Tobacco Taxes: Disparities in Rates for Similar Smoking Products Continue to Drive Market Shifts to Lower-Taxed Options
Published: 2014-07-29T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In 2009, CHIPRA increased and equalized federal excise tax rates for cigarettes, roll-your-own tobacco, and small cigars. Although CHIPRA also increased federal excise tax rates for pipe tobacco and large cigars, it raised the pipe tobacco tax to a rate significantly below the equalized rate for the other products, and the large cigar excise tax can be significantly lower, depending on price. Treasury collects federal excise taxes on domestic tobacco products. Customs and Border Protection (CBP) collects federal excise taxes on imported tobacco products.
This testimony highlights and provides selected updates to key findings from GAO's April 2012 report ( GAO-12-475 ) by examining (1) market shifts among smoking tobacco products since CHIPRA, and (2) the impact of the market shifts on federal revenue and Treasury's actions to respond to these shifts. GAO analyzed Treasury and CBP data to identify sales trends for domestic and imported smoking tobacco products and to estimate the effect of the market shifts to lower-taxed products on federal tax revenues.
section_title: What GAO Found
paragraphs: Large federal excise tax disparities among smoking tobacco products, which resulted from the Children's Health Insurance Program Reauthorization Act (CHIPRA) of 2009, created opportunities for tax avoidance and led to significant market shifts toward lower-taxed products by manufacturers, importers, and price-sensitive consumers. From fiscal year 2008, the last year before CHIPRA, to fiscal year 2013, annual sales of domestic and imported pipe tobacco increased from about 5.2 million pounds to 43.7 million pounds, while sales of domestic and imported roll-your-own tobacco declined from about 21.3 million pounds to 3.8 million pounds. Over the same period, annual sales of domestic and imported large cigars increased from about 5.8 billion sticks to 12.4 billion sticks, while sales of domestic and imported small cigars declined from about 5.7 billion sticks to 0.7 billion sticks. According to government, industry, and nongovernmental organization representatives, many roll-your-own tobacco and small cigar manufacturers shifted to the lower-taxed products after CHIPRA to avoid paying higher taxes.
While revenue collected for domestic and imported smoking tobacco products, including cigarettes, from April 2009 through February 2014, amounted to about $77 billion, GAO estimates that federal revenue losses due to market shifts from roll-your-own to pipe tobacco and from small to large cigars range from about $2.6 to $3.7 billion for the same period. GAO found that the Department of the Treasury (Treasury) has limited options to respond to these market shifts. Differentiating between roll-your-own and pipe tobacco for tax collection purposes presents challenges to Treasury because the definitions of the two products in the Internal Revenue Code do not specify distinguishing physical characteristics and are based on such factors as the use for which the products are suited and their packaging and labeling. GAO also found that Treasury continues to have limited options to address the market shift from small cigars to large cigars—which are differentiated in the Internal Revenue Code only by weight—and faces added complexity in monitoring and enforcing tax payments due to the change in large cigar tax rates.
section_title: What GAO Recommends
paragraphs: GAO is not making any new recommendations in this testimony. In its 2012 report, GAO suggested that Congress consider equalizing tax rates on roll-your-own and pipe tobacco and, in consultation with Treasury, consider options for reducing tax avoidance due to tax differentials between small and large cigars. Treasury generally agreed with GAO's conclusions and observations.

section_title: Letter
paragraphs: Thank you for this opportunity to discuss the market shifts in smoking  tobacco products since passage of the Children’s Health Insurance  Program Reauthorization Act (CHIPRA) and the implications of those  shifts for federal revenue from tobacco taxes. Tobacco use is the leading  cause of preventable death, disease, and disability and a significant  contributor to health care costs in the United States. Federal and state  laws have aimed to discourage tobacco use and raise revenue by  increasing excise taxes on tobacco products. The most recent federal  increase occurred in April 2009 with the passage of CHIPRA, which  amended the Internal Revenue Code of 1986 (IRC) by raising federal  excise tax rates on tobacco products, while also equalizing the tax rates  across some of them. The Department of the Treasury (Treasury) collects  federal excise taxes on domestic tobacco products. Customs and Border  Protection (CBP), within the Department of Homeland Security, collects  federal excise taxes on imported tobacco products.
