Cigarette smuggling: using the shadow economy or creating its own?

Cigarette smuggling undermines policymakers’ efforts to curb smoking while also leading to tax revenue leakages. Policymakers around the world are trying to obtain a better understanding of how to combat cigarette smuggling. This paper adds to the literature on cigarette demand and related smuggling by considering the cross-border influences of both the price differentials and the shadow economy. While price/tax differentials induce both casual and organized smuggling, the presence of the shadow economy facilitates smuggling and opens up possibilities for arbitrage in smuggled goods. Using data across U.S. states for the years 1997–2008, results show that border price effects are positive and statistically significant, and the average shadow economy in bordering states facilitates smuggling, with own shadow economy sometimes showing signs of facilitating intra- and cross-border smuggling. The other findings regarding the negative own-price elasticities and habit persistence for smoking are in line with the larger literature.