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MODELING A SMALL-SCALE ILLICIT CIGARETTE OPERATION 12/31/2012 Jonathan Kulick, Mark Kleiman, Shivesh Puri, Ryan Van Dyk

Modeling a Small-Scale Illicit Cigarette Operation

Summary If the Food and Drug Administration bans the sale of mentholated cigarettes, parallel markets would likely develop to deliver product to those menthol smokers who do not switch to non-menthol product or quit smoking. Parallel markets already exist to evade taxation. Understanding the workings of the current markets illuminates the markets that might develop in illicit menthol product. This memo models a small-scale cigarette retail operation in which cigarettes are bought in a low-tax state and resold in a high-tax state. The purpose of this model is to evaluate the attractiveness of such an operation to a low-wage worker. By looking at the effective hourly wage and potential weekly earnings relative to weekly licit income, this memo finds that starting such an operation would indeed be practical and financially attractive to a low-wage earner. If this evaluation is accurate, we might expect to see such enterprises grow over time--even without a menthol ban-until competition forces illicit prices and profits down to the point where risk balances reward. That process would tend to impair the efficacy of a menthol ban by providing a vehicle for the distribution of banned product, and the process might be accelerated if the illicit market became the exclusive source of mentholated tobacco products.

Background Differentials in state cigarette taxes create the potential for illicit cigarette markets across state lines. This memo models an operation in which cigarettes are bought by the carton in the low-tax state of Virginia and sold by the pack in higher-tax states. This model uses New York and Illinois as its two high-tax states. This operation requires a buyer in Virginia to purchase the cartons and ship them by parcel service to a distributor in the higher-tax area.

Assumptions This model operates under the following assumptions: 1) Each customer purchases one pack per day, seven days a week. 2) Distributor in NY works a licit job 40 hours per week at $8.00 per hour (NY minimum wage is $7.25) for a weekly income of$3201; distributor in IL works 40 hours per week at $9.00 per hour (IL minimum wage is $8.25) for a weekly income of$360. 2 3) Cartons in VA cost on average $44 (or $4.40 per pack). 3 labor.ny.gov /workerprotection/laborstandards/workprot/minwage.shtm dol.gov /whd/minwage/america.htm# Illinois 3 Phone calls with several VA convenience stores. 1

2

4) Agent in VA who buys the cigarettes, packs them, and ships them takes $50 per shipment, independent of shipment size. 5) Distributor re-sells cigarettes at $8 per pack (typical licit retail is $12.50). 6) It takes five minutes to sell a pack to an established customer, and thus approximately 1 hour to sell a carton. Model

The earnings model considers total revenues minus total costs. Costs are calculated as: C = (44 * ~arlonJ + T + P, where T is transportation costs and P is the payment to the contact per shipment. Revenues are calculated as: R = 8 * f2cigarelles Thus, earnings are calculated as: E

=

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Virginia to New York

A pack of Marlboro Reds in New York costs $12.50.4 At $44 per carton in Virginia, the distributor is essentially paying $4.40 per pack, creating the potential for an $8.10 profit. As assumed, the distributor will resell packs at $8 to overcome the purchaser's preference for licit product and the convenience of being able to purchase at many locations. Interstate transportation costs range from $15 (for five cartons) to $25 for the base case of 50 cartons,5 plus the buying agent's flat rate of$50 per shipment. Earnings

Selling five cartons in one week yields earnings of $1 05 and requires $295 in working capital (the price of cigarettes in the low-tax state plus transportation and the agent's fee). Selling 50 cartons in one week yields earnings of$I,725 and requires $2,275 in working capital. Each five-carton increase per week yields an extra $180 in earnings. Figure 1 shows profitS at different levels of cartons sold.