In my statement today, I will address two topics: (1) market shifts among  smoking tobacco products since CHIPRA went into effect, and (2) the  impact of the market shifts on federal revenue and Treasury’s actions to  respond to these shifts. Our study focuses on four smoking tobacco  products: roll-your-own tobacco (sometimes called RYO), pipe tobacco,  small cigars, and large cigars.
My statement is based on a GAO report issued in April 2012, which we  have supplemented with updated market-shift data analysis and recent  observations on tobacco marketing. To identify sales trends for our 2012  report, we analyzed Treasury removals data for domestic smoking  tobacco products from October 2000 through September 2011. To  identify sales trends for this testimony, we included CBP’s data on  imported smoking tobacco products in our analysis. To estimate federal  tax revenue losses due to the market shifts after CHIPRA, we also  analyzed Treasury’s and CBP’s revenue data and Bureau of Labor  Statistics (BLS) price data for smoking tobacco products. We updated our  analysis of sales trends to cover October 2000 through February 2014  and our estimate of revenue losses to cover April 2009 through February  2014. We assessed the reliability of the data by performing data checks  for inconsistency errors and completeness and by interviewing cognizant  officials. We determined that the Treasury, CBP, and BLS data were  sufficiently reliable for our purposes. We estimated what the effect on tax  revenue collection would have been if the sales trends for roll-your-own  and pipe tobacco and for small and large cigars had not been affected by  substitution between the products but had been affected by the increase  in price due to the tax—in other words, if the market shifts resulting from  the substitution of higher-taxed products with lower-taxed products had  not occurred. Our analysis takes into account the expected fall in quantity  demanded due to the price increases resulting from higher federal excise  tax rates that CHIPRA imposed on all four of these smoking tobacco  products. To update some of our previous observations of marketing  practices, we returned to tobacco stores and some of the Internet retailers  that we had visited for our April 2012 report. For that report, we reviewed  documents and interviewed agency officials from Treasury’s Alcohol and  Tobacco Tax and Trade Bureau, the Food and Drug Administration  (FDA), and the Centers for Disease Control and Prevention, as well as  tobacco industry members, representatives of public health and other  nongovernmental organizations, and academics, to obtain information on  tobacco legislation and regulations, tobacco product sales trends, and  consumption patterns. Appendix I in our 2012 report provides detailed  information on our scope and methodology. For this testimony, we  interviewed officials from Treasury’s Alcohol and Tobacco Tax and Trade  Bureau and from CBP, as well as other experts. The information  contained in this testimony was reviewed for technical accuracy by  Treasury and CBP officials.
The work upon which this testimony is based was conducted in  accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: While cigarettes are the smoking tobacco product preferred by most  smokers, the consumption of other smoking tobacco products is growing.  Cigarettes continue to dominate the market for domestic and imported  smoking tobacco products, accounting for approximately 88 percent of  sales in fiscal year 2013. However, sales of other smoking tobacco  products increased in fiscal years 2001 through 2013, with combined  sales of roll-your-own tobacco, pipe tobacco, and small and large cigars,  both domestic and imported, growing from 3 percent of the smoking  tobacco market to about 12 percent.
Roll-your-own tobacco, pipe tobacco, and small and large cigars are  broadly defined in the IRC. Roll-your-own tobacco and pipe tobacco are  defined by such factors as the use for which the product is suited and  how the products are offered for sale, as indicated by their appearance,  type, packaging, and labeling. The definitions in the IRC do not specify  the physical characteristics that would differentiate pipe tobacco from roll- your-own tobacco. Cigars are differentiated from cigarettes by their  wrapper and whether the product is, for a number of reasons, likely to be  offered to, or purchased by, consumers as a cigarette. The IRC  distinguishes between small and large cigars only by weight; small cigars  are defined as weighing 3 pounds or less per thousand sticks. Figure 1  shows a sample of different smoking tobacco products.
