[Senate Hearing 113-648]
[From the U.S. Government Publishing Office]




                                                        S. Hrg. 113-648

                TOBACCO: TAXES OWED, AVOIDED, AND EVADED

=======================================================================

                                HEARING

                               before the

                          COMMITTEE ON FINANCE
                          UNITED STATES SENATE

                    ONE HUNDRED THIRTEENTH CONGRESS

                             SECOND SESSION

                               __________

                             JULY 29, 2014

                               __________

         [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]                            


                                     

            Printed for the use of the Committee on Finance
                                         ______

                         U.S. GOVERNMENT PUBLISHING OFFICE 

94-638-PDF                     WASHINGTON : 2015 
-----------------------------------------------------------------------
  For sale by the Superintendent of Documents, U.S. Government Publishing 
  Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; 
         DC area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, 
                          Washington, DC 20402-0001  
            
            
            
            
            
            
            


                          COMMITTEE ON FINANCE

                      RON WYDEN, Oregon, Chairman

JOHN D. ROCKEFELLER IV, West         ORRIN G. HATCH, Utah
Virginia                             CHUCK GRASSLEY, Iowa
CHARLES E. SCHUMER, New York         MIKE CRAPO, Idaho
DEBBIE STABENOW, Michigan            PAT ROBERTS, Kansas
MARIA CANTWELL, Washington           MICHAEL B. ENZI, Wyoming
BILL NELSON, Florida                 JOHN CORNYN, Texas
ROBERT MENENDEZ, New Jersey          JOHN THUNE, South Dakota
THOMAS R. CARPER, Delaware           RICHARD BURR, North Carolina
BENJAMIN L. CARDIN, Maryland         JOHNNY ISAKSON, Georgia
SHERROD BROWN, Ohio                  ROB PORTMAN, Ohio
MICHAEL F. BENNET, Colorado          PATRICK J. TOOMEY, Pennsylvania
ROBERT P. CASEY, Jr., Pennsylvania
MARK R. WARNER, Virginia

                    Joshua Sheinkman, Staff Director

               Chris Campbell, Republican Staff Director

                                  (ii)
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                            C O N T E N T S

                              ----------                              

                           OPENING STATEMENTS

                                                                   Page
Wyden, Hon. Ron, a U.S. Senator from Oregon, chairman, Committee 
  on Finance.....................................................     1
Hatch, Hon. Orrin G., a U.S. Senator from Utah...................     2

                               WITNESSES

Manfreda, John J., Administrator, Alcohol and Tobacco Tax and 
  Trade Bureau, Washington, DC...................................     4
Gootnick, Dr. David, Director, International Affairs and Trade, 
  Government Accountability Office, Washington, DC...............     6
Bernstein, Ronald J., president and CEO, Liggett Vector Brands 
  LLC, Morrisville, NC...........................................    15
Patel, Rocky, owner, Rocky Patel Premium Cigars Inc., and board 
  member, Cigar Rights of America, Naples, FL....................    16
Tynan, Michael, policy officer, Oregon Public Health Division, 
  Portland, OR...................................................    18
Drenkard, Scott, economist and manager of State projects, Tax 
  Foundation, Washington, DC.....................................    20

               ALPHABETICAL LISTING AND APPENDIX MATERIAL

Bernstein, Ronald J.:
    Testimony....................................................    15
    Prepared statement with attachments..........................    29
    Responses to questions from committee members................    72
Drenkard, Scott:
    Testimony....................................................    20
    Prepared statement...........................................    74
    Responses to questions from committee members................    84
Gootnick, Dr. David:
    Testimony....................................................     6
    Prepared statement...........................................    85
    Responses to questions from committee members................   110
Hatch, Hon. Orrin G.:
    Opening statement............................................     2
    Prepared statement...........................................   113
Manfreda, John J.:
    Testimony....................................................     4
    Prepared statement...........................................   115
    Responses to questions from committee members................   129
Patel, Rocky:
    Testimony....................................................    16
    Prepared statement...........................................   141
    Responses to questions from committee members................   148
Tynan, Michael:
    Testimony....................................................    18
    Prepared statement with attachments..........................   151
    Responses to questions from committee members................   171
Wyden, Hon. Ron:
    Opening statement............................................     1
    Prepared statement with attachments..........................   176

                             Communications

Center for Regulatory Effectiveness..............................   183
National Association of Convenience Stores (NACS)................   221
Small Business Cigar Coalition...................................   228

 
                     TOBACCO: TAXES OWED, AVOIDED, 
                               AND EVADED

                              ----------                              


                         TUESDAY, JULY 29, 2014

                                       U.S. Senate,
                                      Committee on Finance,
                                                    Washington, DC.
    The hearing was convened, pursuant to notice, at 10:06 
a.m., in room SD-215, Dirksen Senate Office Building, Hon. Ron 
Wyden (chairman of the committee) presiding.
    Present: Senators Cardin, Warner, Hatch, Grassley, Crapo, 
and Thune.
    Also present: Democratic Staff: Jocelyn Moore, Deputy Staff 
Director; David Berick, Chief Investigator; Chris Arneson, Tax 
Policy Advisor; and Anne Dwyer, Professional Staff Member. 
Republican Staff: Chris Campbell, Staff Director; Kimberly 
Brandt, Chief Healthcare Investigative Counsel; and Nicholas 
Wyatt, Tax and Nominations Professional Staff Member.

   OPENING STATEMENT OF HON. RON WYDEN, A U.S. SENATOR FROM 
             OREGON, CHAIRMAN, COMMITTEE ON FINANCE

    The Chairman. The Finance Committee will come to order.
    Today the Finance Committee will examine a classic case of 
tax evasion; specifically, how dozens of companies making 
tobacco products are able to dodge taxes owed under current law 
by changing only a few words on the packaging labels. This 
evasion fleeces American taxpayers out of billions of dollars, 
and it means children and teens are more easily hooked on 
tobacco.
    The tax evasion tale goes like this. In 2009, the Congress 
renewed the Children's Health Insurance Program, which 
currently provides insurance coverage to more than 8 million 
children each year. To pay for that coverage, the Congress 
raised excise taxes on certain types of tobacco products, 
including cigarettes and loose roll-your-own tobacco. The tax 
rate on tobacco for pipes and some large cigars, however, 
remained lower.
    So, immediately after the law was enacted, companies pried 
open a big loophole. They started changing the labels on their 
packaging. Products that would have been labeled ``roll-your-
own tobacco'' one day were labeled ``pipe tobacco'' the next, 
and the tax bill on them plummeted. Companies also stuffed 
small cigars with a few extra grams of tobacco. That way they 
could be considered large cigars and be taxed at a lower rate.
    Now, the numbers show just how big this loophole has 
become. Sales of pipe tobacco have skyrocketed more than 10-
fold in just 5 years. It just seems implausible that so many 
more Americans would suddenly start smoking pipes.
    Today the Finance Committee is going to inquire as to why 
it is so easy to skirt the law. Clearly there has been a lapse 
in good government. After 5 years, the Treasury Department's 
Alcohol and Tobacco Tax and Trade Bureau, or TTB, still has not 
drawn a meaningful distinction between tobacco products. 
Instead, they have ignored everything except for the words on 
the package: ``roll-your-own'' or ``pipe.'' All it takes to 
exploit this loophole is some ink on the label, and the 
committee is going to see that demonstrated today. No muss, no 
fuss, no teams of tax lawyers poring over legal documents.
    Unfortunately, the financial burden this loophole inflicts 
on American taxpayers is enormous. The committee is going to 
hear today that the tobacco loophole has cost taxpayers more 
than $2 billion over the last 5 years--more than $2 billion. 
Furthermore, the loophole seriously undermines the effort to 
discourage smoking among America's children and our teens. 
According to the Surgeon General, evidence shows that raising 
the cost of cigarettes is a factor in stopping kids from 
smoking, but when tobacco is cheap because of a blatant 
loophole, young people are more likely to buy it.
    TTB has had ample time to solve this problem, but it has 
not followed through. So today the Finance Committee is going 
to inquire why that is the case. Is it a lack of resources 
needed to mount an adequate enforcement effort? TTB has four 
criminal agents at this point to enforce the law for the entire 
country. Could it be that one hand does not know what the other 
hand is up to? When the Food and Drug Administration was 
dragged into the situation, it made matters worse by actively 
allowing companies to continue using the loophole. The Food and 
Drug Administration even sent letters to companies giving them 
the green light.
    My bottom line, as we begin this inquiry, is that this 
loophole hurts taxpayers, it hurts kids, and it needs to be 
closed. As has been our practice, we are going to work on this 
important issue, we are going to work on it in a bipartisan 
way, and I am very pleased to yield to Senator Hatch for his 
comments.*
---------------------------------------------------------------------------
    * For more information, see also, ``Present Law and Background 
Relating to Tobacco Excise Taxes,''Joint Committee on Taxation staff 
report, July 25, 2014 (JCX-93-14), https://www.jct.gov/
publications.html?func=startdown&id=4659.
---------------------------------------------------------------------------
    [The prepared statement of Chairman Wyden appears in the 
appendix.]

