Does bootlegging really make sense as a business model? We asked this question after reading what Tax Foundation lead economist Patrick Fleenor said about interstate cigarette smuggling becoming more common in an opinion piece in the Wall Street Journal back on September 7 of this year (HT: Tax Foundation Policy Blog):

Something similar is going on all over the U.S., where cigarette taxes have on average tripled in the last decade, but treasuries aren't getting the revenue boost. For consumers, tax-free online cigarettes are only a mouse click away, and these purchases now cost the states more than $1 billion a year in lost tobacco taxes, according to the Campaign for Tobacco-Free Kids. Washington state, which levies a tax of $2.03 a pack, loses an estimated $200 million a year to out-of-state purchases, according to the Seattle Times. Californians smoke 300 million untaxed packs of cigarettes a year thanks to the Internet, smuggling, and out of state sales.

In New York City, where the combined city and state tax is $3 a pack, smugglers sell bootlegged cigarettes on street corners much like drug dealers. Three weeks ago a sting operation in Queens busted a black market tobacco ring of "unbelievable proportions," in the words of one official. The sting found a half-million untaxed cartons of cigarettes that were being sold out of car trunks to avoid the tax hit. The Tax Foundation estimates that half the cigarettes smoked in the Big Apple come from such illicit operations.

It would seem from this discussion that bootlegging is really a kind of arbitrage where the difference in the prices of an identical product between two markets creates the opportunity for someone to profit from that difference by buying the product in the lower cost market, transporting it to the higher cost market, then selling the product there at a higher price than what they paid. Only here, nearly all of the difference in the price of the product between two markets is solely the result of the taxes levied upon the cigarettes, which runs afoul of the laws in the places where bootleggers seek to sell their wares.

We wondered just how profitable bootlegging might actually be if we take into account the basic costs associated with the business of bootlegging. To find out, we build the following tool, which takes such factors into account as the difference in taxes per pack of cigarettes between two states, the price at which the bootlegger will be selling their product, the cost of transportion and the cost of labor.

One factor we left out entirely is any business taxes paid by the bootlegger. By definition, the bootlegger's business is all about evading taxes, which we'll assume carries over into their operations....

The default numbers for the tool above are taken for Maryland (as the state in which the bootlegged cigarettes will be sold) with Virginia as the state in which the product will be purchased. The retail price per pack has been increased by $1.00 to show the effect of the tax increase the state's Democratic governor has recently proposed.

One other assumption that we have made is that the bootlegger is competing against the state's established cigarette retailers who must price their packs to include the full state excise tax, which means that the bootlegger must offer a lower price - we've opted for an even $5.00 per pack, but the beauty of our tool is that you can run whatever numbers you like. If you think you could sell at the retail price, plug it in. Or if you think you should sell at a lower price, use that instead!

Speaking of which, we've also assumed that the bootlegger is only hauling 30 cartons of cigarettes across the Maryland-Virginia border in their car once a day, on 260 days in a year - much like the regular commuters whom they would blend in with might do in the regular course of their workday. You might consider increasing the number of cartons being carried (as you might if you filled a van with cigarettes) and perhaps reduce the number of days you bootleg cigarettes across state lines.

Even with the very limited numbers we used, we find that our prospective bootlegger would clear nearly $70,000 in raw profit each year. That probably marks the high end of what a bootlegger could expect as most Maryland smokers would shift to making cross-state cigarette buying trips themselves, but in either case, that's a lot of revenue that Maryland's cigarette vendors and state government aren't going to get unless they go out of their way to target these individuals.

It turns out that state governments targeting individuals making cross state line cigarette runs is not some theoretical exercise. Presently, the state of Tennessee has already initiated a program designed to increase the penalties to individuals found carrying "surplus" cigarette products into the Volunteer State:

Smokers who cross the state line to buy cheaper cigarettes could see their cars searched or seized as Tennessee tax agents start cracking down on the practice, revenue officials announced Friday.

Stores in border towns have seen business dip since July 1, when the state more than tripled its tax on cigarettes to 62 cents — a bump that made per-pack taxes in Tennessee higher than any of its neighbors.

Laws already on the books prohibit people from bringing more than two cartons of smokes across the line on any one trip, and now David Remke with the state Revenue Department is warning Tennesseans that his staff plans on enforcing the often-ignored rule.

He said the state is out to protect its corner stores and tobacco shops.

"It's not fair to them that they've lost a lot of their business," said Remke, director of special investigations. "Really from this point forward, people need to be aware" of the law.

Clarksville resident Sherman Allen didn't know it was illegal to stock up on tobacco in other states, and he wasn't happy about it when he found out about the crackdown.

"They can't do that. People have a right to buy where they want to buy," he said while shopping at a convenience store in Oak Grove, Ky. He buys all his cigarettes across the state line. "They can't dictate where I buy nothing."

Not being Tennessee tax agents, we're not exactly sure how this practice doesn't trip over both the fourth amendment restrictions against unreasonable searches and seizures of private property and the commerce clause in the U.S. Constitution, but that doesn't make any such "enforcement" exercise any less of a risk for those seeking the best price for cigarettes.

At the very least though, we find that the potential money that might be made from exploiting a state's poorly considered tax policy will prove to be an irresistable lure for individuals seeking to make it big through the black market.

Labels: business, economics, tool

- posted by Ironman at 8:46 AM | Permalink | |