LAO 2003-04 Budget Analysis: General Government

Legislative Analyst's Office

Analysis of the 2003-04 Budget Bill

Board of Equalization (0860)

The Board of Equalization (BOE) is one of California's two major tax collection agencies. In terms of its responsibilities, BOE: (1) collects state and local sales and use taxes, and a variety of business and excise taxes and fees, including those levied on gasoline, diesel fuel, cigarettes, and hazardous waste; (2) is responsible for allocating certain tax proceeds to the appropriate local jurisdictions; (3) oversees the administration of the property tax by county assessors; and (4) assesses railroad and specified utility property. The board is also the final administrative appellate body for personal income and corporation taxes that the Franchise Tax Board administers, as well as for the taxes that BOE administers. The BOE is governed by a constitutionally established five-member board—four elected board members and the State Controller.

The 2003-04 Governor's Budget proposes $321 million in support of BOE operations, of which $199 million is from the General Fund. This proposal represents a slight increase in overall support from the estimated $320 million in 2002-03, and level support from the General Fund. The number of personnel-years for the BOE is budgeted to remain stable for 2003-04 at 3,840.

Sales Tax Simplification

We recommend that the Board of Equalization report at hearings regarding the impact—both budgetary and revenue related—of participating in the Streamlined Sales Tax Project and adopting the project's multistate agreement.

The sales and use tax (SUT) is one of the state's major revenue sources, accounting for an estimated $23.7 billion in 2003-04, or approximately one-third of total General Fund revenues. In addition, the SUT constitutes a significant share of revenues for cities, counties, and other local governments. The SUT is levied on the sale of tangible personal property consumed or used in the state, and is generally remitted by the seller to the Board of Equalization (BOE).

Administration and Collection of the SUT. Retailers in California are required to file with the BOE as registered sellers. These registered in-state sellers collect the SUT from purchasers and remit the proceeds monthly or quarterly to the state. Sellers that have no physical presence (or "nexus") in California cannot be required to register with BOE or collect the SUT. Thus, "remote sales" (sales through mail order, telephone, or the Internet) to Californians from an out-of-state business with no nexus in the state are not subject to sales tax collection by the seller.

Although the out-of-state sellers are not required to collect the sales tax on behalf of California, the resident purchaser is still required to submit an equivalent tax—the use tax—directly to the BOE. Despite this requirement, however, the enforcement of this use tax is virtually impossible in the great majority of situations; in fact, many Californians may not even be aware of the tax's existence. Typically, the use tax is collected from individual consumers only in situations requiring registration of personal property by the state (for example, motor vehicles).

Legal Restrictions on SUT Collections

States are prevented from requiring out-of-state sellers to collect the SUT due to a series of U.S. Supreme Court decisions regarding remote sales. Through its rulings on these cases, the Court has determined that allowing states to require SUT collection by out-of-state sellers would violate the Commerce Clause of the U.S. Constitution, which reserves for Congress the ability to regulate interstate commerce. However, Congress can adopt legislation allowing states to collect the tax on remote sales. Thus far, Congress has chosen not to do so.

State Sales Taxes Can Be Administratively Burdensome. Currently, 45 states levy a SUT on the sale of personal tangible property. Although states share some similarities in their SUT, many substantial differences exist. Not only do rates vary considerably across states, but the base upon which the tax is levied varies as well. Adding substantial complexity is the fact that the definitions of various goods comprising the base also vary. Thus, what may be taxable at a certain rate in one state may be tax exempt in another. Similar differences also exist among local government jurisdictions. The complexity inherent in these diverse state SUT systems helps explain why court decisions have gone against state efforts to require sellers to collect taxes on remote sales.

Internet Sales Constitute a Revenue Threat. Remote sales across state lines have posed a problem for state revenue systems for some time. However, the advent and increased development of the Internet has caused additional concerns to be raised regarding the amount of potential SUT revenues that go uncollected. Based on estimates from the U.S. General Accounting Office (GAO), it is likely that the revenue losses to California stemming from all remote sales are in the mid-to-high hundreds of millions of dollars annually. Studies by other governmental agencies (federal and state) as well as academic estimates confirm the magnitude of the GAO estimates. We also note that the existing tax treatment of remote sales results in tax inequities based on the method through which commerce is conducted. For example, a book purchased over the Internet is not subject to taxation while a book purchased from a store in California is.

