that
that is different in other States.
There needs to be some sort of national assessment of the
retail space to identify what has occurred in the retail space
or to see if the stores have gone underground. But simply,
Senator, it may just be that smokers did not understand how
much of a tax advantage there was with roll-your-own tobacco.
When these machines came into the stores, maybe consumers
just got a taste of it, so to speak. But one thing I want to
point out is that this is not just happenstance that this
happened. I was still at the CDC at the time when the 2009
tobacco tax increase occurred. We were very interested to see
if we could see an immediate impact of the increase, and we did
not yet know that there was this pipe/roll-your-own difference
that was going to happen.
So I was tracking the TTB data on a month-to-month basis.
When the new data came out for April 2009, I called TTB because
I thought they had made a mistake in their data. I called them
and said, you guys mixed up your pipe and your roll-your-own
data. I think you reported them in the opposite. They said, no,
no, we didn't, that data is right. So the fact that it happened
the month it came out says to me that this was not an accident.
The Chairman. What in your view, since you are a public
health office, are the impacts to children of these various tax
dodges? I want to get Mr. Drenkard into this debate about taxes
a little bit later, but in your view what are the implications
for children and the take-up rate and that sort of thing?
Mr. Tynan. Well, the implications for children are twofold.
One is, if cigarettes cost less, we know children will be more
likely to start smoking. Raising the price of tobacco products
is one of the most effective tools to prevent youth from even
starting.
Eighty percent of people who start smoking start by the age
of 18. I am going to say that again: 80 percent of people who
start smoking start by the age of 18. We know that flavors,
flavors like candy flavors, like vanilla and wild cherry that
these products are available in, are some of the things that
make tobacco products attractive to children.
We have published studies with my colleagues at CDC that
show that 40 percent of youth who smoke tobacco products smoke
a flavored tobacco product. So it is not only the price,
Senator, but it is the fact that by classifying your product as
a cigar you are able to get around FDA regulations that
prohibit flavors, candy-like flavors, in cigarettes.
The Chairman. Let us go to you, Mr. Patel, if we could. I
am new chairing the committee and trying to think about the
steps ahead. As you know, we have been talking about 2006,
2009, trying to clarify the difference between cigarettes and
cigars.
In 2009, when faced with the task of trying to prevent
cigarette-
type products from being rebranded as cigars to avoid the new
higher tax on cigarettes, Congress just said, we will apply the
new higher tax to small cigars. That pretty clearly has not
been exactly an ideal situation.
Would you support the idea of, in effect, going back to the
drawing board and just getting a clear definition of what
constitutes a cigarette and what constitutes a cigar?
Mr. Patel. Certainly. I represent the premium cigar
category. In regards to cigars in general, I think under the
TTB tax code, the language is very, very broad. There needs to
be a concise definition separating what a premium cigar is,
what a large cigar is, and what a small cigar is.
Unfortunately, right now we have the migration from the small
cigars to the large cigar category because of the weight
requirement, the weight requirement being 3 pounds per
thousand.
What we suggest for the premium cigar category is to shift
that weight to 6 pounds per thousand. That would stop the
migration for the small cigars to the large cigar category. I
think there needs to be a separate definition for the premium
cigar category, which is the one I represent, because premium
cigars are totally unique, they are different, they are an art
form, they are a culture that has transited over generations.
By the time we plant the seedling in the ground to the time
we get a cigar in the box takes 4 to 5 years, and 300 different
hands touch the tobacco. It is a totally different audience. It
is marketed to adults, sold to adults. Minors cannot buy it,
cannot enter tobacco stores where premium cigars are sold. So
it is a unique product, and I certainly think that narrowing
the definition for premium cigars, large cigars, and small
cigars would certainly help the cause.
The Chairman. Well, it is clear there are some clever
people out there trying to rejigger their tax bills, and I am
anxious to pick up on your suggestions.
Let me ask you a question, Mr. Drenkard. It goes to this
question of the e-cigarettes. I have worked with you all at the
Tax Foundation on a variety of issues, especially tax reform,
and always enjoy getting your input about where markets are
headed. If e-cigarettes are not taxed and tobacco products are
taxed, in your view, where is the market going to go?
Mr. Drenkard. Well, the market is going to go to electronic
cigarettes to some degree. Now, I think it depends more on how
that sort of thing affects the price. Also, that might be a
desirable outcome from a public health perspective.
Electronic cigarettes are found by many people who have
looked at them to have a lower risk profile associated with
them. To put it very basically, there are tens of thousands of
carcinogens in a traditional incinerated tobacco product, and
there are really only three items in electronic tobacco liquid.
