Results in Brief
Cigarettes and tobacco products are subject to various federal, state, and local taxes and fees, including excise taxes—taxes on the sale or consumption of these products—which provide funds for early childhood development, environmental, and other programs. The California State Board of Equalization (board) administers the collection and enforcement of these excise taxes through its Cigarette and Tobacco Products Tax and Licensing Programs (tax and licensing programs). The board’s most recent estimate is that in fiscal year 2012–13 the State lost $214 million in excise tax revenue for cigarettes and tobacco products due to the evasion of these taxes by consumers, retailers, wholesalers, and distributors. According to the board’s economists, however, the board’s efforts to stop such tax evasion prevented the State from losing an additional $91 million in tobacco tax revenue that year.
Since 2004 and 2005 the board has used a three-part approach involving licensing, an encrypted cigarette tax stamp, and inspections to enforce compliance with excise tax laws in California. Of the four states that we surveyed, two have a similar three-part enforcement approach to California. However, unlike the four states we surveyed and most others, California uses an encrypted tax stamp for cigarettes—while most of the other states use a lower-technology unencrypted cigarette tax stamp with traditional security features instead. The board adopted an encrypted tax stamp in 2005, as required by law. According to the board, to date the tax stamp’s encrypted digital signature has never been successfully counterfeited. Following these improvements, inspectors found that instances of stamp counterfeiting leading to tax evasion declined by 94 percent and have remained very low.
In addition to using an encrypted tax stamp, the requirement that retailers, distributors, wholesalers, manufacturers, and importers of cigarettes and tobacco products be licensed is a fundamental component of the board’s enforcement efforts. However, the fees charged for the licenses do not cover all of the licensing program’s costs. For example, in fiscal year 2014–15 the licensing program received about $1.8 million mostly from license fees, but the program cost more than $9.8 million to administer. As a result, the licensing program had a funding shortfall of roughly $8.0 million that fiscal year, and has experienced annual funding shortfalls since fiscal year 2006–07. To make up the program’s funding shortfall, the Legislature approved a budget change proposal in fiscal year 2006–07 to appropriate funds from the four funds that receive taxes from cigarette and tobacco products. The board splits the shortfall among these four tax funds in proportion to how much cigarette tax revenue they receive. The practical effect of using these four funds to offset the $8 million shortfall is that the administrators of those funds are not able to provide the level of services or activities that they otherwise would have, absent the need to make up the licensing program’s funding gap.
Even though the licensing program has a continuing funding shortfall, as of June 2015 it had accumulated more than $9 million in revenue from license fees, which are maintained in the Cigarette and Tobacco Products Compliance Fund (compliance fund), that it could use to offset the costs of the licensing program and reduce its shortfall. According to the board, the balance in the compliance fund steadily grew from $1 million in fiscal year 2006–07 to almost $9 million in fiscal year 2014–15 due to various factors, including underestimating revenues and an almost $3 million fund balance increase due to an accounting adjustment by the Department of Finance. According to best practice guidance for government finance, a reasonable fund balance would equate to two months’ worth of operating expenditures, or $1.6 million using the licensing program’s fiscal year 2014–15 expenditures, leaving the remainder, $7 million, as excess license fee revenue.
Although it is legally permissible to use tobacco taxes to fund the licensing program, options exist to make the program self‑supporting. These options include a combination of retailer, wholesaler, and distributor license fee changes and increases, as well as a cigarette tax increase. For example, the cigarette and tobacco products retailers’ one-time licensing fee of $100 could be changed to an annual fee of $170 for five years and then increase to $215 annually thereafter. During the first five years of this fee increase, the $7 million in excess license fees collected over the past several years could be used to delay the eventual fee increase to $215, which is the annual amount necessary to make the licensing program self sufficient. Another way to finance the licensing program could be accomplished through a combination of raising the license fees paid by cigarette and tobacco products retailers, wholesalers, and distributors; using the excess license fees that the board has collected; and increasing the cigarette tax. The final option would be to increase the cigarette tax, which would allow for a smaller increase in the annual retailer license fee—an increase to $180 rather than the $215 per year proposed in the first option—and could be a reasonable option to make the licensing program self-supporting because California currently has one of the lowest cigarette tax rates in the nation, at 87 cents per pack of 20 cigarettes.
The board’s method for identifying costs associated with each program appears to be reasonable, but its allocation of some of these costs is flawed. Although our testing determined that the types of operating costs the board charged to the tax program and licensing program were appropriate, we noted problems with the basis it uses to allocate some of its costs. Specifically, the board uses the percentage of time that staff in two of its divisions work directly on a particular program to allocate personnel and some of its operating costs. However, the board’s Special Taxes Policy and Compliance Division (special taxes division) did not use supervisor and support staff’s actual time charges to make cost allocations, and some staff in the Investigations and Special Operations Division (investigations division) were using a predetermined, outdated, and discontinued time allocation method from 2005. As a result, allocated payroll costs and any other operating cost allocations based on those time charges were not accurate.
Finally, the cost of the third part of the board’s excise tax enforcement approach, inspections, could be reduced. Specifically, because of the decline in the number of licensees, we believe the board could reduce the number of annual inspections it currently conducts of retailers, wholesalers, and distributors of cigarette and tobacco products in the state without diminishing its ability to enforce the excise tax. The number of cigarette and tobacco product licenses held by retailers, wholesalers, and distributors has declined by 8 percent, from 39,150 to 35,894, since the board’s licensing program began conducting annual inspections of licensed entities in fiscal year 2005–06. We estimate the board may be able to conduct over 800 fewer inspections each year while maintaining the same frequency of inspections that it initially conducted in fiscal year 2005–06. Such a reduction in the number of inspections could result in annual savings of more than $360,000.
To make the board’s licensing program self-supporting, the Legislature should consider passing legislation to implement a funding model that would include a license fee increase or a combination of license fee increases, continued use of money from the Cigarette Tax Fund, and a cigarette tax increase similar to one of the proposed options outlined in this report.
Unless the Legislature directs the board to eliminate the compliance fund’s excess fund balance within a time frame of more than a year, the board should eliminate the excess fund balance by June 30, 2017 by using it to offset the licensing program’s annual funding shortfall. Also, in the future, the board should limit the fund’s balance to no more than two months’ worth of licensing program’s operating expenditures.
The special taxes division should amend its budgeting process to ensure that it reflects actual work that supervisors and support staff perform instead of adjusting these staff members’ predetermined allocations of time to ensure that the division does not exceed each program’s budget.
The investigations division should ensure that investigators charge their time according to division policy and determine a method to more accurately allocate investigators’ time instead of using a predetermined method established in 2005 and since discontinued.
To reduce the licensing program’s enforcement costs without compromising the level of compliance with the cigarette and tobacco products tax law that the inspection program has produced, the board should reduce the number of inspections and reinspections of retailers, distributors, and wholesalers it conducts each year.
The board agreed with all but one of our recommendations. Specifically, the board does not believe that it is economically feasible to implement one of our recommendations and contends that its current approach to allocating staff time is the most equitable.