The federal excise tax rates on different tobacco products are calculated  in different ways. CHIPRA also raised the federal excise  tax rate on pipe tobacco, but to a rate that is considerably lower. CHIPRA’s 2009 changes in federal excise tax rates on tobacco products  also resulted in an immediate shift in the cigar market, with sales of lower- taxed large cigars rising sharply while sales of higher-taxed small cigars  dropped. Market Shifts to Avoid Taxes Have Reduced Federal Revenue, and Treasury Has Limited Options to Respond

While tax revenue collected for all smoking tobacco products from April  2009 through the end of fiscal year 2011 amounted to $40 billion, we  estimate that the market shifts from roll-your-own to pipe tobacco and  from small to large cigars reduced federal revenue by a range of  approximately $615 million to $1.1 billion for the same period. For example, Treasury has pursued  differentiating between roll-your-own and pipe tobacco for tax collection  purposes but faces challenges because the definitions of the two  products in the IRC do not specify distinguishing physical characteristics. Furthermore, Treasury also has limited options to address the market  shift to large cigars. Estimated Federal Revenue Losses from Market Shifts after CHIPRA Range from $615 Million to $1.1 Billion

We estimated that federal revenue losses due to the market shifts from  roll-your-own to pipe tobacco and from small to large cigars range from  $615 million to $1.1 billion. However, according to Treasury comments in the Federal  Register, the large differences in tax rates resulting from CHIPRA created  an incentive for industry members to present roll-your-own tobacco as  pipe tobacco products, thus enabling them to pay a lower tax rate. Before  CHIPRA, there was little incentive for small cigar manufacturers to alter  their product to meet the definition of a large cigar. FDA Currently Regulates Cigarettes and Roll-Your-Own Tobacco but Not Pipe Tobacco and Cigars

When the Tobacco Control Act amended the Food, Drug, and Cosmetic  Act in June 2009, it granted FDA immediate regulatory authority over four  tobacco products, including cigarettes and roll-your-own tobacco, but did  not specify authority over pipe tobacco and small and large cigars. While FDA announced its intent to issue a  proposed rule that would subject additional products, including pipe  tobacco and small and large cigars, to its regulation, it had not issued the  proposed rule as of March 2012. In light of that fact, as Congress continues its oversight of  CHIPRA and Tobacco Control Act implementation, it should consider  modifying tobacco tax rates to eliminate significant tax differentials  between similar products. Specifically, Congress should consider  equalizing tax rates on roll-your-own and pipe tobacco and, in  consultation with Treasury, also consider options for reducing tax  avoidance due to tax differentials between small and large cigars. Our objectives for this report are to (1) review the market shifts  among smoking tobacco products since the Children’s Health Insurance  Program Reauthorization Act (CHIPRA) of 2009 went into effect on April  1, 2009; (2) examine the impact of these market shifts on federal revenue  and the Department of the Treasury’s (Treasury) actions to respond; and  (3) describe differences in regulation of various smoking tobacco products  by the Food and Drug Administration (FDA). To address the three objectives in this study, we reviewed documents  and interviewed agency officials from Treasury’s Alcohol and Tobacco  Tax and Trade Bureau, FDA, and the Centers for Disease Control and  Prevention, as well as tobacco industry members, representatives of  public health and other nongovernmental organizations, and academics  to obtain information on tobacco legislation and regulations, tobacco  product sales trends, and consumption patterns.
Why GAO Did This Study

In 2009, CHIPRA increased and equalized federal excise tax rates for cigarettes, roll-your-own tobacco, and small cigars. Though CHIPRA also increased federal excise tax rates for pipe tobacco and large cigars, it raised the pipe tobacco tax to a rate significantly below the equalized rate for the other products, and its large cigar excise tax can be significantly lower, depending on price. Treasury collects federal excise taxes on tobacco products.
Also passed in 2009, the Family Smoking Prevention and Tobacco Control Act (Tobacco Control Act) granted FDA regulatory authority over tobacco products. This act directed GAO to report on trade in tobacco products, including the effects of differing tobacco tax rates. This report (1) reviews the market shifts in smoking tobacco products since CHIPRA; (2) examines the impact of the market shifts on federal revenue and Treasurys actions to respond; and (3) describes differences in FDAs regulation of various smoking tobacco products. GAO interviewed agency officials, industry members, and public health representatives. GAO analyzed tax and revenue data and reviewed relevant literature.

What GAO Found

Large federal excise tax disparities among tobacco products, which resulted from the Childrens Health Insurance Program Reauthorization Act (CHIPRA) of 2009, created opportunities for tax avoidance and led to significant market shifts by manufacturers and price sensitive consumers toward the lower-taxed products. Monthly sales of pipe tobacco increased from approximately 240,000 pounds in January 2009 to over 3 million pounds in September 2011, while roll-your-own tobacco dropped from about 2 million pounds to 315,000 pounds. For the same months, large cigar sales increased from 411 million to over 1 billion cigars, while small cigars dropped from about 430 million to 60 million cigars. According to government, industry, and nongovernmental organization representatives, many roll-your-own tobacco and small cigar manufacturers shifted to the lower-taxed products after CHIPRA to avoid paying higher taxes.
While revenue collected for all smoking tobacco products from April 2009 through fiscal year 2011 amounted to $40 billion, GAO estimates that federal revenue losses due to market shifts from roll-your-own to pipe tobacco and from small to large cigars range from about $615 million to $1.1 billion for the same period. The Department of the Treasury (Treasury) has limited options to respond to these market shifts. Treasury has attempted to differentiate between roll-your-own and pipe tobacco for tax purposes but faces challenges because the definitions of the two products in the Internal Revenue Code of 1986 do not specify distinguishing physical characteristics. Treasury also has limited options to address the market shift to large cigars and faces added complexity in monitoring and enforcing tax payments due to the change in large cigar tax rates.
Unlike cigarettes and roll-your-own tobacco, pipe tobacco and cigars are not currently regulated by the Food and Drug Administration (FDA) and thus are not subject to the same restrictions on characterizing flavors, sales, or distribution. In 2011, FDA indicated its intent to issue a proposed rule that would deem products meeting the statutory definition of tobacco product to be subject to FDAs regulation. However, FDA had not issued the proposed rule as of March 2012. FDA officials told GAO that developing the rule was taking longer than expected.

What GAO Recommends

As Congress continues its oversight of CHIPRA and Tobacco Control Act implementation, it should consider equalizing tax rates on roll-your-own and pipe tobacco and, in consultation with Treasury, consider options for reducing tax avoidance due to tax differentials between small and large cigars. Treasury generally agreed with GAOs conclusions and observations.