It is propylene glycol, nicotine, and glycerine. Other than
nicotine, those two other items are found in food products.
So my reading in the literature is that the risk profile is
a lot lower. To me that indicates that there are a lot of
desirable outcomes to be had from people switching from
traditional incinerated tobacco to smokeless tobacco like that,
or electronic tobacco like that. My brother, for example, quit
cigarettes and moved to electronic tobacco, and I think that
was a good move.
The Chairman. Well, as you know, some who study the e-
cigarette industry have said that these products have not been
on the market long enough to know whether they have any
negative health effects.
I am very much, as we get into this, affected by that
testimony that I heard in 1994, where clear scientific evidence
was ignored. That is why I think there are real implications
for this debate about when something is untaxed and something
is taxed. We ought to get to the bottom of how markets work.
Let us just give Mr. Tynan an opportunity to respond to the
same question. If e-cigarettes go untaxed and traditional
tobacco products are taxed, where do you think the market goes?
Mr. Tynan. I mean, the challenge with e-cigarettes is that
they are currently an unregulated product, Senator. We do not
know what the long-term health effects are going to be from
smoking e-cigarettes. Being unregulated, we could have two e-
cigarettes that come from the same manufacturer on the same
assembly line that have completely different constituents in
them. Many of them also come from China. I would not put a
plastic toy from China in my mouth, let alone something you
have to inhale that puts things into your lungs. So, I mean, I
think we have to be very careful when we think about the impact
that it could have on long-term population health and the
impact that it could have on youth starting to smoke.
What we do not want is people to become addicted to
nicotine through an e-cigarette and then switch later to
smokeless tobacco or cigarettes, which we know are harmful. So
there need to be more long-term studies on the health effects.
The challenge with many of the studies that are out there is
that they have not necessarily been independent studies.
We know from the 2006 Federal court case that the tobacco
industry has been found by a Federal judge to be racketeers.
One of the findings in that court case was that the tobacco
industry manipulated scientific studies. So we need to be very
thoughtful and look very closely at the studies that have found
that e-cigarettes are safe and effective.
The Chairman. And what is your take, Mr. Bernstein, on that
same question of where the market will go if e-cigarettes are
untaxed and traditional tobacco products are taxed?
Mr. Bernstein. Yes, Senator. Before I answer that, if I
could just point out that when Mr. Tynan referenced the tobacco
industry being convicted of racketeering, it is important to
note that the judge dismissed Liggett from that because of
Liggett's behavior and viewed it in a much more positive light.
The e-cigarette is a big question mark. I think the first
question is, what is it? I think that has to be determined. In
my opinion, it is either a medical device or it is a tobacco
product, and it should be regulated as such in either case. I
believe it is very difficult to predict where the e-cigarette
market is going to go, because we do not know how it is going
to be regulated, we do not know how it is going to be taxed. If
it is not taxed and if it is not regulated, it will grow. But I
cannot tell you that it will grow at an exponential rate,
because there is not enough evidence yet to be able to say
that.
What I will tell you, though, is that there are people who
are--and I understand the concerns about China--mixing up vats
of e-liquid in the back of their stores and then are selling it
to individuals, and nobody has any idea what is in it.
The Chairman. In the United States?
Mr. Bernstein. In the United States. In fact, our offices
are in Morrisville, NC. There is a store in our center, the E-
Liquid Lady, and she basically mixes up vats of----
The Chairman. And the E-Liquid Lady does exactly what?
Mr. Bernstein. They mix up vats of e-liquid in the back,
and then they inject it into devices that people buy.
The Chairman. And all of this takes place without any
oversight?
Mr. Bernstein. None.
The Chairman. All right.
You four have been very helpful. I came here this morning
with the view that this was a classic case of tax evasion. I
have added to that judgment that we are certainly moving
towards a classic case of government foot-dragging. I think
what all of you on this panel have demonstrated is that those
who skirt the laws clearly look like they are going to get more
inventive about how they go about it. Mr. Tynan talked about
kitty litters, and Mr. Bernstein talked about e-liquid ladies
making injections and the like.
That ought to give everybody pause. So we have a lot of
work to do to follow up here, and I want to thank all of you
for your testimony and your cooperation. Members of the
committee are going to have until the close of business on
Friday, August 8th, to submit questions for the record.
With that, the hearing is adjourned.
[Whereupon, at 11:34 a.m., the hearing was concluded.]
A P P E N D I X
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