Academic journal article Economic Inquiry

The Demand for Cigarette Smuggling

Academic journal article Economic Inquiry

The Demand for Cigarette Smuggling

Article excerpt

INTRODUCTION

An enduring issue in economic analysis involves accounting for the behavior of agents when illegal or quasi-legal activity is rewarded. Smuggling, retrading under regulations or restrictions, bribery, and bootlegging are all aspects of the general phenomenon. Common contemporary forms of such activity are the smuggling of prohibited substances such as drugs or medicines, prohibited arms or weapons, or highly taxed commodities between countries.(1) But smuggling or bootlegging of highly taxed or otherwise regulated legal commodities such as alcohol, cigarettes, or gasoline also takes place within countries. In the United States, such illegal activity, both "casual" and "organized", may have significant effects on state tax revenues. It may also alter the expected consumption effects of specific tax changes. In a competitive environment, the existence of different tax structures between states may mean that a given state's tax enactments will not have their desired revenue or consumption effects.

This paper offers a new econometric methodology for estimating the economic effect of "border crossing" between U.S. states. Our technique, in contrast to previous models of cross-border effects, allows accommodation of the dichotomy between variations in state-level sales due to state-specific characteristics such as prices, tastes, incomes and other demographic factors, the presence of organized smuggling, tourism, and so on, and demand variations due to casual border crossing. Beginning with a simple theoretical model of a representative consumer's border-crossing decision, we develop a nonlinear econometric model which produces estimates of the representative consumer's demand in each state. It allows estimation of the degree and direction of sales to border-crossing consumers for each state and facilitates explicit testing of the statistical significance of border crossing in explaining variations in cigarette sales between jurisdictions. The data set is comprised of state-level cigarette sales for the forty-eight contiguous states and the District of Columbia over the period 1960 to 1986. We obtain strong evidence that border crossing is a significant factor in explaining cigarette sales differentials and we identify states which have important border-crossing sales. Further, we note the consequences of border crossing for demand elasticity estimation and tax policy: in general, the evidence indicates that the ability of states to raise revenue via cigarette taxation is more constrained than conventional analysis suggests.

The paper is divided into five sections. Section II discusses bootlegging and previous literature on cigarette demands and smuggling. Section III presents our theoretical and empirical models, while section IV discusses the data and our statistical results. Section V concludes the paper and examines some of the policy implications of our findings.

II. THE ECONOMIC LITERATURE ON SMUGGLING

Smuggling, bootlegging or "arbitrage" takes place when full prices (net of all costs) differ for legal or illegal goods between specific economic units. When net returns to smuggling or bootlegging - all production and consumption opportunity costs being considered - are positive, arbitrage will occur in an organized and/or casual fashion. A primary (though not an exclusive) reason for smuggling has been the often-significant divergence between full prices in different locales caused by differences in tax treatment.

A variety of models starting with Wales [1968], have been employed to analyze problems related to smuggling and bootlegging. Jensen, Thursby, and Thursby [1988], and Bhagwati and Hansen [1973]) study "Camouflaging" systems - the mixture of legal and illegal sales - from the firm's perspective with contrasting welfare results. Smith [1976] integrates illegal markets into the traditional theory of taxation but explicitly ignores casual smuggling. Earlier studies considering cross-border effects have not specified a theoretical foundation and, in this respect, our approach is fundamentally different. …

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