           OPENING STATEMENT OF HON. ORRIN G. HATCH, 
                    A U.S. SENATOR FROM UTAH

    Senator Hatch. Well, thank you, Mr. Chairman. According to 
written testimony we received today, the Alcohol and Tobacco 
Tax and Trade Bureau collected approximately $23 billion in 
taxes in fiscal year 2013, making it the third-largest tax 
collection agency in the U.S. Government. This amount is even 
more significant when you consider the number of tobacco-
related transactions undertaken and that millions of Americans 
are represented somewhere in that $23 billion. Of that amount, 
around $14 billion came from collecting taxes on tobacco 
products. It seems that there is some truth to the quip 
attributed to former House Majority Leader Thomas Foley that 
``if you don't drink, smoke, or drive a car, you're a tax 
evader.'' [Laughter.]
    Now, because of the large sums of money involved in this 
issue and because of the number of people and businesses 
affected, it is important that Federal excise taxes are 
administered accurately and fairly. In fact, Senator Kennedy 
and I made the tobacco tax the basis for the Children's Health 
Insurance Program and the State Children's Health Insurance 
Program, otherwise known as SCHIP.
    But, as with the income tax and our tax system as a whole, 
compliance needs to be based on a belief that clear rules are 
constantly enforced in a way that does not put taxpayers at a 
disadvantage to those who do not follow the rules. We also need 
to keep in mind--and this is true for all tax policy--that tax 
avoidance and tax evasion are very different behaviors. The tax 
code should consist of clear rules, and people will either 
follow them or they will not. To the taxpayer, the tax code is 
not a bill for a government program or a claim on whatever 
someone might consider to be the patriotic amount, it is a set 
of rules for arriving at a specific and definite number.
    During today's hearing, we will specifically discuss two 
market shifts in tobacco products that seem prevalent since the 
passage of the Children's Health Insurance Program 
Reauthorization Act, or CHIPRA, in 2009, which increased 
tobacco taxes. One of these is an apparent shift from roll-
your-own tobacco to pipe tobacco, as the chairman has 
suggested, which is taxed at a lower rate. As one of our 
witnesses noted in his written testimony, one tobacco 
manufacturer has ``acknowledged that there was no real 
difference between its roll-your-own tobacco and its pipe-cut 
tobacco.'' Given the fact that roll-your-own tobacco is taxed 
at around 10 times the rate of pipe tobacco, this market shift 
deserves our attention. Another market trend that I expect to 
be highlighted in this hearing concerns an apparent shift from 
what the Internal Revenue Code defines as ``small cigars'' to 
``large cigars,'' which results in tax savings if the 
manufacturer's price is below a certain amount.
    In addition to these recent market shifts, we need to be 
mindful of more longstanding issues that clearly deal with tax 
evasion. For example, smuggling of counterfeit or diverted 
products where Federal taxes have not been paid is a serious 
problem, possibly costing the U.S. billions of dollars in tax 
revenue every year.
    Finally, since we are discussing tobacco, the health 
component of this issue is also important. Evasion, 
counterfeiting, and black markets, in addition to denying 
Federal, State, and local governments revenue, also side-step 
health-related requirements along with restrictions intended to 
reduce the appeal of tobacco to minors.
    I hope this hearing sheds light on how we can improve tax 
administration by ensuring that our tax laws are being enforced 
appropriately. I also hope that it will help us understand if 
the laws themselves have not been written in a way to 
accomplish what was intended. And, though we are talking about 
a specific set of Federal excise taxes on a product that is 
controversial, that should not distract us from the 
fundamentals of good tax policy. One of the things I have 
always worried about in taxing tobacco is that we have to be 
careful how we do that, because you are going to have an 
underground economy doing things that we will not be able to 
control. So I am very concerned about how we approach this.
    I appreciate the chairman's interest in trying to do what 
is right here, and we will see what we can do. I have to tell 
you, Mr. Chairman, I can only stay for a few minutes and then I 
have to leave, but I appreciate your leadership.
    The Chairman. Well, Senator Hatch, first of all, I want 
everyone to understand that one of the reasons it is so 
important to get this right is that you have led this fight 
with respect to children and the Children's Health Insurance 
Program for years. You and Senator Kennedy--and I think we know 
our colleague Senator Rockefeller--have been partners in this 
effort. I so appreciate the advocacy on behalf of children that 
you have engaged in for many, many years. I think it drives 
home why both of us are committed to getting this right, and I 
look forward to working with you.
    [The prepared statement of Senator Hatch appears in the 
appendix.]
    The Chairman. Our hearing today is going to consist of two 
panels. The first panel will include two government witnesses 
from the Alcohol and Tobacco Tax and Trade Bureau, known as 
TTB, and the Government Accountability Office. Our second panel 
includes industry members and experts on the cost of tobacco 
tax evasion. We are going to, therefore, have six witnesses, so 
we would like our guests to limit their testimony to 5 minutes.
    Our first witness will be Mr. John Manfreda, the 
Administrator of the Alcohol and Tobacco Tax and Trade Bureau 
that is part of the Department of the Treasury. Our second 
witness will be Dr. David Gootnick, Director of International 
Affairs and Trade at the Government Accountability Office. We 
thank both of you for your cooperation and for coming. Your 
prepared statements are going to be made a part of the record.
    We will start with you, Mr. Manfreda.

   STATEMENT OF JOHN J. MANFREDA, ADMINISTRATOR, ALCOHOL AND 
          TOBACCO TAX AND TRADE BUREAU, WASHINGTON, DC

    Mr. Manfreda. Mr. Chairman, Ranking Member Hatch, and 
distinguished members of the committee, thank you for the 
opportunity to testify about TTB's tobacco enforcement 
activities. We greatly appreciate your interest in our bureau.
    The Internal Revenue Code imposes Federal excise taxes on 
tobacco products and establishes a comprehensive framework to 
protect the revenue. Under this authority, we collected over 
$14 billion in tobacco excise taxes in fiscal year 2013. Our 
tax authority also extends to alcohol products, firearms, and 
ammunition, under which we have collected an additional $9 
billion last year.
    Our tax enforcement strategy involves the development and 
application of multiple tools and skills to ensure compliance 
with the Internal Revenue Code and to detect and address tax 
evasion. Our specialists evaluate permit applications to ensure 
that only qualified persons operate in the tobacco industry, 
and we investigate high-risk applicants prior to approval.
    Through the use of risk models and other intelligence, our 
analysts identify diversion schemes and refer cases for further 
field work. Our auditors and investigators then apply advanced 
investigative techniques to pursue these leads, deploying teams 
with diverse skill sets for large, complex investigations. As 
these cases develop, if there are indications of criminal 
activity, they are referred to our special agents for 
investigation and potential referral for prosecution. We also 
operate a tobacco laboratory which ensures the appropriate tax 
classification of products and provides analytical support for 
audits, investigations, and rulemaking.
    The Children's Health Insurance Program Reauthorization Act 
increased the tax rate for all tobacco products and equalized 
the tax rate for cigarettes, roll-your-own, and small cigars. 
The tax rate for pipe tobacco was also increased, but to a 
significantly lower rate. These tax changes resulted in 
increased tobacco tax collections, although the amount of the 
increase has decreased steadily since fiscal year 2010, the 
first full year following CHIPRA. Overall, however, tobacco tax 
collections remain higher than they were pre-CHIPRA. The tax 
rate differentials resulting from CHIPRA created new incentives 
for manufacturers, importers, and consumers of certain tobacco 
products.
    Since CHIPRA increased the tax on small cigars and small 
cigarettes, we have not found evidence of widespread 
misclassification of cigarettes as cigars under the Internal 
Revenue Code. We have, however, seen a notable shift in the 
cigar market. Although CHIPRA raised the tax on both small and 
large cigars, it created an incentive to shift production to 
the large cigar category because, depending on price, the tax 
rate on a large cigar can be significantly lower than the tax 
on small cigars. Large cigars are the only tobacco product for 
which the excise tax is based on the manufacturer's or 
importer's sale price.
    Since CHIPRA, we have found that cigar manufacturers and 
importers are structuring operations or sales to lower their 
taxable sale price, resulting in a decrease in the average tax 
collected per large cigar. We have also seen a significant 
shift in removals of pipe and roll-your-own tobacco. Because 
the two products can be similar, and because the tax on roll-
your-own tobacco was significantly increased as compared to 
pipe tobacco, a portion of the roll-your-own tobacco market has 
switched to pipe tobacco since CHIPRA. We believe that this 
disparity, combined with the tax rate increase on cigarettes, 
has resulted in an increase in the popularity of machines that 
can make cigarettes from roll-your-own or pipe tobacco. These 
issues will likely exist as long as incentives remain under the 
Internal Revenue Code for manufacturers to reclassify products 
or restructure transactions to achieve a lower tax by taking 
advantage of rate differentials.
    In addition, a 150-percent increase in the Federal excise 
tax on cigarettes imposed by CHIPRA increased the incentive to 
evade Federal taxes through tobacco diversion. We have seen 
numerous diversion schemes and are addressing them through 
multiple means, including criminal prosecution. Our Criminal 
Enforcement Program is critical to our ability to effectively 
curtail current illicit operations and deter others from 
engaging in diversion activity.
    I am proud of this bureau and what we have been able to 
accomplish in the 11 years since we were established. Despite 
our small size of about 465 employees, we have worked to 
maximize the reach of our resources, collecting roughly $23 
billion in fiscal year 2013, which represents a return of 
approximately $450 for every dollar invested in TTB's revenue 
collection activities.
    I sincerely appreciate the opportunity to testify before 
the committee today and would be happy to answer any questions 
you have.
    Thank you.
    The Chairman. Thank you very much.
    [The prepared statement of Mr. Manfreda appears in the 
appendix.]
    The Chairman. Dr. Gootnick?