The federal excise tax rates on different tobacco products are calculated  in different ways. Cigarettes and small cigars are taxed on a per unit  basis—the number of sticks. Roll-your-own and pipe tobacco are taxed by  weight. Before CHIPRA, the federal excise tax rate on cigarettes was  higher than the rates on roll-your-own tobacco, pipe tobacco, and small  cigars. In 2009, CHIPRA significantly raised the tax rates on these four  products. The act equalized the rates for cigarettes, roll-your-own  tobacco, and small cigars, but not for pipe tobacco (see fig. 2). Prior to  CHIPRA, roll-your-own and pipe tobacco were taxed at the same rate  ($1.10 per pound). However, CHIPRA raised the federal excise tax rates  for roll-your-own tobacco and pipe tobacco by different amounts, resulting  in a $21.95 per pound difference between the higher-taxed roll-your-own  tobacco ($24.78 per pound) and the lower-taxed pipe tobacco ($2.83 per  pound). As a result, of the three cigarette products shown in figure 1, the  cigarette made with pipe tobacco (marked as number 2) is taxed at a  much lower rate than either the factory-made cigarette (number 3) or the  cigarette made with roll-your-own tobacco (number 1).
CHIPRA also significantly changed the federal excise tax rate on large  cigars. Large cigars are unique among tobacco products in that the tax  rate is ad valorem—calculated as a percentage of the manufacturer’s or  importer’s sale price—up to a maximum tax per thousand sticks. While  CHIPRA increased the small cigar tax rate from $1.83 to $50.33 per  thousand sticks (the same rate as cigarettes), the ad valorem rate for  large cigars increased from 20.72 percent to 52.75 percent of the  manufacturer’s or importer’s sale price, up to a maximum tax of $402.60  per thousand sticks (see table 1). As a result, cigars with a  manufacturer’s price of $50 per thousand, for example, would experience  a tax savings of $23.95 per thousand if they qualified as large rather than  small cigars. In figure 1, although the small cigar (marked as number 4)  and the filtered large cigar (number 5) are similar in appearance, they are  likely taxed at significantly different rates, depending on the price of the  filtered large cigar.
Domestic manufacturers and importers of tobacco products must obtain a  permit from Treasury before engaging in business. Treasury collects the  federal excise taxes on domestic tobacco products when these products  leave manufacturing facilities. CBP collects the federal excise taxes on  imported tobacco products when those products are released from  customs. According to Treasury, when Treasury investigates or audits an  importer of tobacco products and determines liability, Treasury refers the  case to CBP for collection of the tax.
section_title: Large Tax Disparities among Similar Tobacco Products Triggered Significant Market Shifts to Avoid Higher Taxes
paragraphs: Large federal excise tax disparities among tobacco products resulting  from CHIPRA created opportunities for tax avoidance and led to  significant market shifts by manufacturers, importers, and price-sensitive  consumers toward the lower-taxed products. Specifically, the market for  roll-your-own tobacco shifted to pipe tobacco, and the cigar market  shifted from small to large cigars. According to government, industry, and  nongovernmental organization representatives, many roll-your-own  tobacco and small cigar manufacturers shifted to the lower-taxed  products after CHIPRA to avoid paying higher taxes.
subsections: section_title: The Market Shifted from Roll-Your-Own Tobacco to Pipe Tobacco after CHIPRA
paragraphs: Market trends for roll-your-own and pipe tobacco changed immediately  after CHIPRA, with sales of pipe tobacco rising steeply while sales of roll- your-own tobacco plummeted. CHIPRA introduced a large disparity in  rates on these two products, which had been taxed at the same rate, as  shown previously in figure 2.
Figure 3 shows the market shift through monthly and annual sales of  domestic and imported roll-your-own and pipe tobacco from October 2000  through February 2014. Total annual sales of pipe tobacco grew from  about 5.2 million pounds in fiscal year 2008, the last year before CHIPRA,  to 43.7 million pounds in fiscal year 2013, representing an increase of  about 740 percent. Over the same period, total annual sales of roll-your- own tobacco declined from about 21.3 million pounds to 3.8 million  pounds, a decrease of 82 percent.
According to government officials, representatives of nongovernmental  organizations, and industry, the new pipe tobacco products have minimal,  if any, differences from roll-your-own tobacco products. Treasury also  emphasized that it is unclear to what extent domestic manufacturers  modified their roll-your-own tobacco beyond reclassifying it as pipe  tobacco. Representatives of industry and nongovernmental  organizations provided examples of current pipe tobacco brands that had  been roll-your-own brands prior to CHIPRA, with minimal differences in  the packaging and the appearance of the tobacco itself. For both our  2012 report and this testimony, we found examples of Internet retailers  signaling to customers in their marketing that pipe tobacco was suitable  for smoking in roll-your-own cigarettes.
