FROM THE OFFICE OF PUBLIC AFFAIRS

Thank you, Mr. Chairman. I am pleased to be joined this morning by the Director of the Bureau of Alcohol, Tobacco and Firearms, John Magaw and by the Acting Deputy Commissioner of Customs for International Affairs, Doug Browning. We are pleased to have this opportunity to discuss administrative and enforcement issues arising from the implementation of new tobacco legislation, particularly those issues related to controlling illegal domestic diversion and cross-border smuggling of tobacco products.

As you know, the prospect of comprehensive tobacco legislation is an issue of enormous consequence to the health and economic well-being of the American people. Comprehensive tobacco legislation such as Senator McCain's bill would stop 3 million teens from smoking over the next five years, prevent approximately one million premature deaths, and reduce the costs that smoking imposes on our economy by almost $80 billion in the long run. The Department of the Treasury and the Administration support the efforts of your Committee and others in Congress to protect America's children from the deadly threat of smoking.

In addition, the Administration shares your interest in assuring that the enactment of tobacco legislation does not result in either a domestic black market or smuggling of tobacco products into the United States. We believe that it is essential that comprehensive tobacco legislation contain provisions that will minimize the diversion of cigarettes from legitimate domestic channels of distribution and the smuggling of cigarettes into the United States from abroad.

It is not possible to reach definitive conclusions about the risks of smuggling given the wide range of changes contemplated by comprehensive tobacco legislation. Incentives to smuggle may well be sensitive to details of tobacco legislation, including price changes, the way in which assessments are levied and other specifics. Nonetheless, the Treasury Department believes that the creation of a sound regulatory system -- one that will close the distribution chain for tobacco products -- will ensure that the diversion and smuggling of tobacco can be effectively controlled and will not defeat the purposes of comprehensive tobacco legislation.

By closing the distribution chain for tobacco products, we will be able to ensure that these products flow through legitimate channels and effectively police any leakages that do take place. The Treasury Department already licenses tobacco manufacturers and export bonded warehouses in connection with collecting tobacco excise taxes. We believe that such licensing should be extended to the other entities in the upper end of the tobacco distribution chain -- wholesalers, exporters, importers and distributors. We are comfortable with a system that places primary responsibility for licensing retailers on state governments, as provided in Senator McCain's bill. Under this system, tobacco products would move through legitimate channels. Most importantly, such channels would not be open to America's youth.

An effective system must include the following elements:

• First, as I have described above, all entities in the distribution chain for tobacco products -- manufacturers, wholesalers, exporters, importers, distributors and retailers -- should be required to hold a license or a permit. Licensing of retailers could be done at the state level. Licenses would be issued based on certain clearly specified criteria and could be revoked or suspended for certain specified violations. Those conducting business without a license would be subject to penalties. Licensed entities should only be authorized to sell tobacco products to other licensed entities. The sale or distribution to any entity that is unlicensed would be unlawful.
• Second, legislation should require the marking, branding and identification of packages of tobacco products intended for domestic distribution and for export so that they may not be diverted or smuggled in circumvention of the legitimate channels of distribution.
• Third, any regulatory proposal should include penalty and administrative provisions that will allow for effective, efficient and uniform enforcement of controls over distribution.

A regulatory scheme for tobacco products such as that I just described would be similar to the way the Federal Government has effectively regulated alcoholic beverages for over sixty years. The system in place has allowed for effective commerce in alcoholic beverages while effectively curtailing trafficking in illicit, non-tax paid products. In addition, all states currently regulate their alcohol retailers.

Current laws regulating tobacco are aimed at collecting the Federal excise tax and assisting states in their efforts to collect excise taxes imposed on certain tobacco products, not at regulating the distribution of tobacco products and preventing smuggling. For example, the Contraband Cigarette Trafficking Act, or CCTA, was designed solely to assist states in enforcing their tax laws. It does not address or ensure a closed national distribution system and was only intended to proscribe domestic diversion as it applies to state taxes. The CCTA does not address cross-border smuggling, and it applies only to cigarettes, and not to any other tobacco products.

