Arbitrage in Flavor Country

One of the hazards of levying excessive excise taxes at the state level is that, in some cases, smugglers can take advantage of arbitrage. This is not such a problem with a commodity like gasoline. Sure, Georgia may have lower excise taxes on gas (and thus, a lower price) than Florida. But, it is almost impossible for a third-party to profit off of this differential, since gasoline is difficult to transport and sell outside of a designated service station.

Cigarettes, however, are another matter. The Wall Street Journal reports:

States across the U.S. have been taking a harder line against an old problem -- cigarette smuggling -- as part of the widening search for solutions to their budget problems.

States including Florida, Maryland, Michigan, New York, Rhode Island and Virginia this year have stepped up law-enforcement efforts with the aim of recouping taxes lost to bootleg cigarette sales.

Studies indicate states are losing about $5 billion annually in tax revenue because of illegal tobacco sales, said Phil Awe, who heads the tobacco-diversion division of the Bureau of Alcohol, Tobacco, Firearms and Explosives.

"We do not want to have our tax laws ignored and lose tax revenue from legitimate sales of cigarettes," Maryland State Comptroller Peter Franchot said of the crackdown. He estimates that his state is losing "hundreds of thousands of dollars" annually.

Even worse, organized crime is replacing what was once "mom-and-pop" smuggling operations:

In one recent case, an undercover investigation by the New York State Department of Taxation and Finance led to the arrests of 18 residents of Nassau and Queens counties. Investigators from the tax department posed as cigarette bootleggers and sold illegal, untaxed cigarettes to a network of store owners, including two 7-Eleven operators. The operation cost state and local governments $2.1 million in uncollected taxes.