In 2011, we approached 15 pipe tobacco manufacturers based in the  United States to ask about their companies’ actions in response to the  CHIPRA tax changes. Each of the three tobacco manufacturers that  agreed to speak with us explained that their companies switched from  selling higher-taxed roll-your-own tobacco to lower-taxed pipe tobacco to  stay competitive. One company changed the cut of its roll-your-own  tobacco and labeled it as pipe tobacco, although a company  representative acknowledged that there was no real difference between  its roll-your-own tobacco and its pipe-cut tobacco. A representative from  another company that switched from selling roll-your-own tobacco to  selling pipe tobacco stated that she was not aware of any difference in  the two products other than the federal excise tax rate. As of April 2014,  each of the three companies continued to manufacture the same brand of  pipe tobacco.
section_title: The Market Shift from Roll-Your-Own to Pipe Tobacco Continues despite Provision in 2012 Law
paragraphs: We noted in our 2012 report that the rise in pipe tobacco sales after  CHIPRA coincided with the growing availability of roll-your-own machines.  Treasury officials stated that the use of roll-your-own machines, which  enabled customers to produce a carton of cigarettes using pipe tobacco  and cigarette-paper tubes with filters, had grown considerably. By using  pipe tobacco instead of roll-your-own tobacco, customers were able to  save almost $9 per carton in federal excise taxes. In addition, a roll-your- own machine could produce a carton of cigarettes in less than 10  minutes, providing a significant time saving compared with rolling  cigarettes by hand.
Following the publication of our report in April 2012, the President signed  the Moving Ahead for Progress in the 21st Century Act (MAP-21) on July  6, 2012, which clarified the definition of “manufacturer of tobacco  products” for tax purposes. The relevant MAP-21 provision amended the  IRC and states that the term manufacturer of tobacco products shall  include any person who, for commercial purposes, makes available for  consumer use a machine capable of making cigarettes, cigars, or other  tobacco products. As a manufacturer of tobacco products, such a  person is liable for the federal excise tax on the resulting tobacco  products. According to Treasury officials and experts, some retailers  responded to the MAP-21 legislation by establishing social clubs that  make available to their members machines capable of making cigarettes  from pipe tobacco. However, according to Treasury’s guidance, the tax  liability applies to any person who for commercial purposes makes the  machine available for use by consumers of tobacco products regardless  of whether the machine is used at a retail premises. The guidance goes  on to state that the nonprofit status of the “person” is not relevant in  evaluating “commercial purposes.”
The statutory and regulatory requirements for manufacturers of tobacco  products include obtaining a permit from Treasury before engaging in  business; filing tax returns and paying the federal excise tax on a  semimonthly schedule; paying a special (occupational) tax; obtaining a  bond; and complying with Treasury’s record-keeping, reporting, and  inventory requirements. Following the passage of MAP-21, Treasury  received 92 applications for tobacco manufacturer permits; it determined  that only 4 of these applications involved roll-your-own machines. Of the 4  applicants, none are currently manufacturing under the requested permit:  the applicants have either gone out of business, are no longer pursuing  their application, or are currently being investigated by Treasury.
As figure 3 above demonstrates, since July 2012 the sales of roll-your- own tobacco have continued to decline, while the sales of pipe tobacco  have continued to grow. Despite the MAP-21 legislation, the disparity in  the federal tax rates, introduced by CHIPRA in 2009, maintains an  incentive for the substitution of higher-taxed roll-your-own tobacco with  lower-taxed pipe tobacco by price-sensitive consumers and for the  operation of roll-your-own machines for commercial purposes without  proper permits and payment of federal excise taxes by retailers. When  we visited a tobacco store near Washington, D.C., in April 2014, we  observed a large price differential between roll-your-own tobacco and  pipe tobacco. For example, we bought a 6-ounce bag of pipe tobacco for  $13.77 and a 6-ounce bag of roll-your-own tobacco for $26.49, inclusive  of federal and state taxes.
