High taxes, sometimes by diminishing the consumption of the taxed commodities, and sometimes by encouraging smuggling, frequently afford a smaller revenue to government than what might be drawn from more moderate taxes.

From Adam Smith, The Wealth of Nations.

Notice that there are two “leakages” due to the high tax. The first is simply a move up the demand curve for the taxed item. The second is a reduction in the quantity purchased legally.

When I gave my recent OLLI talk on The Wealth of Nations, I noted that there appeared to be such a case in Canada in the early 1990s. I noticed it at the time and found the following, from testimony by a GAO official before a House subcommittee:

According to the Canadian government, sharp increases in Canadian federal and provincial cigarette taxes in the late 1980s and early 1990s led to large-scale smuggling between the United States and Canada conducted almost entirely by organized crime. Violence increased, merchants suffered, and in one year alone, Canada and its provinces lost over $2 billion (in Canadian dollars) in tax revenues. Canada responded in 1994 by sharply reducing federal and provincial cigarette taxes and increasing its enforcement efforts, among other steps. Since then, smuggling has declined considerably.

In his testimony, the official pointed out that from 1984 to 1993, Canada’s federal cigarette taxes rose from 42 cents per pack to $1.93; Ontario’s rose from 63 cents to $1.66; and Quebec’s rose from 46 cents to $1.78. Those two provinces alone accounted for well over 50 percent, and close to 60 percent, of Canada’s population. The result of all these tax increases was that the price of a pack rose from $2.64 in 1984 to $5.65 in 1993, all in 1994 dollars.

How did the illegal flow occur? The official stated:

During most of this period, cigarettes made in Canada were exported tax-free to the United States. Organized criminal groups purchased Canadian cigarettes that had been exported to the United States and smuggled them back into Canada. This resulted in more than an 11-fold increase in United States cigarette imports from Canada from 1990 to 1993 (see fig. 1). The 1994 study found that an Indian reserve that straddles the U.S.-Canadian border between Cornwall, Ontario, and Massena, New York, had become the primary conduit for smuggling cigarettes into Canada.

I had grown up in Canada thinking of us Canadians as relatively law-abiding and I think that was true. But change the incentives, and behavior changes. Adam Smith would not have been surprised.