With the necessary regulatory provisions in place to deal with potential smuggling, we do not expect a large-scale smuggling problem for several reasons. First, the "closed" distribution scheme I just described would limit drastically smugglers' ability to enter products into a legitimate distribution channel. Potential black marketeers will not be able to move products through legitimate wholesalers or distributors. Nor will they be able to sell products to retail consumers at the local convenience stores or other licensed retail outlets. Instead, without a way to place contraband products in the market legally, smugglers would have to sell cigarettes outside channels of legitimate distribution. This would be a risky proposition and one we do not believe will represent a significant problem. Second, U.S. cigarette manufacturers would have great incentives not to become complicit in any smuggling operation, as they would encounter enormous legal risks (such as the possibility of losing their license or, as the McCain bill provides, losing their cap on liability risk) and public opprobrium. Indeed, it is hard to imagine that large scale smuggling could occur without the manufacturers' knowledge. Third, the U.S. Customs Service has the expertise and the experience to deal with imported contraband products and has already made a substantial investment in the currently planned introduction of non-intrusive inspection systems and other equipment needed to detect smuggling of contraband. The organic nature of tobacco and the distinctive shape of cigarettes makes them readily detectable by equipment that Customs currently has in place.

Some have cited current levels of interstate smuggling as a reason why comprehensive tobacco legislation such as Senator McCain's bill will lead to wide-scale smuggling. Such arguments fail to account for the fundamental difference between interstate diversion and cross-border smuggling. Commerce between states is not controlled the way it is across the United States' international borders. The Customs Service simply does not monitor the movement of products across state borders, while it does effectively monitor our international borders. More importantly, the current levels of interstate smuggling exist without having in place a closed distribution system like the one I described earlier. If anything, such a system would be expected to have the collateral benefit of substantially reducing existing interstate diversion of tobacco products.

The Canadian experience is also frequently highlighted by those who predict the emergence of a large black market. There are several reasons to believe, however, that the Canadian experience is not an appropriate predictor of what would occur if tobacco legislation such as that supported by the Administration were to become law.

First, the size of the Canadian population as well as its concentration along the border with the United States, makes the Canadian example not particularly instructive for the United States. Because of its smaller population, the total number of cigarettes sold in Canada is only one-tenth as large as the number sold in the U.S., so small amounts of smuggling have a noticeable impact on their tobacco market and would have none on ours. That is, it would take ten times as much smuggling by volume to have an equivalent proportional effect on the U.S. market for tobacco products. Moreover, smuggling became a problem in Canada because of the ease of access to alternative markets. Eighty percent of the Canadian population lives within a two-hour drive of the U.S. border, placing it within easy reach of smugglers transporting cigarettes from the United States. The U.S. population is more dispersed, making the logistics of a nationwide black market in smuggled cigarettes more complex and expensive for organized smugglers. The dispersal of the U.S. population also means that a U.S. resident is less likely than a Canadian resident to be able to cross the border routinely for casual cigarette smuggling.

Secondly, and most importantly, Canada did not have in place the type of effective licensing and enforcement regime that is advocated by the Administration. For example, Canada did not mark its cigarette packaging with "For Export Only" labels until after the smuggling problem of 1992-93. Canadian law enforcement had very few personnel devoted to tax evasion. The vast majority of enforcement with respect to Canadian taxes was done at the provincial level and there was little or no coordinated enforcement effort at the national or inter-provincial levels. In addition, Canada does not license the distribution chain with respect to tobacco products, with the exception of manufacturers. Finally, Canada's laws on tax evasion did not contain strong penalties and there were inadequate resources to enforce these laws.

We are confident that a proper regulatory enforcement system will minimize the diversion of tobacco products from legitimate channels and the development of cross-border smuggling. Such a system would closely parallel the regime that has been in place for the regulation of alcoholic beverages for more than sixty years. We look forward to working with you and your Committee, as well as other Committees in Congress, to fashion such a regulatory system.

Thank you, Mr. Chairman.