As part of its ongoing enforcement efforts related to MAP-21, since  October 2012 Treasury has sent out warning letters to 1,467 persons  suspected of making roll-your-own machines available to consumers for  commercial purposes. Treasury officials stated that to date Treasury’s  Alcohol and Tobacco Tax and Trade Bureau has completed 34  investigations of such persons. In all locations where roll-your-own  machines were found, Treasury determined that they had been made  available to consumers for commercial purposes without the proper  permit. Treasury officials also stated that as of July 2014 the Alcohol and  Tobacco Tax and Trade Bureau had 37 open investigations related to roll- your-own machines and that most of these investigations involved social  clubs.
section_title: Cigar Market Shifted from Small to Large Cigars after CHIPRA
paragraphs: CHIPRA’s 2009 changes in federal excise tax rates on tobacco products  resulted in an immediate shift in the cigar market, with sales of lower- taxed large cigars rising sharply while sales of higher-taxed small cigars  dropped. CHIPRA significantly changed the tax rates on cigars, resulting  in a large tax-rate disparity between low-priced large cigars and small  cigars.
Figure 4 shows the market shift through monthly and annual sales of  domestic and imported small and large cigars from October 2000 through  February 2014. Total annual sales of large cigars grew from about 5.8  billion sticks in fiscal year 2008 to 12.4 billion sticks in fiscal year 2013, an  increase of about 115 percent. Over the same period, total annual sales  of small cigars declined from about 5.7 billion sticks to 0.7 billion sticks, a  decrease of 88 percent. While sales for both domestic and imported  large cigars increased significantly after CHIPRA, the sales of imported  large cigars quadrupled, growing from about 1 billion sticks (or 17 percent  of the total large cigar sales) in fiscal year 2008 to 4.4 billion sticks (36  percent) in fiscal year 2013. By contrast, the sales of imported small  cigars decreased from about 357 million sticks to 58 million sticks over  the same period.
According to government officials and representatives of  nongovernmental organizations, because weight is the only characteristic  that distinguishes small cigars from large cigars, cigar manufacturers  made their small cigars heavier to qualify for the large cigar tax rate and  avoid higher taxes levied on small cigars after CHIPRA. CHIPRA’s  changes to the federal excise tax rate on large cigars created an incentive  for small cigar manufacturers to switch to making large cigars when the  manufacturer’s or importer’s sale price per thousand cigars is $95.40 or  lower. According to Treasury officials and other industry experts, prior to  CHIPRA, many small cigars weighed close to 3 pounds per thousand  sticks, which is the dividing line between small and large cigars set by the  IRC. Small cigars that weighed just under or exactly 3 pounds per  thousand sticks would be able to qualify as large cigars with minimal  changes. CHIPRA produced incentives for small cigar manufacturers to  alter their product to meet the definition of a lower-taxed large cigar. The  same companies could use the same machines to add a small amount of  weight to their product, turning small cigars into a product legally defined  and taxed as large cigars. For example, manufacturers could add weight  by packing the tobacco more tightly. Some manufacturers then changed  their labels from “small cigars” to “filtered cigars” or “cigars”—often with  the same packaging and design. Treasury officials stated that the agency  lacks the authority to remedy the tax revenue losses resulting from  manufacturers’ legitimate modifications of small cigars to qualify them for  the lower tax rate on large cigars.
section_title: Market Shifts to Avoid Taxes Have Reduced Federal Revenue, and Treasury Has Limited Options to Respond
subsections: section_title: Estimated Federal Revenue Losses from Market Shifts after CHIPRA Range from $2.6 Billion to $3.7 Billion
paragraphs: While tax revenue collected for domestic and imported smoking tobacco  products, including cigarettes, from April 2009 through February 2014,  amounted to about $77 billion, we estimate that federal revenue losses  due to the market shifts from roll-your-own to pipe tobacco and from small  to large cigars range from approximately $2.6 billion to $3.7 billion for the  same period. This range includes combined tax revenue losses for the  roll-your-own and pipe tobacco markets, as well as the small and large  cigar markets. We conducted analyses of data from Treasury, CBP, and  BLS to estimate tax revenue losses in these markets. Our methodology  takes into account the expected fall in demand for a product following a  price increase, holding other variables constant. To calculate the range of  federal revenue losses, we included high and low estimates based on  assumptions about the effect of a price increase on projected sales.  Economic studies show that, when the price of a product increases, the  quantity demanded for the product will adjust downward, decreasing at an  estimated rate based on the quantity demanded for the product, that is,  price elasticity. On the basis of our interviews with government officials  and academics and our literature review, we determined that the price  elasticity of demand for the smoking tobacco products ranges from -0.6 to  -0.3 for the low and high revenue estimates, respectively. Our projections  also take into account the historic sales trends for these products and the  tax component of the price.