   STATEMENT OF DR. DAVID GOOTNICK, DIRECTOR, INTERNATIONAL 
     AFFAIRS AND TRADE, GOVERNMENT ACCOUNTABILITY OFFICE, 
                         WASHINGTON, DC

    Dr. Gootnick. Thank you, Mr. Chairman. Mr. Chairman and 
members of the committee, thank you for asking GAO to 
participate in this hearing.
    As you know, Federal excise taxes on tobacco products have 
long aimed to both raise revenue and discourage tobacco use. My 
statement today will focus first on the market shifts among 
smoking tobacco products that followed the 2009 changes to the 
Internal Revenue Code, and second, on the impact of these 
market shifts on tax revenues.
    I will focus on the four tobacco products: roll-your-own 
tobacco, pipe tobacco, small cigars, and large cigars. 
Consumption of these four products has increased over the past 
decade and now represents 12 percent of smoking tobacco sales 
in the United States.
    As Figure 2 from my written testimony shows, CHIPRA 
eliminated certain tax disparities among these products and 
created others, as we have been discussing. You can see here 
the pre-CHIPRA rates and the post-CHIPRA rates, and you can see 
that the rates on cigarettes, roll-your-own tobacco, and small 
cigars were raised and made equivalent. However, you can also 
see that the post-CHIPRA rate on pipe tobacco is now roughly 
one-tenth of the rate of roll-your-own.
    Unlike these products and not shown in the slide, the large 
cigar tax, as has been mentioned, is calculated as a percentage 
of the manufacturer or importer's sales price, up to a maximum. 
This is the so-called ``ad valorem'' tax. The key point on 
large cigars is that, after CHIPRA, inexpensive large cigars 
are now taxed at a much lower rate than their counterpart small 
cigars. So, as you would expect, the market shifted in response 
to these changes. Manufacturers shifted their products to take 
advantage of lower tax rates, and price-sensitive consumers 
shifted their preferences.
    As you can see in Figure 4, the sales of low-tax products 
spiked after CHIPRA, and high-tax products plummeted. 
Specifically in this figure, you see that sales of large cigars 
more than doubled, while sales of small cigars declined by 
nearly 90 percent. So the immediate spike in large cigars is 
shown here on the heavy line, and the crash of the small cigar 
market on the thin line. Likewise in Figure 3, you see sales of 
pipe tobacco increasing over 7-fold, 744 percent, and sales of 
roll-your-own tobacco declining by over 80 percent.
    The key here is that manufacturers can shift their products 
because the tax code differentiates roll-your-own and pipe 
tobacco in large measure by their appearance, packaging, and 
labeling, which allow firms to re-label their products with 
minimal, if any, changes. Likewise, the tax code distinguishes 
small and large cigars only by their weight, and at a 
breakpoint of 3 pounds per thousand, a small cigar can undergo 
minimal changes, as you have mentioned, to qualify as a large 
cigar.
    Regarding the revenue consequences of these shifts, we 
modeled what tax revenues would have been if market shifts 
resulting from the substitution had not occurred. Our analysis 
used the long-term trends in consumption prior to CHIPRA and 
the expected fall in demand due to higher tax rates. Thus, we 
believe our estimates made conservative assumptions on the 
magnitude of tax avoidance.
    In the bottom line, we estimate the tax avoidance due to 
the observed market shift to be in the range of $2.6 to $3.7 
billion since the enactment of CHIPRA. Over the same interval, 
actual post-CHIPRA revenue on these four products is roughly 
$5.3 billion, so you can see that the tax avoidance, in both 
magnitude and as a percentage, is significant.
    As you have heard, TTB has limited options in response. 
They have sought to curtail the growing availability of 
unpermitted roll-your-own tobacco machines in commercial use 
that emerged after CHIPRA; however, the core incentives towards 
pipe tobacco remain. In addition, the Bureau has analyzed 
proposals to differentiate roll-your-own and pipe tobacco based 
on the physical attributes, but there is no real consensus on 
what, if any, characteristics truly distinguish these two 
products.
    Finally, there are additional challenges with the ad 
valorem tax on large cigars, which creates opportunities for 
tax avoidance or evasion through intermediary transactions. 
These transactions truly blur the line between tax avoidance 
and tax evasion.
    In conclusion, we maintain that Congress should consider 
equalizing the tax rates on roll-your-own and pipe tobacco and, 
with TTB, consider options for reducing tax avoidance due to 
the gap between small and large cigars. Proposals in this 
regard have included establishing a floor on the ad valorem tax 
or increasing the weight threshold for large cigars.
    Mr. Chairman, this completes my remarks. I am happy to 
answer your questions.
    The Chairman. Doctor, thank you very much.
    [The prepared statement of Dr. Gootnick appears in the 
appendix.]
    The Chairman. Obviously, when you are talking about $2.6 
billion to $3.7 billion being evaded in taxes, if anything, the 
committee has understated this challenge. You are talking about 
sums of money that are very substantial. Of course, the whole 
point of this exercise, which Senator Hatch and Senator Kennedy 
and Senator Rockefeller started, is to try to make sure that we 
are taking steps to protect children.
    Now, Mr. Manfreda, at this point we have 39 States asking 
you to issue new rules to more clearly distinguish between 
cigarettes and cigars. So that is the majority--well over the 
majority--of our States that are asking for clarification on 
this central point, which of course goes right to the tax 
evasion that Dr. Gootnick is talking about.
    Now, almost 8 years ago you all issued a Notice of Proposed 
Rulemaking, but nothing happened. So let us start by having you 
tell us why that is the case, that after 8 years and 39 States 
asking for clarity on something that is right at the heart of 
this tax evasion question, why it has not been done.
    Mr. Manfreda. That is a fair question. Back in 2006, we did 
do a Notice of Proposed Rulemaking regarding differentiating a 
cigarette from a cigar. However, with CHIPRA equalizing the tax 
rates between a small cigarette and a small cigar, the priority 
for the revenue issue associated with that was pretty much 
neutralized. What I mean is, they are now taxed the same way.
    Given the fact that we are a very small agency, we have 
very small resources, CHIPRA created other rather large 
problems for us to address in regard to classification issues, 
specifically roll-your-own tobacco versus pipe tobacco.
    So we have been looking at and we have been going forward 
with the research and the differentiation; however, it has not 
had that big a priority from a tax collecting point of view as 
roll-your-own tobacco or pipe tobacco does have. So we are in 
the process. We have it on track as a rulemaking effort. Down 
the road we will be coming out with rulemaking on that.
    The Chairman. So when will that be? Because, as of right 
now, the small cigars are getting through the loophole. So 
when?
    Mr. Manfreda. Well, small cigars are getting called a 
loophole. What they are exercising their right to do is 
increase the tobacco with regard to the weight of the small 
cigar to make it a large cigar. That is a statutory line we 
cannot change, sir. By that, when they are adding maybe 2 or 3 
ounces of more tobacco to make it a large cigar, that is how 
they are crossing the line.
    The Chairman. The problem, however, is that cigarettes are 
now in effect cigars, and that is the problem. I just keep 
looking at all these proposals that you make, and the tax 
evaders always seem to get around them. Then you say there is 
some other reason that you cannot act.
    So let us go then to the question of pipe tobacco after the 
Children's Health Insurance Program Reauthorization. A number 
of participants in the roll-your-own tobacco cigarette market 
quickly shifted to labeling their products as lower-taxed pipe 
tobacco. Then they got a wink and a nod from the retailers, to 
direct consumers to the right bag, and the companies were able 
to dodge $22-per-pound in tax by slapping pipe tobacco labels 
on bags full of cigarette tobacco.
    Now again, in 2010, you issued an Advanced Notice of 
Proposed Rulemaking to deal with a problem that GAO has 
spotlighted and I have spotlighted. But again, somehow the 
regulation just was not issued. In fact, I gather there was not 
even a formal proposed regulation, and GAO points out that 
billions of dollars are being lost as a result of this 
loophole. So what is the reason for the delay here?
    Mr. Manfreda. Again, a fair question, sir. If you will 
remember, we put out an Advanced Notice of Proposed Rulemaking 
back in 2010. We extended that comment period in 2011, airing 
industry proposals for differentiation.
    In our airing, we looked at characteristics that could 
differentiate these products, from cut size, moisture content, 
residual sugar, the amount of black tobacco in a product, or 
the amount of weight associated with flavors or other non-
tobacco products.
    The Chairman. The bottom line is--because I want to ask one 
other question--we do not have a regulation that will ensure 
that we are not seeing tax law evaded. When is that regulation 
going to come out? Can you give us a firm commitment now?
    Mr. Manfreda. We are going to air a rulemaking in January.
    The Chairman. Of 2015?
    Mr. Manfreda. Of 2015.
    Sir, the issue here, and what has made this so very 
difficult is, if you go back and you look at our comments from 
our 2011 rulemaking, we got an additional 170 comments, 32 of 
which came from industry members. Those comments were so 
diverse, and, when you dug into them, you actually got into the 
point of, they were reflective of their own individual products 
that were on the market. So what we are left with is, we are 
trying to come up with an objective, measurable, not easily 
manipulated standard that draws the line at the right place.
    The Chairman. But of course an agency gets comments. To not 
have issued even a proposed rule is, I just think--we have had 
a classic case of tax evasion, and it seems like we are looking 
at a classic case of foot-dragging, and we have to do better.
    I want to ask you one other question, and my time is up. 
That is, there of course is tremendous interest in the question 
of e-
cigarettes. After decades of work, there has been an effort to 
cut down on kids smoking, and fewer Americans pick up a 
cigarette every day, but there has been an explosion in the use 
of e-
cigarettes, especially among young people.
    I am concerned about whether history is going to repeat 
itself, because it was not very long ago when I was in the 
House and I went down a row with tobacco executives and asked 
whether nicotine was addictive and they all said no, and I am 
very concerned about whether we are going to go down the same 
route with people saying, let us study this and then we will 
finally decide whether these nicotine delivery devices ought to 
be taxed and regulated. So it would be very helpful to have on 
the record whether or not TTB now has the authority to tax e-
cigarettes.
    Mr. Manfreda. Sir, we do not, under the Internal Revenue 
Code, have the authority to tax an e-cigarette that does not 
contain tobacco. We have to have tobacco in the product to meet 
an Internal Revenue Code definition of a tobacco product, so 
currently we do not.
    The Chairman. All right.
    Let us go, next, to Senator Warner.
    Senator Warner. Thank you, Mr. Chairman. Thank you for 
holding this hearing. Let me also say I concur with you that it 
appears, on these tax avoidance issues, the failure to have at 
least a regulatory framework is losing the government revenue. 
It is not fair; it is not right.
    I was curious to hear comments about at least some level of 
a floor, since it seems like your ability to manipulate a 
little bit of tobacco in or out of a product puts you above or 
below a threshold that could have a huge change in your 
taxation. Obviously, I think the charts were pretty powerful 
about how the market has diverged so much.
    In Virginia we have a tradition of tobacco products. Most 
of our companies are extraordinarily responsible in how they 
deal with this. I do not think there should be such a wide 
variety of tax consequences between products that may have 
equal or similar health concerns.
    What I want to ask the witnesses is, let's move a little 
away from this question of straight avoidance, or manipulation 
in a sense, to issues around just plain illicit activities. Mr. 
Manfreda, I want to start with you, and then I will go to Dr. 
Gootnick. My understanding is that, at this point, there is 
little to no transparency regarding what entities actually hold 
TTB permits, so investigative efforts are in many ways hindered 
from their inception.
    Without adequate enforcement--and I believe either in my 
notes or in your testimony I read that you have only about four 
enforcement agents--manufacturers without permits, that do not 
have any authorization at all, are free to operate without fear 
of enforcement of any laws. Often without that enforcement, 
they avoid any payments at all of Federal or State excise tax.
    I have heard actually some extraordinary and astounding 
numbers. In some places, as much as half the cigarettes 
consumed may be either totally non-taxed or under-taxed, 
particularly in certain jurisdictions with very high-tax 
components around cigarettes.
    So, Mr. Manfreda, I understand that you are a small agency. 
I want to associate myself with the chairman's remarks that I 
do think we need to start this regulatory process sooner rather 
than later. But when we are talking about just plain illicit 
activities, how concerned are you about this? Can you talk 
about efforts that your office is undertaking with State 
enforcement agencies to deal with this illicit trade of 
tobacco?
    Mr. Manfreda. Yes, sir. Our criminal enforcement function 
over the last 4 years has actually developed 72 cases, 70 of 
which are presently accepted by U.S. Attorneys' Offices to 
