Smuggling and Counterfeiting

Evasion of cigarettes taxes in the developed world occurs in two forms, smuggling and counterfeiting.

The smuggling form involves cigarettes that have incurred tax somewhere and that were legal through all but the last steps of the supply chain.  A typical transaction involves a pack of cigarettes bought legally and tax-paid in a low-tax tobacco-producing state and resold illegally without further tax in a high-tax jurisdiction like New York City.  Those cigarettes were cost-effectively manufactured by an identifiable, deep-pocketed corporation that tested them for quality  — on which its reputation depends.  They bore federal tax and the tax of some state (or maybe tax of some country).  They are in a recognizable branded package, designed by the manufacturer to prevent counterfeiting.  Customers know what they are getting.  Analogous jurisdiction-shifting evasion for marijuana will not appear until at least two jurisdictions legalize it.  Then bootleggers will be interested in transporting tax-paid marijuana from a low-tax state to a high-tax state.  As today’s Wall Street Journal points out, tobacco companies may turn a blind eye to smuggling: “Tobacco Firms Step Up Fight Against Cigarette Smuggling:  Labs Examine Fake Smokes; Critics Say Industry Turns Blind Eye to Smuggling of Real Cigarettes.”

The counterfeiting form also turns up in today’s Wall Street Journal.  Cigarette companies are on the side of government here, “attempting to keep up with counterfeiters’ increasingly sophisticated production techniques.” “[E]lectron microscopes peer at packaging” that imitates that of real cigarettes.

This cigarette counterfeiting calls to mind counterfeiting of Viagra.  There, government comes to the aid of industry.  Intangible-intensive manufacturers depend on the rule of law to protect huge mark-ups between the cost of raw ingredients and the price the consumer pays.  The intangible premium for pharmaceuticals is different in some respects from the illegality premium for marijuana, but it is enormous.  Despite high fixed costs, the main reason patented pharmaceuticals command high retail prices is not that they are hard to reverse engineer and manufacture.[1]  The main reason for those high prices is that government won’t allow unlicensed wildcat producers and sellers to operate openly and freely.  To be sure, the rule of law alone does not maintain high retail prices.  Packaging, distribution, and marketing costs are high.  Legal producers join government in protecting against unauthorized competitors.[2]  Branding adds value.  Consumers’ fear of fake pharmaceuticals drives them into legitimate commerce; sellers of bootlegged marijuana would quickly overcome consumer skepticism and put pressure on legal prices.  But government power forcing commerce into legal channels by shutting down illegal competition is a factor to reckon with.

[Much of this appeared in “Gangs, Ganjapreneurs, or Government: Marijuana Revenue up for Grabs,” State Tax Notes, Volume 66, Number 4, pages 255-269 (October 22, 2012), online at http://ssrn.com/abstract=2165864.]

[1] In 2000, an Indian manufacturer “[made] sildenafil citrate, the active ingredient in Viagra, for 2 cents a pill” with a 10 cent per pill selling price in mind.  Donald G. McNeil, Jr., “Selling Cheap ‘Generic’ Drugs, India’s Copycats Irk Industry,” The New York Times (Dec. 1, 2000), http://www.nytimes.com/2000/12/01/world/selling-cheap-generic-drugs-india-s-copycats-irk-industry.html?pagewanted=all&src=pm.  But “[i]n January 2005, India amended its patent laws governing pharmaceuticals” to conform with world standards, so “Indian drug markers can no longer manufacture and market reverse-engineered versions of drugs patented by foreign drug producers.”  William Greene, U.S. International Trade Commission, “The Emergence of India’s Pharmaceutical Industry and Implications for the U.S. Generic Drug Market” (Office of Economics Working Paper), http://www.usitc.gov/publications/332/working_papers/EC200705A.pdf (May 2007).  While Viagra is much harder to produce and verify than marijuana, and real Viagra is preferable to even a sophisticated copy, Viagra prices are nearly an order of magnitude greater than any prices suggested for taxed marijuana.  Viagra comes in 25 mg., 50 mg., or 100 mg. pills.  Spectrometer-tested Viagra can (but rarely does) sell at retail for as little as $12.50 per 100 mg. pill, or $125 a gram.  Roger Bate and Kimberly Hess, “Assessing Website Pharmacy Drug Quality: Safer Than You Think?” Table 3, http://www.ncbi.nlm.nih.gov/pmc/articles/PMC2921371/?tool=pmcentrez (Aug 13, 2010).  See also Mary Hiers, “Cost of Viagra at CVS, Walgreens, and Walmart,” http://www.accessrx.com/blog/erectile-dysfunction/cost-viagra-cvs-walgreens-walmart/ (Apr, 25, 2012) (online supplier claiming that name-brand retailers charge over $200 per gram).

[2] Illegal copiers of pharmaceuticals may foreshadow another front that bootleggers may open in any price war.  Viagra’s manufacturer warns consumers of fake packages that “have foil, have holograms, have any sort of trademarking that you’d want to look for.”  Pfizer Corp., http://www.youtube.com/watch?v=6S4kuz5Dhm0&feature=youtu.be (Aug. 22, 2011).