Tax revenue losses in the roll-your-own and pipe tobacco markets.  Treasury and CBP collected about $1.1 billion in tax revenue from  domestic and imported roll-your-own and pipe tobacco from April 2009  through February 2014. We estimate that during the same period the  market shift from roll-your-own to pipe tobacco reduced federal revenue  by between $783 million and $1.3 billion (see fig. 5).
Tax revenue losses in the small and large cigar markets. Treasury  and CBP collected about $4.2 billion in tax revenue from domestic and  imported small and large cigars from April 2009 through February 2014.  We estimate that during that same period the market shift from small to  large cigars reduced federal revenue by between $1.8 billion to $2.4  billion (see fig. 6).
section_title: Developing Standards to Differentiate between Roll- Your-Own and Pipe Tobacco Presents Challenges to Treasury
paragraphs: Differentiating between roll-your-own and pipe tobacco for tax collection  purposes presents challenges to Treasury because the definitions of the  two products in the IRC do not specify distinguishing physical  characteristics and are based on such factors as the use for which the  products are suited and their packaging and labeling. Treasury officials  and representatives of nongovernmental organizations we spoke with  stated that because the two products were taxed at the same rate prior to  CHIPRA, there was no revenue-related reason to clarify the differences  between the two products beyond the existing statutory definitions.
After the CHIPRA tax changes and the market shift from roll-your-own to  pipe tobacco that immediately followed, Treasury took rulemaking actions  intended to more clearly differentiate the two products for tax collection  purposes. The tobacco industry members’ comments on Treasury’s June  2009 temporary rule on packaging and labeling requirements and July  2010 advance notice of proposed rulemaking on standards to differentiate  roll-your-own and pipe tobacco highlighted the complexity and difficulties  in developing objective standards that clearly differentiate the two tobacco  products. Some industry members expressed concerns that proposed  standards could easily be manipulated by consumers. As of July 2014,  Treasury has not yet issued a final rule to distinguish the two products  based on physical characteristics.
section_title: CHIPRA’s Changes to Tax Rates on Large Cigars Also Present Challenges to Treasury
paragraphs: Treasury’s efforts to monitor and enforce tax payments became more  complex after CHIPRA because many more manufacturers and importers  must now determine their tax liability by applying the tax rate to the sale  price per stick (ad valorem) rather than simply paying the set maximum  tax. According to Treasury officials, prior to CHIPRA, the majority of  domestic manufacturers of large cigars paid the federal excise tax at the  maximum rate of $48.75 per thousand cigars. CHIPRA’s significant  increase in the set maximum tax resulted in many more manufacturers  and importers of large cigars paying taxes based on a percentage of the  manufacturer’s or importer’s sale price, according to Treasury officials.
After CHIPRA, according to Treasury officials, some large cigar  manufacturers and importers began to restructure their market  transactions to lower the sale price for large cigars to obtain the tax  savings of a lower ad valorem rate, creating enforcement challenges.  These Treasury officials stated that some manufacturers and importers  are “structuring” or “layering” sales transactions by including an additional  transaction at a low price before the sale to the wholesaler or distributor  and using this low initial price to calculate the tax. This transaction is  conducted with an intermediary that may have a special contract  arrangement with the manufacturer or importer. A large markup may then  be added to the intermediary’s subsequent sale to the wholesaler or  distributor. This added transaction effectively lowers the manufacturer’s or  importer’s sale price and thus reduces the taxes collected. According to  Treasury officials, these layered transactions have become more  common after CHIPRA. For our 2012 report, Treasury officials noted that  manufacturers and importers of large cigars approached the agency for  advice on different proposals to structure their sales transactions to lower  their taxes and still comply with the law. They also stated that Treasury  had not determined the legality of all these proposals and that, while  Treasury could investigate individual cases, its authority to enforce  additional tax collection from these kinds of large cigar transactions was  limited. For our 2012 report, officials stated that Treasury was carefully  examining the tobacco manufacturer and importer pricing arrangements  and taking corrective actions where appropriate on a case-by-case basis.  In May 2014, Treasury officials stated that the practice of layering cigar  transactions to reduce tax payments continues. They also stated that  industry members may be able to further reduce their tax payments by  importing, instead of domestically manufacturing, large cigars. The  federal excise tax on imported large cigars is based on the price for which  they are sold by the U.S. importer upon release from customs.