pursue as criminal cases. Out of that, we have identified over 
$345 million in potential tax liability, and we have physically 
seized over $121 million worth of merchandise as well. But 
diversion is a real problem, especially with a commodity like 
we are regulating. When the intrinsic value of the commodity is 
dwarfed by its tax liability, it is a recipe for illegal 
conduct.
    Senator Warner. But is it safe to say that some of the 
numbers that I have referenced, that in some States as much as 
half of the tobacco products sold may be fully illicit and not 
have even appropriate TTB permits, is that too high a number, 
or is that in the range?
    Mr. Manfreda. Sir, I do not have statistics on that. I am 
unable----
    Senator Warner. But you are the enforcement entity.
    Mr. Manfreda. Yes, but diversion----
    Senator Warner. It seems fairly stunning to me that you do 
not have statistics, plus or minus 10 percent, or up to 50 
percent of the tobacco products in a State like New York with a 
high tobacco tax, are illicit.
    Mr. Manfreda. Well, again, are we talking about Federal 
excise tax or are we talking about State taxes that are covered 
under the jurisdiction of ATF?
    Senator Warner. Pick your poison.
    Mr. Manfreda. We do not have jurisdiction over contraband 
cigarette taxing. That is when you----
    Senator Warner. But because there is a failure to have any 
kind of transparency about which of these manufacturers that 
are not following the rules at all in terms of TTB permits----
    Mr. Manfreda. Well, we coordinate our efforts with State 
authorities. We have ongoing dialogue with most States. We have 
tax agreements to give us the ability to share tax information 
with State authorities.
    Senator Warner. Mr. Chairman, may I take one more moment to 
ask one other question?
    The Chairman. Of course.
    Senator Warner. It just seems to me we should have concerns 
about this agency, both in terms of the regulatory approach as 
well as the fact that we do not seem to have a lot of good data 
in terms of actual illicit activities that are also potentially 
losing us revenue. That is where, Dr. Gootnick, I wanted to ask 
you, can you talk in any detail about how the illicit trade is 
affecting tax collection and how changes in CHIPRA may have 
affected that positively or negatively?
    Dr. Gootnick. Right. Start with the observation that, for a 
pack of cigarettes, for example, more than 50 percent of the 
retail sales price of a pack of cigarettes is taxes and fees. 
That is the Federal excise tax the TTB is responsible for, plus 
State excise taxes, local taxes in many cases, the master 
settlement agreement, the tobacco buy-out. That set of taxes 
and fees is over 50 percent of the price of a pack of 
cigarettes. So, when you get a product where the profit margin 
for illicit activity is high and the penalty is relatively low, 
there is going to be a range of activities.
    Those activities range from true smuggling across 
international boundaries to diversion of product that is deemed 
for export but is reintroduced into the domestic market absent 
the Federal excise tax, to what I think you are talking about, 
which is movement of cigarettes from, say, Virginia, a low-tax 
State, to New York, a high-tax State. In addition, there are 
Internet sales that do not pay required taxes.
    There have been estimates that the magnitude of diversion 
on State excise taxes is in the range of $5 billion annually. I 
do not know how reliable those numbers are. It is inherently 
difficult to quantify what is covert and what is an underground 
activity.
    Senator Warner. Mr. Chairman, I guess my final point--and I 
appreciate you giving me a little bit of extra time here--is 
that it seems like there may be two buckets here. One bucket, 
which I think you focused appropriately on, is, do we have a 
floor? How do we make sure that there is not an ability to game 
the system somehow within the, at least quasi-legal, context of 
roll-your-own or moving from small cigar to large cigar, these 
kind of manipulations which affect us in terms of a lot of 
revenue?
    There is also this other bucket of activities which we have 
heard referenced of up to 50 percent full tax evasion or fully 
illicit manipulation, or failure to even have any kind of 
registration. Those just seem to be out-and-out wrong actions. 
I believe we need to take action in both areas.
    Again, I appreciate the chairman giving me this extra time 
and having this very important hearing.
    The Chairman. The Senator from Virginia is being too 
logical. Heaven forbid that logic should break out on this, but 
I very much appreciate your separating those two considerations 
out. I look forward to working with you to pursue that.
    Let us move on again to kind of stay with this question of 
what is behind the inaction. Dr. Gootnick, you have reviewed 
the roll-your-own tobacco issue, the shift to large cigars. You 
have said that the problem is getting worse, this effort to 
circumvent the higher taxes, and it has gotten worse since you 
last looked at it.
    Now, given all that, the committee, back in 2012, included 
a provision in the Highway Bill that required roll-your-own 
machines offered for use at retail locations--we would be 
talking about convenience stores, tobacco shops--to be 
registered as commercial cigarette manufacturers. It was the 
point of the committee back then that this provision would stop 
the use of these machines for tobacco tax evasion and reduce 
the use of mislabeled roll-your-own tobacco.
    My sense is that that has not happened, and that is pretty 
much what you have said. But what is your sense of why the 
transportation bill provision has not worked? I mean, why has 
that not been an effective tool to close the loophole and block 
the bleeding of these enormous sums of money?
    Dr. Gootnick. Right. I would say, in a nutshell, it is 
because the incentive remains to switch from roll-your-own to 
pipe tobacco. But you are very correct that the transportation 
legislation in 2012 made clear that roll-your-own machines in 
commercial use were to be considered manufacturers of tobacco 
and should be taxed accordingly.
    The use of commercial roll-your-own machines went 
underground a little bit more than it had been. Insofar as 
these roll-your-own machines still exist, they do not 
necessarily as frequently exist right inside a retail tobacco 
outlet, but they do exist right next door.
    So we have observed--I had a team go, in this local area 
within 20 to 30 miles from here, to retail outlets and observe 
one retail outlet that formerly had a roll-your-own machine on 
its premises. Now there was a wall between the roll-your-own 
machine and the tobacco outlet where an individual could buy 
the pipe tobacco and the tubes, go around the corner to the 
roll-your-own machine. We actually observed an individual walk 
in, join the club for $10, and then provide them with their 
tobacco and walk out with a carton of cigarettes. Using roll-
your-own tobacco, they saved easily 10 bucks on a carton of 
cigarettes. So the incentives remain, and the process still 
goes on.
    The Chairman. And, Mr. Manfreda, what is your response to 
that? I mean, again, we have a substantial question of 
enforcement, where it seems like the government is just behind 
those who would try to skirt the laws and rules. What is your 
response to exactly what Dr. Gootnick just said?
    Mr. Manfreda. I would concur with him that the major 
incentive here is the tax differentiation between the products. 
I would tell you that, at present, we have over 72 
investigations under way regarding cigarette-making machines. 
All but six of those have raised issues of whether or not a 
social club is exempt from the liability as a manufacturer.
    We have not seen any representation where a social club 
would fall within the exemption from being considered a 
manufacturer of tobacco products. Some of the issues associated 
with finding this--and I do agree with the doctor that these 
have gone underground--when MAP-21 * was issued, we sent out 
over 1,467 letters to locations where we knew these machines 
were.
---------------------------------------------------------------------------
    * The Moving Ahead for Progress in the 21st Century Act of 2012.
---------------------------------------------------------------------------
    The problem is, we have no jurisdiction over these machines 
or their operators, they are not required to keep records, and 
they are not required to cooperate with us. They are really 
easily moveable. So enforcement of this becomes a very 
difficult problem.
    I do know that, out of the 72 investigations we have under 
way, the liability associated with any one location is about 
$54,000. So it is time-consuming. They do not cooperate with 
us. Even the manufacturers of the machines have an incentive 
not to cooperate with us. So, it is a very difficult problem to 
put to bed, because they are mobile and they hide.
    The Chairman. Fourteen hundred machines, 72 investigations, 
and still--unless I am missing something--no actual enforcement 
actions. Part of my concern is that, when there are no 
enforcement actions, it basically says to those who try to 
skirt the laws, you are home free.
    I mean, the whole point of enforcement, especially with 
scarce resources--and I am aware that you all are pressed in 
terms of resources--is, if you do not have some enforcement 
actions where you go the distance, it just sends the worst 
possible message, because those who would try to make money and 
exploit these loopholes to take advantage know they are home 
free. That is what I am so troubled about.
    I want to move on to one other area where I need to know 
whether new legislation is actually needed, and that is the 
question of processed tobacco and the diversion of it. Now, in 
2009 the Congress expanded your authority to address this 
issue, the shipment of untaxed processed tobacco, so that the 
agency could get a better handle on whether or not the 
manufacturers were paying the right taxes.
    Now, you all have asked for additional authority in this 
area because of your concern that untaxed processed tobacco 
shipments are being diverted through intermediaries and your 
ability to track the shipments is being lost. So why was the 
authority in the Children's Health legislation inadequate on 
this point, so we know exactly why you need the additional 
authority that you are talking about?
    Mr. Manfreda. In the President's budget, we proposed that 
any transfer to a non-permittee would be regarded as a removal 
of roll-your-own tobacco. The reason the current framework is a 
problem is that, when a manufacturer or processed manufacturer 
ships to a non-permittee, the first shipment is required to be 
reported to us, but what we have seen is there are multiple 
shipments after that that are not required to be reported to 
us.
    The ability to follow that shipment is at the whim of the 
persons we are going to, who are not required to report to us, 
keep records, or do anything like that, so the audit trail 
becomes almost impossible to follow without cooperation. That 
is why we would want to limit the transferability of processed 
tobacco to non-permittees.
    The Chairman. Did you want to add anything to that, Dr. 
Gootnick?
    Dr. Gootnick. I was just going to say that processed 
tobacco is really, I think, a straightforward example of an 
intermediate good being treated as a consumer item. So the 
intention under the definition of processed tobacco is that it 
is used as a factor in the making of a consumer good, but 
indeed it is just simply being used, and can be used with 
minimum modification in, for instance, these commercial roll-
your-own machines to make cigarettes.
    The Chairman. Thank you very much, Dr. Gootnick.
    I am going to excuse you both at this time, but I want it 
understood that, with the problem now more serious even than we 
had originally assessed, Mr. Manfreda, we need some clear 
rules. The idea that 39 States, as I stated, wait around for 
years and years, and there are proposals, it kind of reminds me 
of the marquee at the old movie house where it says ``coming 
soon'' and it never gets there.
    I mean, you all make these proposals, and year after year 
after year goes by, as those who would try to skirt the laws 
get more inventive and more and more creative, and the 
combination of the lack of clear rules--for reasons that I am 
still not clear on--plus the fact that we cannot even have a 
handful of enforcement actions to send a message of deterrence, 
I think is a prescription for trouble. So at this point I am 
going to ask----
    Senator Crapo is here, and I will just make a unanimous 
consent request, and then see if my colleague has questions.
    At this point I am going to ask unanimous consent to 
include in the record two analyses prepared by the TTB 
analyzing the number of tobacco companies that switched their 
small cigars to large cigars and roll-your-own cigarette 
tobacco to pipe tobacco. The identity of the individual 
companies is not included in these analyses because the 
information is considered protected under section 6103 of the 
Internal Revenue Code. These analyses were provided to and were 
discussed with minority staff. Without objection, they will be 
made part of the record.
    [The analyses appear in the appendix on p. 178.]
    The Chairman. So let me recognize my friend and colleague 
Senator Crapo for any questions he has for the first panel.
    Senator Crapo. Senator, I have no questions for the first 
panel, and I look forward to moving on to see what the next 
panel has.
    The Chairman. Very good. Gentlemen, you are excused.
    Our next panel will be Mr. Ronald Bernstein, president and 
CEO of Liggett Vector Brands of Morrisville, NC; Mr. Rocky 
Patel, owner of Rocky Patel Premium Cigars and board member of 
Cigar Rights of America in Naples, FL; Mr. Michael Tynan, 
Policy Officer, Oregon Public Health Division in Portland, OR; 
and Mr. Scott Drenkard, economist and manager of State 
projects, Tax Foundation of Washington, DC.
    Gentlemen, if you all will come forward. All right. I am 
very pleased that we have this panel, and let us begin with 
you, Mr. Bernstein.