States Are Attempting to Address the Issue

In an effort to simplify various states' SUT systems, 34 states (and the District of Columbia) that levy the SUT—representing approximately 64 percent of the total population—have participated in the Streamlined Sales Tax Project (SSTP) and adopted related model legislation. These participating states are shown in Figure 1.

The SSTP adopted the Streamlined Sales and Use Tax Agreement in November 2002, which creates a blueprint for a simplified tax collection system and attempts to remove the burden and cost of tax collection from sellers. The agreement addresses issues associated with tax collections, definitions of the tax base, uniformity of tax bases, electronic registration of sellers, simplification of tax rates, simplification of returns and remittances, uniform sourcing rules, as well as other issues. This agreement will now be submitted to the individual states for ratification.

Participating states in the SSTP anticipate that the interstate agreement will lead to voluntary participation by businesses and the subsequent petitioning of Congress to allow states to require out-of-state collection of their sales taxes. It is important to note that the simplification effort would not itself result in states being able to require that out-of-state sellers begin collecting the SUT. Rather, the interstate agreement represents an effort on behalf of the participating states to demonstrate to Congress that the simplified sales tax system does not impose unfair costs on out-of-state businesses and thus would not interfere with interstate commerce. Federal legislation would still be needed that would allow states to require out-of-state sellers to collect the SUT.

California Not Participating in Sales Tax Simplification Efforts

In our January 2000 report entitled California Tax Policy and the Internet, we recommended that the Legislature pursue multistate agreements to minimize foregone revenues, reduce tax inequalities, and lessen administrative costs. During the 1999-00 legislative session, the Assembly and the Senate approved SB 1949 (Costa), which directed the Governor to enter into discussions with other states regarding the development of a multistate, voluntary, streamlined system for sales and use tax collection and administration. The BOE was neutral on this bill. This legislation was vetoed by the Governor, based on his view that California participates in a number of other multistate forums where taxes are discussed.

While California does participate in a number of multistate organizations—including the Federation of Tax Administrators, the Multistate Tax Commission, the National Conference of State Legislatures, and the National Governors' Association—the SSTP has become the avenue through which each of these organizations have put their efforts with respect to SUT simplification. 

The BOE Should Report Regarding California's Participation in Multistate Efforts

In view of the existing and potential revenue implications of Internet and other remote sales activity—as well as for reasons of tax neutrality—we recommend that the Legislature direct the BOE to examine the advantages and disadvantages of participating in the interstate agreement and report its findings at budget hearings. When the current federal moratorium on state and local taxes on Internet access expires in November 2003, it is possible that Congress will address the issue of whether states will be granted the authority to require that out-of-state sellers collect states' SUT. Thus, a rapid and thorough examination of the costs and benefits of California's adoption of the multistate agreement is recommended. While these efforts would not result in immediate budget impacts, they are important in terms of ensuring California's input on one of the most significant current tax issues.

State Options Concerning Cigarette Tax Evasion

Cigarette smuggling and related tax evasion is a current concern in California, as well as in many other states. In view of the administration's proposal to more than double cigarette excise taxes, the incentives for such evasion are likely to increase. This analysis presents options the state could take to address this issue.

Current Taxation of Cigarettes and Tobacco Products

Currently, the state levies an excise tax on the sale of cigarettes at the rate of 87 cents per pack, assessed at the cigarette distributor level. The great majority of revenues raised through this excise tax—77 cents per pack—are dedicated to special funds, with the remaining portion going to the General Fund. The cigarette excise taxes are allocated as follows:

In addition to the tax on cigarettes, other tobacco products—such as pipe tobacco, snuff, and chewing tobacco—are subject to a similar tax based on their wholesale price. The revenue generated by taxes on these other tobacco products is entirely allocated to special funds. The federal government also subjects cigarettes to an excise tax (the rate is currently 39 cents per pack). The state and local SUT is levied on the retail price of the cigarettes (inclusive of the state and federal excise taxes).

Cigarette Tax Revenue

Excise Tax Revenue Has Increased Only With Tax Increases. Revenue received from the taxation of cigarette and tobacco products from 1992-93 through 2002-03 is shown in Figure 2. While revenues from the cigarette excise tax have increased over the 12-year period as a whole, these increases have resulted entirely from increases in cigarette and tobacco products taxes. Specifically, revenues stemming from the excise tax have only displayed growth during this period when the tax was increased by 2 cents per pack as a result of 1994 legislation and by 50 cents per pack as result of the passage Proposition 10 in November 1998.