In conclusion, in equalizing the federal excise tax rates on roll-your-own  tobacco and small cigars with the tax rate on cigarettes, CHIPRA was  responding to concerns that these products were increasingly used as  substitutes for factory-made cigarettes. However, by introducing large tax  disparities between cigarettes, roll-your-own tobacco, and small cigars,  on the one hand, and pipe tobacco and large cigars, on the other,  CHIPRA has contributed to the substitution of higher-taxed tobacco  products with lower-taxed products. Sales of the lower-taxed pipe tobacco  and large cigars, both domestic and imported, saw significant growth  following CHIPRA, as manufacturers, importers, and consumers sought  to take advantage of the lower-taxed products. We estimate that this tax  avoidance behavior has resulted in between approximately $2.6 billion  and $3.7 billion in lost federal revenues since April 2009.
In the absence of legislative changes, Treasury has limited options for  effectively addressing the continued tax avoidance behavior reflected in  the market shifts to pipe tobacco and to large cigars. First, roll-your-own  and pipe tobacco are similar and, in some cases, may be substitutable  products, and the IRC lacks specificity on how they should be  distinguished based on physical characteristics. Treasury has analyzed  various proposals to more clearly and objectively differentiate the two  products based on their physical characteristics. However, the lack of  consensus on which characteristics or criteria truly define and  differentiate roll-your-own from pipe tobacco reveals the complexity and  difficulty of developing standards to distinguish the products from each  other. In addition, there is the concern that products could easily be  manipulated to negate any newly established standards. In a MAP-21  provision enacted in July 2012, Congress clarified the definition of  “manufacturer of tobacco products” for tax purposes to include persons  who make available to consumers machines capable of making  cigarettes, cigars, or other tobacco products. However, the large tax  disparity maintains the tax avoidance incentives driving the market shift  from higher-taxed roll-your-own tobacco to lower-taxed pipe tobacco and  may encourage the operation of roll-your-own machines for commercial  purposes without proper permits and payment of federal excise taxes by  retailers.
Because small and large cigars are distinguished in the IRC only by  weight, and because many small cigars already weighed at or close to the  3 pounds per thousand threshold for classification as large cigars, many  small cigar manufacturers were able to legally shift to the lower-taxed  large cigar category with minimal changes to their products. In addition,  the large cigar tax structure, which consists of an ad valorem tax rate up  to a maximum rate, is complex and creates an incentive to lower the  manufacturer’s or importer’s sale price to avoid paying higher federal  excise taxes.
In responding to a draft of our report in April 2012, Treasury generally  agreed with our overall conclusion that CHIPRA’s introduction of large tax  disparities between similar products contributed to the substitution of  higher-taxed tobacco products with lower-taxed products. Treasury also  agreed with our observation concerning modifying tobacco tax rates to  eliminate significant tax differentials between similar products, which is  consistent with the Matter for Congressional Consideration in our report.  Our work to update the findings of our April 2012 report confirms that the  negative revenue implications of the tobacco tax differentials have  changed little since we issued that report.
We maintain that Congress should consider equalizing tax rates on roll- your-own and pipe tobacco and, in consultation with Treasury, also  consider options for reducing tax avoidance due to tax differentials  between small and large cigars.
Chairman Wyden, Ranking Member Hatch, and Members of the  Committee, this concludes my prepared statement. I would be pleased to  respond to any questions you may have at this time.
section_title: GAO Contact and Staff Acknowledgments
paragraphs: If you or your staff have any questions about this testimony, please  contact me at (202) 512-3149 or gootnickd@gao.gov. Contact points for  our Offices of Congressional Relations and Public Affairs may be found  on the last page of this statement. GAO staff who made key contributions  to this testimony include Christine Broderick (Assistant Director), Sada  Aksartova, Pedro Almoguera, David Dayton, Etana Finkler, Jeremy  Latimer, Grace Lui, and Alana Miller.
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