 STATEMENT OF RONALD J. BERNSTEIN, PRESIDENT AND CEO, LIGGETT 
               VECTOR BRANDS LLC, MORRISVILLE, NC

    Mr. Bernstein. Chairman Wyden, Ranking Member Hatch, and 
members of the committee, my name is Ron Bernstein, and I am 
president and CEO of Liggett Vector Brands. Liggett is the 
fourth-largest cigarette manufacturer in the United States and 
has been operating since 1873. Thank you for inviting me to 
testify today.
    Seventeen years ago, Liggett became the first tobacco 
company to break ranks with the industry and settle tobacco-
related litigation. We also were the first, and remain the 
only, company to state that smoking is addictive on our 
packaging and to voluntarily list ingredients on our cartons. 
These actions reflect Liggett's longstanding cooperative 
relationship with Congress, the public health community, and 
regulators. With that backdrop, we are here today to shine a 
light on illegal conduct that is costing the U.S. billions in 
tax revenues.
    In 2009, Congress raised tobacco taxes to help fund the 
State Children's Health Insurance Program. The taxes on 
cigarettes, roll-your-own tobacco, and on little cigars were 
raised to the equivalent of $10.07 per carton. At the same 
time, Congress only marginally raised the tax on pipe tobacco 
to $1.15 per carton equivalent. That means the Federal excise 
tax on cigarette tobacco is roughly 10 times that on pipe 
tobacco. Before the ink was dry on the legislation, certain 
tobacco manufacturers embarked on a campaign to evade the tax 
increase by relabeling roll-your-own tobacco as pipe tobacco.
    For example, what a smoker would have found in a store 
before the tax increase was called Kentucky Select cigarette 
tobacco. The product made available after the tax increase is 
called Kentucky Select pipe tobacco. The chief differences 
between these products are the label and a substantially lower 
tax rate.
    Here is a bag of Desperado. Astoundingly, this company 
pasted on a label that says ``All Natural Pipe Tobacco'' and 
used tape to cover the statement ``Makes approximately 500 
cigarettes'' on the back. Everyone knows that this is cigarette 
tobacco. The manufacturer knows, the consumer knows, and I 
know. I know because I tried smoking it in a pipe and it was 
not a pleasant experience.
    We met with representatives from TTB in 2010 and showed 
them that all of the growth in the category was coming from 
mislabeled pipe tobacco rather than genuine pipe tobacco. TTB 
advised they were aware and had expected this problem when 
Congress failed to equalize the tax on pipe tobacco with roll-
your-own tobacco and cigarettes in 2009.
    Since the existing tax code definition of RYO included 
anything sold as cigarette tobacco or roll-your-own tobacco, 
TTB already had clear authority to enforce the law, especially 
since the manufacturers of the product knew exactly what they 
were doing and were using a variety of tactics to inform 
consumers that the product was really roll-your-own tobacco.
    We were pleased to learn shortly after the meeting that TTB 
had issued a statement on its website indicating that specific 
guidance would be forthcoming in the near future. Four years 
later, we are still waiting for that guidance. Meanwhile, sales 
of pipe tobacco have grown by over 700 percent, while roll-
your-own has declined by over 80 percent, and cigarettes have 
declined by over 20 percent.
    This chart--which is included in my written statement--
looks very similar to the one that GAO put up and really tells 
the whole story. None of the manufacturers of genuine pipe 
tobacco have seen any real growth during this period, nor are 
we aware of any growth in the sale of pipes. Yet products 
labeled as pipe tobacco have grown in sales from less than 1 
percent of the total cigarettes equivalent market to over 6 
percent, or more than 18 billion cigarette equivalents. Despite 
this, TTB has issued no specific guidance, and over $3 billion 
in excise taxes have been lost by the Federal Government.
    Even after a GAO report clearly demonstrated that the 
explosion of pipe tobacco sales was entirely due to roll-your-
own tobacco sales and had admissions from manufacturers to this 
fact, TTB still failed to act. Under the definition of 
cigarette tobacco in the Tobacco Control Act, FDA also has 
clear authority to treat mislabeled pipe tobacco as misbranded 
and to require it to be properly labeled and regulated as 
cigarette tobacco, but they too have allowed two markets to 
exist, one regulated and properly taxed, the other not.
    Additionally, since 2009 the renegade tobacco industry has 
also relabeled little cigars as filtered cigars. Here is an 
example, which you can see looks exactly like a pack of 
cigarettes and also contains menthol, which is not typically 
found in real cigars. This has created another tax dodge that 
has cost the Federal Government close to $900 million. Together 
with mislabeled pipe tobacco, these products now comprise over 
8 percent of the cigarette market.
    We welcome the attention that Congress is once again 
bringing to this issue and look forward to working with you to 
address the problem. Thank you for your attention.
    The Chairman. Mr. Bernstein, thank you. I just am struck by 
the fact that, 2 decades ago when I asked tobacco executives 
whether nicotine was addictive and they were under oath, they 
said ``no,'' and you have come here today and in effect given 
us real candor as to what is going on in the marketplace. I 
very much appreciate it, and we will have some questions for 
you in a moment.
    Mr. Bernstein. Thank you, Mr. Chairman.
    [The prepared statement of Mr. Bernstein appears in the 
appendix.]
    The Chairman. Mr. Patel, welcome.

