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Memo to Congress: Yes, you can influence behavior with taxes, but not always the way you intended.

A more than 2,000% increase in the federal tax on roll-your-own tobacco and small cigars has led consumers to roll lower-taxed pipe tobacco and smoke lower-taxed big cigars instead, according to a report released today by Congress’ Government Accountability Office. Not surprisingly, that switch has been aided by manufacturers, who have repackaged and re-sized their products to minimize the tax bite.

The background: When the Democratic controlled Congress reauthorized the State Children’s Health Insurance Program in 2009, it paid for an expansion of the program by raising the federal excise tax on cigarettes by 158%---from $19.50 per thousand to $50.33 per thousand. And, anticipating that smokers---particularly price sensitive teens---might switch from cigarettes to what had been lower-taxed roll-your-own tobacco and small cigars, Congress boosted the levies on those products  all the way up to the  cigarette level.  As a result, the tax on roll-your-own tobacco jumped from $1.10 per pound to $24.78 per pound, a 2,159% increase, while the levy on small cigars (cigarillos) jumped  from $1.83 per thousand to $50.33 per thousand, a 2,653% hike. That change was supported by the Campaign for Tobacco-Free Kids, the American Medical Association, the American Cancer Society and the American Lung Association. The Campaign boldly predicted that the tax increases would prevent two million children from ever starting to smoke.

By contrast, the tax on pipe tobacco was increased by the same 158% as the cigarette tax, going from $1.10 a pound  to $2.83 a bound. The tax on big cigars, which is imposed as a percent of the manufacture’s or importer’s price, increased 155%, rising  from 20.72% of  the price to 52.75% of the price.

President Obama signed the expansion of SCHIPs, which pays for insurance for poor families who earn too much for Medicaid, on Feb. 4, 2009. The tax hike took effect on April 1, 2009.  Since then? According to the GAO, roll-your-own tobacco sales have fallen 74% while pipe tobacco sales have increased more than nine-fold-- from 3.2 million pounds to 30.5 million pounds a year.  See more tweedy pipe-smokers these days?  Nope. Neither did the GAO, which concluded: “The shift can be mostly attributed to consumers switching from using roll-your-own tobacco to pipe tobacco in roll-your-own cigarettes, rather than to a sudden increase in pipe smoking.”

In fact, the GAO noted, manufacturers of roll-your-own tobacco products have simply re-branded their products as pipe tobacco by changing the packaging and labeling, while making minimal, if any, changes in the product. Sometimes, they're not even subtle about it. One manufacturer of "pipe tobacco" brazenly designed its label "with three-letter markings, to indicate to customer the product’s similarity to brand-name cigarettes," the GAO found.  So, for example, "pipe tobacco" marked MRD is supposed to roll into cigarettes that taste like the Altria Group's Marlboro Red and tobacco labeled CML is supposed to replicate Reynolds American Inc.'s Camel Light,  the GAO reported.

The spurt in pipe tobacco sales has coincided with the spread of commercial roll-your-own machines. “By using pipe tobacco instead of roll-your-own tobacco, customers are able to save almost $9 per carton in federal excise taxes,’’ the GAO noted.  The savings can be even greater when state taxes are taken into account too.  GAO testers visited a tobacco outlet store in Maryland and were able to roll a carton of 200 cigarettes in 8 minutes for $25, including state and federal taxes. In nearly retail stores, cartons of discount cigarettes were going for $51.50 and cartons of premium cigarettes for $69.50.

The Treasury knows what’s going on, the GAO said, but is finding it difficult to come up with a rule that distinguishes true pipe tobacco from pipe tobacco that is meant to be rolled into cigarettes.  Treasury proposed a rule that would force retailers who offer cigarette rolling machines to collect the higher cigarette tax as if they were manufacturers. But that rule has been blocked by a federal court.  (Some states, in an effort to protect their own cigarette tax revenues,  have been taking action to ban the machines.)

Meanwhile, since weight is the only thing that distinguishes a small cigar from a large one,  cigar makers have simply increased the size of their stogies to qualify for the lower big cigar tax rate.  The Treasury told GAO that it doesn’t have legal authority to do anything about that.

So how much has this tax-avoidance-by-substitution cost Uncle Sam? The GAO estimated that the shift to pipe tobacco and big cigars means the fed has realized somewhere  between $615 million and $1.1 billion less in taxes than if the product mix hadn’t changed. The GAO didn't directly address whether the substitution had undermined the attempt to prevent price sensitive teens from starting to smoke. But it seems likely to  have had that effect; the sales of roll-your-own and pipe tobacco combined have increased since the passage of the tax hike, the GAO noted.

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