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Figure 1. Weekly Earnings in NY 2,000 1,800 1,600

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Wages

Assuming the distributor spends four hours per week managing the buyer in VA, keeping the books, and picking up his shipments from a non-residential mailbox, the distributor's imputed hourly wage would be his weekly earnings (a function of the number of cartons sold in a standard workweek) divided by the sum of his time spent distributing plus four hours of overhead. At five cartons per week, the distributor's hourly wage is $11.67. Working 44 hours a week selling 40 cartons, the distributor's hourly wage is $31.02. Thus the operation can be scaled to work either as a supplement to licit labor-market income or as a substitute entirely. Figure 2 shows hourly wages by number of cartons sold per week. However, the distributor is also vulnerable to incurring additional costs (thus lowering his hourly wage) in the case of embezzlement on the part of the buyer in Virginia.

Figure 2. Hourly Wages by Number of Cartons Sold Per Week in NY 35

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Earnings as a Percent of Weekly Low-wage Income

To understand how the distributor's time spent on illicit activities affects his overall earnings, we can look at profits as a percent of weekly low-wage income. Working just five hours a week in addition to his licit job and illicit overhead activities, the distributor can make 33 percent of his weekly income. By working an extra 15 hours per week, the distributor makes 145 percent of his weekly income. Figure 3 depicts profits as a percent of weekly income by the quantity of cartons sold per week (a function of the number of hours worked per week). Figure 3. Weekly Earnings as a Percent of Weekly Income in NY

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Constraints on the Market

Clearly, this kind of operation presents considerable opportunities for minimum-wage workers in NY to supplement their weekly incomes and even to supplant those incomes entirely. However, the continued expansion of such operations is constrained by the number of clients that a single distributor can reach in a week. To match his weekly licit income, a distributor must reach at least 21.4 customers every day (selling 10.7 cartons, as shown above). Figure 4 shows how many customers are needed to sell a certain number of cartons per week.

Figure 4. Customers Required for Volume of Sales 80 >,

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Profitability

In order to match his licit hourly wage, an NYC distributor requires six pack-a-day customers, to whom he will sell 4 cartons weekly. That activity provides the distributor with $8.63 hour (compared to $7.25 minimum wage) but provides only eight hours of work weekly. In order for his weekly tobacco distribution earnings to match his licit paycheck, an NYC distributor requires sixteen customers. This larger-scale activity provides $324 weekly (compared to $320 at $8/hr) but consumes only 15 hours per week. Thus, a distributor able to work 55 hours weekly and obtain 16 recurring customers could double his earnings. Virginia to Illinois A pack of Marlboro Reds in Illinois costs $10.25, compared to $4.40 in Virginia, producing profit potential of up to $5.85 per pack. In this model, the distributor resells packs in Illinois at $6 to overcome buyers' preference for licit product, reducing profit potential to $1 .60 per pack. Earnings

Selling five cartons in a week yields $5, for an hourly wage of $0.55. Selling 50 cartons per week yields $725, an hourly wage of $13.40. In order to match his licit weekly income, a distributor must sell 25 cartons weekly to a total of 36 customers. Clearly, the gains under these parameters are more modest than in the New York scenario. But selling cigarettes at $6 per pack is still a profitable endeavor.

Profitability

A Chicago-based distributor is in poor position to profit from illicit distribution compared to his NYC-based peer. Just to match his licit hourly wage ($9.00), he would have to obtain 23 pack-a-day customers - providing him with $9.05 hourly for 20 hours/week. Matching his weekly licit earnings would require an even larger clientele: 39 customers. That business would require 31 hours and net the distributor $11.50 per hour, only 27% more hourly than his licit wage. Conclusion

According to the model, the economic viability of an illicit cigarette-distribution model is extremely sensitive to the tax differential between the low- and high-tax areas. Distribution schemes operating across low-differential areas (such as VA-Chicago) face a much larger minimum scale; on the other hand, schemes operating in high-tax areas are much more feasible to individual entrepreneurs. Operations larger than that model in the Chicago example would likely require multiple street-level vendors working underneath the distributor, an organization which could be accounted for in future modeling.