  STATEMENT OF ROCKY PATEL, OWNER, ROCKY PATEL PREMIUM CIGARS 
  INC., AND BOARD MEMBER, CIGAR RIGHTS OF AMERICA, NAPLES, FL

    Mr. Patel. Thank you, Chairman Wyden, Ranking Member Hatch, 
and members of the committee, for granting me this opportunity 
to testify before this committee. My name is Rocky Patel, and I 
am the owner and CEO of Rocky Patel Premium Cigars, founded in 
Naples, FL.
    The 20 million premium cigars we handle each year embody 
the values of artisan craftsmanship, strict quality control, 
and the use of the finest aged tobaccos. While not defined 
under the tax code, premium cigars are made from a 100-percent 
wholly tobacco wrapper, are made by hand with 100-percent 
tobacco binder and filler containing no filter, tip, or non-
tobacco mouthpiece, and weigh in at at least 6 pounds per 
thousand. These are considered to be high-grade tobacco 
products. The closest approximation to a premium cigar in the 
tax code is the large cigar, which weighs at least 3 pounds per 
thousand. As a result, there are physical weight differences 
between what we consider a premium cigar and what is considered 
a large cigar under the code.
    The premium cigar culture is also unique and is rooted in 
the social nature of premium cigar consumption, often used in 
celebrations. The typical cigar shop is a family-owned brick-
and-mortar store that is the modern-day equivalent of a general 
store or barbershop where men and women who share a passion for 
premium cigars can enjoy each others' company, share common 
interests, and discuss the issues of the day in a relaxed, 
comfortable environment. Many of these experienced tobacconists 
have spent years visiting my farms and factories so as to 
provide the superior expertise their customers expect. Premium 
cigars occupy a niche within the overall cigar and tobacco 
market, serving an adult consumer base with a complex palate 
and appreciation for high-quality tobacco products.
    Since the 1970s, cigars have been classified as either 
small or large based upon weight and taxed differently based 
upon this classification. Premium cigars are lumped into the 
large cigar category under the code. In 2009, the enactment of 
CHIPRA transformed tobacco taxation by significantly raising 
the Federal excise taxes on both small and large cigars, along 
with other tobacco products including cigarettes, pipe tobacco, 
and roll-your-own tobacco.
    Before CHIPRA, premium and large cigars were taxed at a 
greater amount of either 20.719 percent per cigar or not more 
than 4.875 cents per cigar. After CHIPRA, these rates rose to 
the greater amount of either 52.75 percent per cigar and 40.26 
cents per cigar, respectively. This resulted in as much as a 
726-percent tax increase on premium cigars per thousand, one of 
the highest increases in the history of the U.S. tax code. 
However, taxes on small and large cigarettes only increased by 
approximately 158 percent per thousand sticks after CHIPRA.
    The 2012 GAO report highlighted that price-sensitive 
manufacturers and consumers began substituting higher-taxed 
products with lower-taxed ones. Some industry participants took 
steps to avoid taxes by reclassifying their products by adding 
weight to small cigars in order to qualify as large cigars. Our 
solution to this issue would be to define premium cigars in the 
code to distinguish between non-premium cigars and premium 
cigars. A premium cigar could be defined according to several 
unique factors, including that premium cigars are unfiltered 
products that are hand-wrapped, are 100-percent leaf tobacco, 
and weigh more than 6 pounds per thousand.
    These differences would make it impossible to game the 
definition of premium cigars based on weight alone, allowing 
Congress and the regulators to focus on the differences between 
small, large, and premium cigars and reduce the opportunity and 
incidences of tax avoidance. We also support a lower flat tax 
for premium cigars, which should have the added benefit of 
simplicity and certainty, reducing the compliance burden on the 
premium cigar industry and the enforcement burden on the TTB.
    Such a flat tax could, and should, be lower than the 
current rate applied to large cigars to more appropriately 
calibrate the relative differences between the tax rates. We 
also believe that the policies adopted in the response to the 
GAO report should focus on key sources of revenue loss and not 
focus on tobacco products that are not the source of tax 
avoidance. Importantly, cigars represented less than 4 percent 
of the Federal excise tax revenue from all tobacco products in 
2012.
    Thank you again for this opportunity to testify before the 
committee. I would be pleased to answer any questions.
    The Chairman. Thank you very much, Mr. Patel. We will have 
questions in a moment.
    [The prepared statement of Mr. Patel appears in the 
appendix.]
    The Chairman. We are glad to see Oregon well-represented 
here today. Mr. Tynan, please proceed.

          STATEMENT OF MICHAEL TYNAN, POLICY OFFICER, 
          OREGON PUBLIC HEALTH DIVISION, PORTLAND, OR

    Mr. Tynan. Thank you, Chairman Wyden, Ranking Member Hatch, 
and members of the committee. My name is Michael Tynan. I am 
the Policy Officer for the Public Health Division in the Oregon 
Health Authority. Prior to that, I was at the Centers for 
Disease Control and Prevention's Office on Smoking and Health. 
I have been invited here to talk to you today about studies I 
published on changes that have happened since the Federal 
excise tax increased in 2009, but before that, since I am the 
only public health voice, I want to talk about the dangers and 
health effects of smoking.
    Tobacco use is the leading cause of death and disease in 
the United States. Each year, 480,000 people die from smoking 
and exposure to second-hand smoke, and CDC estimates that 18.1 
percent of adults in the United States are smokers. The good 
news is, we know how to end the tobacco use problem in this 
country. Ending the tobacco use problem is a political 
question, not a scientific one.
    We know what works. Increasing the price of tobacco, 
establishing smoke-free environments, warning about the dangers 
of 
second-hand smoke with aggressive media campaigns, and 
increasing access to cessation are the tools available to 
public health that can significantly reduce smoking and tobacco 
use.
    Increasing the price of tobacco is the most effective 
tobacco prevention tool available for public health. Simply 
put, the more cigarettes cost, the less people will smoke. 
Every 10-percent increase in the price of cigarettes results in 
a 4-percent decline in consumption and can have an even greater 
impact on youth.
    Dr. Gootnick already spoke to you about reports published 
by GAO concerning changes in the tobacco use patterns and 
product design since 2009, and my full testimony contains a 
summary of the papers that I have published, and my colleagues 
at CDC and in Oregon, on this topic. I will summarize those by 
saying that our papers reached complementary conclusions to 
what GAO reported to you earlier today. Our papers included an 
estimate of Federal revenue loss, and, although we used 
different timelines and slightly different methodologies, we 
found that, through June 2013, Federal tax receipts on the 
pipe/roll-your-own switching alone reduced Federal tax receipts 
by $2.3 billion. There were additional losses to State 
governments in lost excise taxes and lost State revenue.
    But let me walk you through what this means practically for 
a smoker. This, as you have seen earlier, is a 1-pound bag of 
roll-your-own tobacco. However, as you can see, it has a pipe 
label on it. This bag can be purchased online for about $10. I 
went to my neighborhood roll-your-own shop on Sunday. I walked 
to it. I did not ride my bike, but I walked to it, Senator, and 
it cost me $16. So, because it has a pipe label on it, that is 
why it is so inexpensive. Had it had a roll-your-own label on 
it, it would have been at least $22 more.
    But the interesting thing was, even though the store's name 
is Roll-Your-Own Mart, they do not even sell roll-your-own 
tobacco. All of the tobacco they sell there is pipe tobacco. 
The clerk told me that roll-your-own tobacco is too expensive, 
so they do not carry it. They sell pipe tobacco instead.
    This $16 bag will make approximately 500 cigarettes. That 
is about 2\1/2\ cartons of cigarettes. So for comparison, a 
single carton of cigarettes in Oregon costs $45. Two hundred 
cigarettes for $45, or you can make 500 for $16--if you were a 
smoker and your taxes went up, which product would you buy?
    The public health community is concerned about this, 
because, instead of quitting in response to the 2009 Federal 
cigarette tax increase, it appears that some smokers have 
switched to pipe tobacco, allowing them to maintain their 
addiction to tobacco products. Also, as you heard earlier, the 
changes do not stop at pipe tobacco. There have been changes to 
the type of cigars people smoke, or at least in the way that 
those cigars are taxed.
    So this is a machine-made cigarette, which you saw earlier, 
made by Cheyenne Tobacco. This is a small cigar made by 
Cheyenne Tobacco. They are identical. The difference is, this 
one is wrapped in white paper, this one is wrapped in tobacco 
leaf. That is how this is classified as a small cigar. Then 
what manufacturers did after 2009 is, they took these products, 
still sold in a pack of 20, that were small cigars, made them a 
little bit heavier, and classified them as large cigars. In 
some cases, as you mentioned, Senator, that was done by adding 
a little bit more tobacco to the product. It has also been done 
by adding kitty litter to the filter to make them heavier.
    So again, the public health concern is that smokers who 
might have otherwise quit have instead switched to products 
that have allowed them to maintain their addiction to tobacco 
products. Public health is also concerned because the morbidity 
and mortality effects of all forms of combustible tobacco are 
the same. If you smoke a cigar the way you smoke a cigarette, 
it does not matter how it is taxed, there are going to be 
health effects.
    Changing how these products are classified also does not 
just result in lost revenue, but also changes how these 
products are regulated by the Food and Drug Administration. 
These products are now available in candy flavors and with 
misleading descriptors like ``Lite,'' ``Mild,'' and ``Low,'' 
even though those practices are banned by the Food and Drug 
Administration and by Congress in the Tobacco Smoking Act.
    So at least two policy approaches exist that can address 
these tax and policy loopholes. First, as was discussed 
earlier, the objective characteristics could be identified that 
could classify these products separately from one another. 
Second though, and more importantly, tax parity for combustible 
tobacco is the direct way to impact this practice.
    Congress was wise in 2009 when it created tax parity for 
cigarettes and small cigars and roll-your-own to discourage 
switching between these products. The issue we are discussing 
today, Senators, is an unfortunate consequence of tax inequity 
between pipe tobacco, large cigars, and other combustible 
tobacco. Simply put, tax parity would expand the public health 
benefit of the 2009 Federal tax increase.
    The Chairman. I want to make sure I heard that right, but I 
thought you said that clay in kitty litter was added to the 
filter to make the small cigar heavier. Is that true?
    Mr. Tynan. There are some instances where that has been 
done. Yes, Senator.
    The Chairman. Could you get us that for the record? I had 
not heard that before.
    Mr. Tynan. Yes.
    [The prepared statement of Mr. Tynan appears in the 
appendix.]
    The Chairman. All right. Let us hear from Mr. Drenkard.

