Cigarettes continue to dominate the smoking tobacco product market, accounting for approximately 91 percent of sales in 2011. However, the use of other smoking tobacco products has increased over the past 10 years. Between 2001 and 2011, combined sales of roll-your-own tobacco, pipe tobacco, and small and large cigars grew from 3 percent of the smoking tobacco market to 9 percent. Although cigarette use in the United States is declining, it is partially offset by growing use of other smoking tobacco products. (See app. II for data on U.S. sales of smoking tobacco products from fiscal year 2001 through fiscal year 2011.) Increasing the price of tobacco products by raising excise taxes is widely recognized as an effective policy for reducing smoking prevalence across socioeconomic and racial groups. Public health and economic studies have found that adolescents are more responsive than adults to tobacco tax and price increases because they have less disposable income. However, the impact of tax increases on reducing overall smoking prevalence is likely to be weaker if smokers can turn to tobacco products that can be used as functional equivalents of factory-made cigarettes and cost significantly less, according to public health officials and academics. Smoking tobacco products are broadly defined in the IRC. Roll-your-own tobacco and pipe tobacco are defined by such factors as the use for which the product is suited and how they are offered for sale, as indicated by their appearance, type, packaging, and labeling. Cigars are differentiated from cigarettes by their wrapper and whether the product is, for a number of reasons, likely to be offered to, or purchased by, consumers as a cigarette. The tax rate for cigars is categorized into small and large cigars, which are differentiated by a weight threshold alone— small cigars are defined as weighing 3 pounds or less per thousand sticks. The definitions found in the IRC characterize five types of smoking tobacco products that are relevant to our discussion, as shown in table 1. Figure 1 shows a sample of different cigarette and cigar products. Several of the products closely resemble each other in size and shape. The three on the left are cigarettes. The first is a roll-your-own cigarette made by hand with roll-your-own tobacco. The second is a roll-your-own cigarette made in a commercial roll-your-own machine with pipe tobacco. And the third from the left is a factory-made cigarette. The three products on the right are cigars, which can vary widely in size, shape, flavor, and aroma. According to industry representatives, a nongovernmental organization, and government officials, traditionally, cigars are hand-rolled, wrapped in a tobacco leaf, large in size, and their smoke is not meant to be inhaled. However, they indicated that many small and large cigars now have filters, are wrapped in a type of paper made with tobacco, and can be similar in size and appearance to cigarettes. While the enactment of CHIPRA in 2009 represents the most recent increase in federal excise taxes on tobacco products, Congress has taxed tobacco products since its inception as a means to raise revenue. Of the smoking tobacco products that we discuss in this report, Congress taxed only cigarettes, small cigars, and large cigars prior to 1989. Congress began taxing pipe tobacco on January 1, 1989, and roll-your-own tobacco on January 1, 2000. As the danger of tobacco became better known, congressional debates surrounding tobacco taxes expanded from increasing revenue to protecting the public from health risks of tobacco. Figure 2 shows the tax rates for four smoking tobacco products from 1951 to 2010. The federal excise tax rates on different tobacco products are calculated in different ways. Cigarettes and small cigars are taxed on a unit basis— number of sticks. Roll-your-own and pipe tobacco are taxed by weight. Table 2 provides information on the different federal excise tax rates for cigarettes, roll-your-own tobacco, pipe tobacco, and small cigars before and after CHIPRA. Before CHIPRA, the federal excise tax rate on cigarettes was higher than the rates on roll-your-own tobacco, pipe tobacco, and small cigars. However, CHIPRA significantly raised the tax rates on these four products and equalized the rates on cigarettes, roll-your-own tobacco, and small cigars (see fig. 3). Congress equalized the tax rates on roll- your-own tobacco and small cigars with the cigarette tax rate in part in response to concerns that smokers had been using these two products as substitutes for higher-taxed factory-made cigarettes, according to nongovernmental organizations. CHIPRA also raised the federal excise tax rate on pipe tobacco, but to a rate that is considerably lower. Prior to CHIPRA, the tax rate on roll-your-own tobacco and pipe tobacco was the same. CHIPRA significantly changed the federal excise tax rate on large cigars. Large cigars are unique among tobacco products in