California About to Destabilise its Three-Legged Cigarette Tax Compliance Programme

The California State Auditor (CSA) recently issued its second report in ten years on the Cigarette and Tobacco Products Licensing Act of 2003 (‘Act’). In its 2006 review, the CSA had looked at the Act and its implementation as a system that, in its entirety, worked from the culmination of three separate, yet complimentary strategies to ensure tax compliance, further referred to as three-legged. The first ‘leg’ required all tobacco-selling entities, including retailers, to be licensed; the second was the implementation of a new cigarette tax stamp with encrypted digital coding; and the third was an increase in retailer, distributor and wholesaler inspections.

Article originally published in Reconnaissance's Tax Stamp News™.

The CSA had concluded that the three-legged approach of the Act, in its entirety, had reduced tax evasion. The CSA highlighted that ‘neither the California Board of Equalization (BOE), nor the CSA ‘can isolate how much of the increased revenue in calendar year 2005 was the result of the Act and how much was the result of the new tax stamp’. As a result, CSA and BOE looked at results and costs as a whole, which has ensured appropriate enforcement funding since 2005. The CSA report of 2016, however, takes a deviation from this approach. The CSA still reports that the Act has reduced tax evasion, but it is looking at the issue of funding in two separate parts: the tax and the licensing programme.

California’s two-programme set-up is unusual. Looking across various US states, licensing fees are customarily imposed to cover only the administrative costs of running the actual licensing programme – such as issuing, maintaining and revoking licenses – but are normally not used to provide the sole funding for retail inspections and tax enforcement. As best practice, enforcement is normally funded from excise tax revenues, penalties, proceeds from seizures or forfeitures, and excess licensing fees to ensure sufficient enforcement funding. Not surprisingly, the CSA identified that current licensing fees are not able to sustain licensing, as well as inspection and enforcement efforts required.

However, rather than provide a recommendation to the legislature to permanently fix this situation (by moving the inspection and enforcement expense under the tax programme), the CSA chose to recommend an increase in licensing fees instead (which are lower than those in several other states), as well as a potential cigarette excise tax increase and a reduction in enforcement inspections.

While the CSA’s view is technically correct, since the California legislature enacted the Act as two separately funded programmes, it could potentially destabilise the three-legged stool by weakening two legs, and transferring the cost burden to combat illicit trade on the legitimate businesses who play by the rules.

Increase rather than decrease enforcement Reducing enforcement efforts to close the licensing budget shortfall is likely to exacerbate cigarette tax evasion in California. The BOE collected $835 million in excise taxes in fiscal year 2012-13, but estimates that it did not collect $214 million in tax revenue due to tax evasion (albeit that this figure also covers other tobacco products, that are not subject to tax stamps). If this estimate is accurate the BOE is currently not collecting over 20% of excise taxes owed.

The CSA noted that the reason for tax evasion is the result of:

(1) ‘retailers that purchased and sold cigarettes without the encrypted stamps’;

(2) ‘consumers evad(ing) taxes by purchasing products from distributors that did not pay the required taxes, perhaps by purchasing in another state and then transporting them back to California’. But the logical way to combat this rather significant black market is through increased enforcement, rather than decreased enforcement.

To put current and future enforcement costs into perspective, it is important to look at the current costs of the three-legged approach:

  • Licensing efforts to process registrations and collect against licensing violations costs California $3.4 million annually;

  • Costs to procure, distribute and execute the encrypted cigarette stamps is currently $8.1million per year (including. investigation tools, such as scanners, MSA look-up and e-filing);

  • Enforcement through inspections and investigations costs $5.6 million per year.

Given these current costs, the CSA could have identified stamp procurement cost opportunities to help offset any budget shortfall, given that costs to procure, distribute and execute the encrypted stamp system are almost as large as licensing and enforcement costs combined. And if California is supposed to become the benchmark for tax stamp programmes in the United States, it will be useful to understand which of the encrypted stamps’ many features and functionalities justify the increased costs without compromising the success and effectiveness of the programme.

The CSA has an opportunity to help identify which of the tax stamp features provide the greatest return on investment and how these expenses compare in effectiveness to spending on enforcement or licensing. The CSA reports of 2006 and 2016 showed that BOE’s ‘enforcement efforts – licensing all entities involved in the sale of cigarette and tobacco products, inspecting roughly 10,000 of these entities each year, and affixing the encrypted tax stamp on every pack of cigarettes – have substantially reduced tax evasion’.

A comprehensive regulatory schema, such as the California Act cannot achieve its full potential without strong corresponding compliance and enforcement efforts. In addition, the publication of enforcement efforts and actions act a deterrent and incentive for voluntary compliance. It will be important for California to maintain equal strength among all three legs of its three-legged approach, not shorten two legs. Anyone who has sat on a bar stool with two legs shorter and weaker than the third knows how this could end.

Sven Bergmann is a Managing Partner at Venture Global Consulting and advises brand owners, technology providers and governments on anti-counterfeit strategies, programmes and technologies.

Send your comments to SBergmann@VentureGlobalCo.com.


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