  STATEMENT OF SCOTT DRENKARD, ECONOMIST AND MANAGER OF STATE 
            PROJECTS, TAX FOUNDATION, WASHINGTON, DC

    Mr. Drenkard. Thank you, Chairman Wyden and members of the 
committee. I appreciate the opportunity to speak today. In our 
77 years since our founding in 1937, the Tax Foundation has 
monitored tax policy trends at the Federal and State levels, 
and our data and research are heavily relied upon by 
policymakers, the media, and the general public.
    Tobacco taxes today are the highest they have ever been in 
the United States. The Federal rate currently stands at $1.0066 
cents per pack of cigarettes, and State and local rates can add 
as much as an additional $6.16 per pack, as in Chicago, IL. 
These combined rates are equivalent to a tax in excess of 200 
percent in some locales. Now, these taxes have a really 
substantial effect on the price of cigarettes as well. The most 
recent survey I found is that a pack of cigarettes costs $14.50 
in New York City.
    The high tax burden on tobacco results in de facto 
prohibition on the products, bringing with it all the 
undesirable outcomes associated with the alcohol prohibition in 
the 1920s. The largest of these is cigarette smuggling. Our 
research shows substantial empirical evidence of tobacco 
smuggling from low- to high-tax jurisdictions, with criminals 
pocketing the profits that would otherwise go to State revenue 
coffers.
    The Mackinac Center for Public Policy estimates that 57 
percent of the cigarettes consumed in New York State in 2012 
were smuggled into the State from other locales. Other States 
with substantial smuggling problems include Arizona at 51.5 
percent, New Mexico at 48.1 percent, Washington at 48 percent, 
and Wisconsin at 34.6 percent.
    On top of that, the news stories surrounding the black 
market for tobacco are shocking. We have uncovered instances of 
violent crime, like one disturbing episode in California where 
criminals sacked a distribution center, rounded up the 
employees at gunpoint, and made off with $1 million in 
cigarettes, and most importantly, the tobacco tax stamps. We 
have seen crime rings that involve corruption of law 
enforcement officers--this happened in Maryland--and even one 
instance of a crime ring running cigarettes from Charlotte to 
Detroit which was funding operations of the terrorist 
organization Hezbollah.
    In addition to smuggling authentic cigarettes from low- to 
high-tax jurisdictions, criminals sometimes skirt the legal 
market altogether with counterfeit name-brand products and 
tobacco tax stamps. Counterfeiting is highly profitable. It is 
an international business that exposes consumers to products 
with increased levels of dangerous chemicals like lead and 
thallium. Various sources report finding insect eggs, dead 
flies, mold, and human feces in counterfeit cigarettes. One 
source estimates that the Chinese counterfeit cigarette 
business produces 400 billion cigarettes per year to meet 
international demand.
    This problem is far more pervasive than people are aware 
of, and even I am surprised by it sometimes. Last week when I 
was preparing for this testimony, I thought it might be 
interesting to see how quickly I could buy a pack of improperly 
stamped cigarettes, and I kid you not, the very first store I 
walked into in the District of Columbia to try to do this sold 
me a pack of cigarettes with a Virginia tax stamp. This is 
illegal.
    I brought along a few visual aids to help me make my point 
today. The first map--Figure 1 in my written statement--shows 
the large amount of the cigarette smuggling problem. Some 
States are outflow States, and those tend to be places where 
taxes are low, or at least relatively low compared to 
neighboring States. Other States are a lot higher, and New York 
is the most shocking, with the rate of 57 percent of the 
cigarette market being under the table.
    The second chart--Figure 2--is a scatter plot where each 
dot represents a State's cigarette tax rate and their 
corresponding smuggling percentage. As you can see, as the 
taxes go up, the rates of smuggling go up in a pretty clear 
fashion.
    Then finally--on the last page of my written statement--is 
a picture of a car, what an apprehended smuggler looks like. As 
you can see, the smugglers are capable of fitting hundreds of 
cartons into just one regular-sized vehicle. In fact, the 
Virginia Crime Commission estimated in 2012 that a well-
structured crime ring could pocket $4 million if they could fit 
a 16-wheeler with contraband cigarettes.
    This is not what sound tax policy looks like. Subjecting 
certain products, even unhealthy ones, to wildly prohibitory 
rates has damaging unintended consequences. In 1994, the 
Canadian government found that smuggling rates were so high and 
crime was so senseless that they cut the Federal excise tax 
rate from $16 to $11 per carton. Many provinces followed suit, 
and smuggling rates declined in response. Canadian tax rates 
have since, unfortunately, crept up little by little, and 
smuggling rates have grown with them. The point here is that 
cigarette taxes are not a good revenue source and the products 
are currently over-taxed.
    Any conversation of raising rates needs to have a realistic 
expectation of how consumers will respond. We have learned from 
these panels that consumers will shift their purchases to 
lower-tax options because it is cheaper. It is our 
responsibility to make sure that we are not giving them 
incentives to shift them to the black market instead. Thank 
you.
    The Chairman. Thank you, Mr. Drenkard. We will have some 
questions in a moment.
    [The prepared statement of Mr. Drenkard appears in the 
appendix.]
    The Chairman. Let me start with you, Mr. Bernstein, because 
it is a pretty rare event in America when a major corporation 
like your company asks to come to Washington, DC and say to the 
government, we need to meet with you and talk about better 
oversight and better regulation. But as far as I can tell, that 
is what you all did. You asked to come to Washington to meet 
with the Treasury Department over this issue. Why did your 
company take this step in terms of asking to come to Washington 
to meet with Treasury officials?
    Mr. Bernstein. Well, Senator, thank you. This is a big 
issue. We obviously operate on the street and we know what is 
going on, and we are able to see things quickly that the 
regulatory agencies may not be able to register as quickly.
    So we went to make them aware--and, at that point, the lost 
revenue was not as dramatic as it is today, because it has 
gradually increased over the 5 years. But at that time we could 
see that clearly there were two markets that were developing: 
one that was properly regulated and taxed and the other not.
    We felt it was appropriate to bring that to their 
attention. As I said in my comments, we were pleased to find 
out that they were, in fact, aware of it. We think we may have 
enlightened them on a few aspects of it that they had not seen, 
particularly the proliferation of the cigarette machines that 
had started at that time. We were hopeful when we left the 
meeting that there would be quick action. Unfortunately, as 
this hearing has indicated, that has not happened.
    The Chairman. And so they told you what at the meeting? 
What did they tell you they were going to do?
    Mr. Bernstein. They did not tell us they were going to do 
anything. What they did was, they indicated that they were not 
surprised, that they were aware that it was a problem, that 
they had been aware that it would be a problem from the time 
that pipe tobacco was not raised to the same level as 
cigarettes and roll-your-own in 2009.
    Just one other comment: our primary objective was to assure 
that the playing field is the same for everybody in the tobacco 
business.
    The Chairman. That is what I wanted to ask you about next, 
because we are looking today at Federal tobacco excise taxes, 
but there are additional incentives to mislabel and convert the 