that the tax rate is ad valorem—a percentage of the manufacturer’s or importer’s sale price per thousand sticks—up to a maximum tax per thousand sticks. Before CHIPRA, large cigars were taxed at 20.72 percent of the manufacturer’s or importer’s sale price up to a maximum tax of $48.75 per thousand sticks. After CHIPRA, the ad valorem rate increased to 52.75 percent of the manufacturer’s or importer’s sale price, and the maximum tax per thousand sticks increased to $402.60 (see table 3). According to an industry association, the retail prices of premium handmade large cigars range from $3 to $20. A public health organization noted that smaller factory-made cigars that meet the legal definition of a large cigar can cost as little as $0.07 per cigar. Figure 4 illustrates the tax structure for large cigars, before and after CHIPRA and includes three different scenarios. The sloped line represents the ad valorem rate, which becomes flat when it reaches the maximum tax per thousand cigars. The following are examples of the federal excise taxes manufacturers and importers would have to pay for differently priced large cigars, before and after CHIPRA (see examples corresponding with fig. 4): A. If the manufacturer’s or importer’s sale price per thousand large cigars is $100, before CHIPRA the ad valorem tax rate was $20.72 per thousand; after CHIPRA it became $52.75 per thousand. B. If the manufacturer’s or importer’s sale price per thousand large cigars is $500, before CHIPRA the tax rate was the maximum tax of $48.75 per thousand; after CHIPRA it became $263.75 per thousand based on the new ad valorem tax rate. C. If the manufacturer’s or importer’s sale price per thousand large cigars is $800, before CHIPRA the tax rate was the maximum tax of $48.75 per thousand; after CHIPRA it became $402.60, which is the new maximum tax rate per thousand. Treasury is responsible for administering and collecting the federal excise tax on all tobacco products, among other things. In general, federal excise taxes are collected when tobacco products leave the domestic factory or, in the case of imports, when the products are released from customs custody. Tobacco manufacturers and importers are required to obtain a Treasury permit to operate and must comply with Treasury’s recordkeeping, reporting, and other requirements. Tobacco product wholesalers and distributors are responsible for paying state and local excise taxes, but they are not required to obtain a Treasury permit and are not subject to Treasury recordkeeping requirements. Figure 5 shows the major steps in the tobacco supply chain, including the key points at which taxes are paid. In the Tobacco Control Act passed in June 2009, Congress amended the Food, Drug, and Cosmetic Act by inserting a chapter governing tobacco products and granting FDA authority to regulate the manufacture, distribution, and marketing of tobacco products under that chapter. The act aims to, among other things, reduce the use of tobacco products to decrease health risks and social costs associated with tobacco-related diseases. It recognizes that virtually all new users of tobacco products are adolescents under the age of 18. According to the law, FDA’s regulation of tobacco products is based, in part, on a public health standard rather than the safety and effectiveness standard by which FDA regulates pharmaceutical drugs and medical devices. For example, FDA can issue restrictions on the sale, distribution, advertising, and promotion of a tobacco product, if the public health standard is met. This standard requires FDA to demonstrate that the proposed regulation is appropriate for the protection of public health, based on a consideration of the risks and benefits to the population as a whole, including users and nonusers of tobacco products. The act specifies that FDA’s authority over tobacco products under Chapter IX of the Food, Drug, and Cosmetic Act shall apply to cigarettes, roll-your-own tobacco, cigarette tobacco, and smokeless tobacco, as well as any other tobacco products that the agency deems by regulation to be subject to such authority. FDA does not at present regulate pipe tobacco and small and large cigars. To implement the Tobacco Control Act, FDA has established the Center for Tobacco Products. Large federal excise tax disparities among tobacco products resulting from CHIPRA caused sizable market shifts from higher to lower-taxed products. According to our analysis and interviews with knowledgeable sources, the tax disparities created incentives for price sensitive manufacturers and consumers to substitute higher-taxed products with lower-taxed products. The market for roll-your-own tobacco shifted to pipe tobacco and the growth rate of the combined market increased after CHIPRA. Roll-your-own tobacco manufacturers shifted to pipe tobacco with minimal, if any, changes to the products, and consumers substituted pipe tobacco for use in roll-your-own cigarettes.