Per Capita Consumption Is Declining. Despite California's growing population, overall consumption of cigarettes—as measured by official data—has declined over the recent past, as shown in Figure 3. This is because per capital consumption of cigarettes has declined sharply, as also shown in the figure, and this decline has not been compensated for by the expanding population growth. These official consumption figures are based on data collected through the sale of cigarette tax stamps (which are purchased by distributors and provide the means for the state to collect the excise tax). (For a further discussion of issues related to the cigarette excise tax, see our discussion of the Governor's cigarette tax proposal in Part V of The 2003-04 Budget: Perspectives and Issues.) 

Figure 3

Total and Per Capita Cigarette Consumption Is Dropping

1991-92 Through 2000-01


Total Consumptiona

Per Capita Consumption


Percent Change


Percent Change



















































a In millions.

b Packs of cigarettes.

Why Has Cigarette Consumption Declined? There are several reasons for the decline in consumption. First, there has been a drop in the propensity to smoke based on both health concerns and smoking restrictions in the workplace and public areas. Generally, this secular decline related to nonprice factors has been in the range of 2 to 3 percent annually during the previous decade. Second, the increased price of cigarettes has resulted in consumption declines. Recent price increases in cigarettes have stemmed both from manufacturers' price increases (partially as a result of the national tobacco settlement), and increased excise taxes at both the state and federal levels.

In addition, some of the apparent decline (based on official statistics) may not reflect an actual decline in smoking, but rather the consumption of untaxed cigarettes obtained from various sources. Recent reports—for example, a report from the U.S. GAO in August 2002—suggest that various cigarette tax evasion activities are partially responsible for the apparent decline in tobacco tax revenues that is reflected in the official data, as we discuss below. 

Types of Cigarette Tax Evasion Activity

Cigarette tax evasion can come in a variety of forms, and includes both cigarette stamp counterfeiting as well as cigarette smuggling across borders (commonly referred to as "butt-legging"). The main forms of tax evasion are:

Counterfeiting Is the Most Significant Issue. According to a recent BOE survey of about 1,300 retail establishments (largely in the San Francisco Bay Area and the Los Angeles area), about one-quarter of the retail outlets had cigarettes with counterfeit stamps (which often can be detected only with specialized techniques). Furthermore, an estimated 10-to-20 percent of cigarette sales from these outlets constituted sales involving such counterfeit stamps.

As noted above, the Legislature has taken action to address the stamp counterfeiting issue by adopting SB 1701. The new process being pursued by BOE using encrypted tax indicia is expected to be completed by January 1, 2005. The BOE legislative analysis of the bill indicated that staff was unable to provide a revenue estimate of the impact of the new indicia system, but BOE staff has indicated that they expect it to reduce the level of tax evasion "to a significant degree." The BOE has subsequently indicated that this program will result in additional cigarette tax revenue of between $9 million and $26 million annually, beginning in 2004-05.

Border Activity Is Also a Significant Problem. According to the BOE, out-of-state activity—including smuggling, sales over the Internet, export diversion, and other similar activity—together constitute another large proportion of the tax evasion problem. With state cigarette excise taxes ranging from 25 cents per pack in Virginia to $1.50 per pack in New Jersey and New York, the opportunities for cross-border activity are apparent. Although California's geographic circumstances insulate the state from certain types of cross-border activity, there are still opportunities for illegal behavior due to variations in the tax treatment of cigarettes. According to BOE surveys and calculations, the incentives for such activity can be substantial. For example: 

Similarly, the potential revenue losses by the state are significant for relatively small operations. For example:

The existence of counterfeit cigarettes (often manufactured overseas and patterned after major brands) can substantially increase the financial rewards accorded various smuggling activities, since the mark-up realized by the smuggler can be considerable.

How Significant Is Cigarette Tax Evasion?

Cigarette tax evasion is important in terms not only of the current revenue losses that it causes, but also in view of proposed cigarette tax increases that would make evasion even more of a problem.

Current Revenue Losses. Because cigarette tax evasion activity is by its very nature part of the informal or underground economy, estimates on the magnitude of the problem are approximations. Nevertheless, the Advisory Commission on Intergovernmental Relations has developed a methodology leading to a general finding that 25 percent of the apparent decline in cigarette consumption due to a price increase results from evasion with the remaining 75 percent due to actual consumption decline. While this response is consistent with long-term consumption responses, the short-term evasion response would typically be somewhat less. This is because it usually takes some period of time for new patterns of consumption (and evasion) to become established.