cigarette-type products and the lower-tax pipe and cigar 
products because you can get around some State and local taxes 
as well.
    When you add all of this up, how big a price advantage do 
the firms that deliberately mislabel and convert their products 
to low-tax products have compared to firms like yours that are 
trying to comply with what the Congress at least intended?
    Mr. Bernstein. Well, I think as was indicated by your 
gentleman from Oregon, you can go and buy 2\1/2\ packs of 
cigarette equivalent in pipe tobacco for about $15, $16, 
whereas you cannot get a pack of legitimate and properly taxed 
cigarettes for under $30. I am using national averages when 
considering State excise tax variations. But if you look at it, 
I mean, the gap can be anywhere from $15 to $40 or $50 when you 
are talking about premium cigarettes.
    The Chairman. All right. Let us move on to Mr. Tynan. We 
thank you for coming, Mr. Tynan. We are glad to have you.
    As I pointed out in my opening statement, the 
reauthorization of the Children's Health Insurance Program 
tried to establish the principle that all cigarette-type 
products would be taxed at the same rate, especially small 
cigars. When it became clear that there were those who were 
going to try to circumvent that principle by using these 
rolling machines, Congress passed legislation to try to shut 
that particular loophole. Your research indicates that all of 
these dodges together cumulatively have meant that the 2012 
legislation has not had any real impact. In your view, why is 
that the case?
    Mr. Tynan. We do not know why that is the case. The 
machines do not appear to be in the stores anymore, at least 
not anecdotally in the stores we have gone into in Oregon. But 
that does not mean that they have not gone underground or that 
that is different in other States.
    There needs to be some sort of national assessment of the 
retail space to identify what has occurred in the retail space 
or to see if the stores have gone underground. But simply, 
Senator, it may just be that smokers did not understand how 
much of a tax advantage there was with roll-your-own tobacco.
    When these machines came into the stores, maybe consumers 
just got a taste of it, so to speak. But one thing I want to 
point out is that this is not just happenstance that this 
happened. I was still at the CDC at the time when the 2009 
tobacco tax increase occurred. We were very interested to see 
if we could see an immediate impact of the increase, and we did 
not yet know that there was this pipe/roll-your-own difference 
that was going to happen.
    So I was tracking the TTB data on a month-to-month basis. 
When the new data came out for April 2009, I called TTB because 
I thought they had made a mistake in their data. I called them 
and said, you guys mixed up your pipe and your roll-your-own 
data. I think you reported them in the opposite. They said, no, 
no, we didn't, that data is right. So the fact that it happened 
the month it came out says to me that this was not an accident.
    The Chairman. What in your view, since you are a public 
health office, are the impacts to children of these various tax 
dodges? I want to get Mr. Drenkard into this debate about taxes 
a little bit later, but in your view what are the implications 
for children and the take-up rate and that sort of thing?
    Mr. Tynan. Well, the implications for children are twofold. 
One is, if cigarettes cost less, we know children will be more 
likely to start smoking. Raising the price of tobacco products 
is one of the most effective tools to prevent youth from even 
starting.
    Eighty percent of people who start smoking start by the age 
of 18. I am going to say that again: 80 percent of people who 
start smoking start by the age of 18. We know that flavors, 
flavors like candy flavors, like vanilla and wild cherry that 
these products are available in, are some of the things that 
make tobacco products attractive to children.
    We have published studies with my colleagues at CDC that 
show that 40 percent of youth who smoke tobacco products smoke 
a flavored tobacco product. So it is not only the price, 
Senator, but it is the fact that by classifying your product as 
a cigar you are able to get around FDA regulations that 
prohibit flavors, candy-like flavors, in cigarettes.
    The Chairman. Let us go to you, Mr. Patel, if we could. I 
am new chairing the committee and trying to think about the 
steps ahead. As you know, we have been talking about 2006, 
2009, trying to clarify the difference between cigarettes and 
cigars.
    In 2009, when faced with the task of trying to prevent 
cigarette-
type products from being rebranded as cigars to avoid the new 
higher tax on cigarettes, Congress just said, we will apply the 
new higher tax to small cigars. That pretty clearly has not 
been exactly an ideal situation.
    Would you support the idea of, in effect, going back to the 
drawing board and just getting a clear definition of what 
constitutes a cigarette and what constitutes a cigar?
    Mr. Patel. Certainly. I represent the premium cigar 
category. In regards to cigars in general, I think under the 
TTB tax code, the language is very, very broad. There needs to 
be a concise definition separating what a premium cigar is, 
what a large cigar is, and what a small cigar is. 
Unfortunately, right now we have the migration from the small 
cigars to the large cigar category because of the weight 
requirement, the weight requirement being 3 pounds per 
thousand.
    What we suggest for the premium cigar category is to shift 
that weight to 6 pounds per thousand. That would stop the 
migration for the small cigars to the large cigar category. I 
think there needs to be a separate definition for the premium 
cigar category, which is the one I represent, because premium 
cigars are totally unique, they are different, they are an art 
form, they are a culture that has transited over generations.
    By the time we plant the seedling in the ground to the time 
we get a cigar in the box takes 4 to 5 years, and 300 different 
hands touch the tobacco. It is a totally different audience. It 
is marketed to adults, sold to adults. Minors cannot buy it, 
cannot enter tobacco stores where premium cigars are sold. So 
it is a unique product, and I certainly think that narrowing 
the definition for premium cigars, large cigars, and small 
cigars would certainly help the cause.
    The Chairman. Well, it is clear there are some clever 
people out there trying to rejigger their tax bills, and I am 
anxious to pick up on your suggestions.
    Let me ask you a question, Mr. Drenkard. It goes to this 
question of the e-cigarettes. I have worked with you all at the 
Tax Foundation on a variety of issues, especially tax reform, 
and always enjoy getting your input about where markets are 
headed. If e-cigarettes are not taxed and tobacco products are 
taxed, in your view, where is the market going to go?
    Mr. Drenkard. Well, the market is going to go to electronic 
cigarettes to some degree. Now, I think it depends more on how 
that sort of thing affects the price. Also, that might be a 
desirable outcome from a public health perspective.
    Electronic cigarettes are found by many people who have 
looked at them to have a lower risk profile associated with 
them. To put it very basically, there are tens of thousands of 
carcinogens in a traditional incinerated tobacco product, and 
there are really only three items in electronic tobacco liquid. 
It is propylene glycol, nicotine, and glycerine. Other than 
nicotine, those two other items are found in food products.
    So my reading in the literature is that the risk profile is 
a lot lower. To me that indicates that there are a lot of 
desirable outcomes to be had from people switching from 
traditional incinerated tobacco to smokeless tobacco like that, 
or electronic tobacco like that. My brother, for example, quit 
cigarettes and moved to electronic tobacco, and I think that 
was a good move.
    The Chairman. Well, as you know, some who study the e-
cigarette industry have said that these products have not been 
on the market long enough to know whether they have any 
negative health effects.
    I am very much, as we get into this, affected by that 
testimony that I heard in 1994, where clear scientific evidence 
was ignored. That is why I think there are real implications 
for this debate about when something is untaxed and something 
is taxed. We ought to get to the bottom of how markets work.
    Let us just give Mr. Tynan an opportunity to respond to the 
same question. If e-cigarettes go untaxed and traditional 
tobacco products are taxed, where do you think the market goes?
    Mr. Tynan. I mean, the challenge with e-cigarettes is that 
they are currently an unregulated product, Senator. We do not 
know what the long-term health effects are going to be from 
smoking e-cigarettes. Being unregulated, we could have two e-
cigarettes that come from the same manufacturer on the same 
assembly line that have completely different constituents in 
them. Many of them also come from China. I would not put a 
plastic toy from China in my mouth, let alone something you 
have to inhale that puts things into your lungs. So, I mean, I 
think we have to be very careful when we think about the impact 
that it could have on long-term population health and the 
impact that it could have on youth starting to smoke.
    What we do not want is people to become addicted to 
nicotine through an e-cigarette and then switch later to 
smokeless tobacco or cigarettes, which we know are harmful. So 
there need to be more long-term studies on the health effects. 
The challenge with many of the studies that are out there is 
that they have not necessarily been independent studies.
    We know from the 2006 Federal court case that the tobacco 
industry has been found by a Federal judge to be racketeers. 
One of the findings in that court case was that the tobacco 
industry manipulated scientific studies. So we need to be very 
thoughtful and look very closely at the studies that have found 
that e-cigarettes are safe and effective.
    The Chairman. And what is your take, Mr. Bernstein, on that 
same question of where the market will go if e-cigarettes are 
untaxed and traditional tobacco products are taxed?
    Mr. Bernstein. Yes, Senator. Before I answer that, if I 
could just point out that when Mr. Tynan referenced the tobacco 
industry being convicted of racketeering, it is important to 
note that the judge dismissed Liggett from that because of 
Liggett's behavior and viewed it in a much more positive light.
    The e-cigarette is a big question mark. I think the first 
question is, what is it? I think that has to be determined. In 
my opinion, it is either a medical device or it is a tobacco 
product, and it should be regulated as such in either case. I 
believe it is very difficult to predict where the e-cigarette 
market is going to go, because we do not know how it is going 
to be regulated, we do not know how it is going to be taxed. If 
it is not taxed and if it is not regulated, it will grow. But I 
cannot tell you that it will grow at an exponential rate, 
because there is not enough evidence yet to be able to say 
that.
    What I will tell you, though, is that there are people who 
are--and I understand the concerns about China--mixing up vats 
of e-liquid in the back of their stores and then are selling it 
to individuals, and nobody has any idea what is in it.
    The Chairman. In the United States?
    Mr. Bernstein. In the United States. In fact, our offices 
are in Morrisville, NC. There is a store in our center, the E-
Liquid Lady, and she basically mixes up vats of----
    The Chairman. And the E-Liquid Lady does exactly what?
    Mr. Bernstein. They mix up vats of e-liquid in the back, 
and then they inject it into devices that people buy.
    The Chairman. And all of this takes place without any 
oversight?
    Mr. Bernstein. None.
    The Chairman. All right.
    You four have been very helpful. I came here this morning 
with the view that this was a classic case of tax evasion. I 
have added to that judgment that we are certainly moving 
towards a classic case of government foot-dragging. I think 
what all of you on this panel have demonstrated is that those 
who skirt the laws clearly look like they are going to get more 
inventive about how they go about it. Mr. Tynan talked about 
kitty litters, and Mr. Bernstein talked about e-liquid ladies 
making injections and the like.
    That ought to give everybody pause. So we have a lot of 
work to do to follow up here, and I want to thank all of you 
for your testimony and your cooperation. Members of the 
committee are going to have until the close of business on 
Friday, August 8th, to submit questions for the record.
    With that, the hearing is adjourned.
    [Whereupon, at 11:34 a.m., the hearing was concluded.]
    
    
    
    
    
                            A P P E N D I X

              Additional Material Submitted for the Record

                              ----------                              


[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]




                                   [all]