How far to the border? The extent and impact of cross - border casual cigarette smuggling.

There are two potential explanations for the finding that increasing home state prices can actually increase consumption. The first explanation rests on the fact that, conditional on the decision to smuggle, a consumer who smuggles will face a lower per-pack price than the consumer who purchases in her home state. If the fixed cost of smuggling is small relative to the per-pack price savings, it is reasonable to expect consumers who smuggle to smoke more than observationally similar consumers who do not smuggle. My results are consistent with such behavior as those close to lower-price borders are those for whom the fixed cost of smuggling is low, and I estimate home state price increases increase their cigarette consumption.

A second explanation is more behavioral, but also is conditional on the existence of fixed smuggling costs. There is much evidence in the marketing literature of an "inventory effect" on consumption: if a consumer faces larger package sizes or stockpiles the good, consumption will increase (Wansink, 1996; Wansink and Park, 2001; Chandon and Wansink, 2002). Such research is relevant to this study because when individuals purchase cigarettes in border localities, they are more likely to purchase in bulk due to the fixed travel cost of obtaining the cigarettes. The increased inventory after purchase may cause more consumption, especially in light of the fact that cigarettes are addictive. Thus, if those living close to lower-price borders are more likely to stockpile cigarettes due to the fixed costs of obtaining their cigarettes, then the inventory effect would imply those living close to a lower-price border should smoke more than those on the other side of the border. Indeed, while a direct test of the inventory effect is beyond the scope of my data, I calculate in MSAs that split state lines, those on the high-price side smoke, on average, 0.35 cigarettes more per day among smokers and have a smoking rate that is 1.2 percent higher than those on the low-price side. While these tabulations and my results are consistent with the existence of an inventory effect, further research in this area is needed.

CONCLUSION

Using data from the CPS Tobacco Supplement for four years over the period 1992-2002, this paper has developed and estimated a cigarette demand model that explicitly accounts for cross-border purchases. Unlike previous studies using individual consumption data, I am able to distinguish between the elasticity with respect to the home state price and the elasticity with respect to the full price of cigarettes, both of which are important parameters in setting effective state cigarette tax policy.

My estimates imply increasing state cigarette taxes, on average, has little impact on smoking behavior; the home state price elasticity is modest in magnitude across the majority of specifications. In fact, in all specifications, the home state price elasticity is indistinguishable from zero. There is, however, a large amount of heterogeneity across states in the effect of tax increases on consumption that is based on the geographic distribution of the population. In contrast, my findings suggest the full price elasticities are negative and are of sizeable magnitude, though also inelastic.

Using the parameters from my demand model, I estimate directly the percent of consumers who purchase in a lower-price jurisdiction as well as the net change in sales due to such behavior. My results indicate between 13 and 25 percent of consumers purchase cigarettes in a lower-price state or Native American Reservation. These estimates represent a lower bound on the percent of cigarettes purchased in border localities and suggest cross-border sales are significantly more prevalent than has been found in previous work (Stehr, 2005). Further, I find significant heterogeneity across states in the sales and revenue effects of casual smuggling.

The large magnitude of smuggling combined with the inelastic home state price elasticities suggest state-level cigarette taxation may be a poor policy instrument with which to decrease smoking and increase home state tax revenues in many states. However, that the full price elasticities are negative and significant across all specifications implies state-level cigarette excise taxes could be a useful tool to change smoking behavior and raise revenue if smuggling were eradicated. Slemrod (2007) found reducing organized smuggling incentives through a cigarette stamping law in Michigan had just such an effect.

The central implication of this study is, while cigarette taxes are ineffective in many states at achieving the goals for which they were levied, there are significant potential gains from price increases that are confounded by cross-border sales. From a policy standpoint, states with large populations near lower-price borders may be better served by expending resources to reduce casual smuggling or by lowering the excise tax to reduce the smuggling incentives supplied by a positive border price differential. In the absence of such policies, differential price increases across states will continue to be counterproductive for many states attempting to decrease smoking behavior and increase tax revenues.

Acknowledgments

I would like to thank Joel Slemrod, John Bound, Jeff Smith, Paul Courant, Jim Hines, Charlie Brown, Gary Solon, Don Kenkel, Matthew Powers, and three anonymous referees for their helpful comments and suggestions as well as seminar participants at the University of Michigan and the National Tax Association Annual Meeting. Scott Swan, at the Center for Statistical Consultation and Research, provided invaluable technical support for the geographic analysis. This project has been generously funded by Rackham Graduate School and the Institute for Social Research at the University of Michigan and by the Searle Freedom Trust.

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