The BOE has indicated that in the short term, the amount of apparent consumption decline due to evasion would be on the order of 12 percent, with a longer term response of 25 percent. Employing this methodology together with current levels of cigarette sales, BOE staff has bracketed the current revenue loss due to cigarette tax evasion between $130 million and $270 million annually.

Additional Losses Due to a Tax Increase. The 2003-04 Governor's Budget proposes to increase the cigarette tax by $1.10 per pack as part of the Governor's realignment proposal. The revenues generated by the tax would be deposited in the Enhanced State and Local Realignment Fund (ESLRF) and used to fund various programs whose responsibility—under the proposal—is shifted to local governments. A minor portion of the revenues ($96 million) would be used to backfill the loss in revenue (due to decreased consumption stemming from the tax increase) to the Cigarette and Tobacco Products Surtax Fund, the California Children and Families First Fund, and the Breast Cancer Fund.

Although the state has taken recent steps to counteract the effect of stamp counterfeiting in an effort to reduce the amount of cigarette tax evasion, this program will not fully be in force until 2005. Thus, in the near term, we would expect to see a continued evasion rate on the scale identified in BOE's analyses. Based on the estimated revenue impact of the current level of evasion, the proposed cigarette tax increase would result in additional annual revenue losses from tax evasion, possibly in the range of the high tens of millions of dollars. In addition, the increase in the price of cigarettes resulting from any tax increase would have the effect of encouraging additional smuggling.

What Can California Do About Cigarette Tax Evasion?

As noted above, the state has already taken some important steps in counteracting tax evasion activity. However, there are two additional areas that present significant opportunities. The first is based on increased federal participation in enforcing or enhancing existing cigarette and tobacco laws and regulations with respect to the reporting of cigarette and tobacco sales across state lines. The second involves additional cigarette tax enforcement activity on the part of the investigations division of BOE. 

Federal-State Enforcement

The Federal Jenkins Act. The Jenkins Act (15 U.S.C, Sections 375-378) requires the sale or shipment of cigarettes and tobacco across state lines (to other than a licensed distributor) to be reported by the cigarette seller or distributor to the tobacco tax administrator in the purchaser's state of residence. States may not require the seller to directly levy and remit any taxes due in the purchaser's state; however, state governments may attempt to collect any tax owed directly from the purchaser.

The Jenkins Act applies to the sale or shipment through any means that cross state lines and has been in place since 1949. However, the Act has taken on increasing importance as the Internet has rapidly developed as a means of purchasing cigarettes in small lots or in bulk. The GAO report cited previously lists the web addresses of some 150 dealers who ship cigarettes through Internet transactions. The GAO indicates that compliance with the Jenkins Act is poor (although it presents no overall quantitative measure). Its survey of 150 Internet sellers revealed that 78 percent of the Web sites state that they specifically do not comply with the Jenkins Act. One Internet seller states the following on its homepage, "We will not divulge your information to any third party without either your express consent or as directed by the lawful order of a court of proper jurisdiction."

Enforcement of the Jenkins Act—the violation of which is a misdemeanor—falls under the purview of the U.S. Department of Justice and the Federal Bureau of Investigation. However, according to the GAO report, neither of these agencies has taken any actions to enforce the Jenkins Act with respect to Internet cigarette sales. (The Bureau of Alcohol, Tobacco and Firearms [ATF] of the U.S Department of Treasury, which has ancillary enforcement authority, has conducted three investigations of Internet cigarette sellers related to Jenkins Act requirements.)

California's Efforts to Enforce the Jenkins Act. The BOE has indicated that the state is losing approximately $15 million to $20 million annually through nontaxed Internet sales of cigarettes. In an effort to enforce the Jenkins Act, BOE contacted what it believes is about 10 percent of Internet sellers, in order to request purchaser information. During its Jenkins Act compliance program (May 1999 through September 2001), BOE contacted 167 out-of-state sellers and received responses from 20 of them. As a result, approximately 23,500 residents of the state were notified of their tax obligations, 13,500 of which responded.

The BOE's efforts at enforcing the Jenkins Act resulted in additional gross revenues of $1.4 million—or less than 5 percent of annual estimated tax evasion through Internet sales. Staff at BOE indicated that additional reporting occurred in the initial stages of this effort, but that since this period ended, reporting by all out-of-state sellers is substantially reduced. California currently has no ability to force reporting by out-of-state sellers, and voluntary compliance by California residents is generally poor.

LAO Recommendation: California Should Urge Federal Action. Collecting excise taxes on Internet sales of cigarettes, as well as on other types of cross-border tax evasion, requires cooperation from both other states and the federal government. We recommend that the Legislature memorialize Congress to enact measures that facilitate the collection of excise (and sales) taxes on such sales of cigarettes. The Multistate Tax Commission—a compact of state governments of which California is a member—adopted a resolution in 2001 supporting legislation that would enhance states' abilities to enforce the Jenkins Act.

The GAO report indicates that giving ATF additional investigative authority would increase compliance under the Jenkins Act and allow more collection of excise and sales taxes owed to states. This change would allow ATF to initiate investigations on its own for the express purpose of pursuing Jenkins Act violations. Other actions by the federal government that would aid in the collection of state cigarette taxes and that California may wish to encourage include:

Expanded State Enforcement

In addition to the cigarette tax stamp anticounterfeiting measures that the BOE is undertaking pursuant to SB 1701, there are other enforcement steps the Legislature could consider in order to enhance the collection of cigarette excise taxes and related sales taxes.

Current State Enforcement Efforts. Enforcement activities are designed to prevent the loss of revenue through tax stamp counterfeiting, butt-legging, tax underreporting, smuggling, and illegal sales of cigarettes and tobacco products. Field inspections are made of distributors' stamping machines to ascertain that indicia are properly affixed. Investigations also are made of cigarette stocks in retail stores and vending machines. Investigators also undertake spot inspections of transit vehicles, vessels, and aircraft in order to deter illegal transportation of untaxed cigarettes and tobacco products into California.

In the aggregate, the BOE's tax-related enforcement and investigations staff of 55 personnel-years are centralized, as opposed to being distributed among its various individual tax programs. Funding for the investigations division is based on enforcement activities associated with the various taxes, with resources allocated to the taxes generating the highest return. The 2002-03 Governor's Budget proposed an increase in enforcement activities for cigarette excise taxes and a shifting of funding for this purpose from the General Fund to various special funds. While there was a shift in funding sources, the proposal to expand overall activities in the enforcement and investigations areas did not become part of the budget. Overall funding for the program in the current year is $2.4 million—with a modest 2.3 percent increase proposed for the budget year.

Recent Cigarette Tax Enforcement Proposals. In its 2001-02 session, the Legislature considered several pieces of legislation that would have added to enforcement efforts, increased penalties for tax evasion, as well as several other similar measures. In addition, in recent past years the BOE itself has considered and approved proposals to reallocate resources to cigarette and tobacco tax enforcement and investigations. Specially, some of the legislative and BOE proposals would have: 

Will Revenues Go "Up in Smoke" Without Additional Resources? Estimates of current cigarette tax evasion activity represent considerable revenue losses to the state. Because roughly 90 percent of the excise taxes raised go to special funds, such evasion has a comparatively minor direct impact on the General Fund. However, such evasion can also affect the SUT (which goes to the General Fund), and could have indirect impacts on the General Fund in the form of pressure for increased support in the event that excise tax revenues erode. In addition, should additional cigarette taxes be approved as part of the 2003-04 budget, the impacts on the ESLRF (where the Governor's proposal dedicates these revenues) could be significant, as we have noted previously.

In the 2002-03 budget, the Legislature approved supplemental report language (SRL) requesting that the BOE provide a report to the Legislature containing the following information with respect to its enforcement activities: 

A draft of the SRL report has been received by the Legislature; however the level of detail provided in the report is not sufficient to provide a basis for a full analysis of the revenue likely to result from an increase in investigation resources or the reallocation of existing resources to this end. Partially, this is due to the difficulty in determining the additional compliance that results from additional enforcement. However, there may be additional information in this area available from the BOE based on recent changes in taxes in other states and their related enforcement activities.

Legislative Analyst's Recommendation: Require BOE to Report at Hearings Regarding Additional Enforcement Policies. We recommend that the Legislature require BOE to report on the effectiveness of additional investigations programs or enforcement policies in order to reduce the amount of cigarette tax evasion. These additional activities may require new funding or the redirection of existing resources. Specifically, we recommend that BOE assess and report at hearings the following: 

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