As a former economist for both the U.S. Treasury’s Office of Tax Analysis and the Senate Finance Committee, I have seen plenty of inane tax policy, but the fact that the U.S. government mails checks to multinational tobacco companies to refund taxes they never paid takes the cake.
This perverse loophole is the result of savvy foreign-based producers exploiting a poorly-written trade law and the bonded warehouse system to fleece the Treasury out of what will soon be billions of dollars.
Here is how it works: Trade policy has long allowed companies that import a product and then later export it to get back any tariffs or excise taxes they paid on the product when it entered the U.S. marketplace. The refunds are called “drawbacks.”
However, after a 2004 expansion of the law and a favorable court ruling in 2021, multinational tobacco companies started to abuse this system. First, they import cigarettes into the U.S. for consumption, paying a $1.01 per pack excise tax. Then, they manufacture an equal amount of cigarettes in the U.S., which they export through a bonded warehouse, which allows excise tax-free exportation.
After the export, the exported cigarettes become eligible for a “substitution drawback” claim, which refunds excise tax on the exported cigarettes, even though the company never paid a tax on them due to the products leaving the U.S. through a bonded warehouse.
Functionally, it means these multinational companies are getting back all of the excise taxes they paid on their imports, which means the cigarettes they sell in the U.S. are effectively excise tax-free.
There is absolutely no economic rationale for this policy: The Treasury Department and U.S. Customs and Border Protection tried to close this accidental loophole--which they dubbed a “double drawback,” in 2018. However, the courts determined that Congress needed to enact legislation in order to close this loophole.
Multinational firms with sophisticated logistics operations and global manufacturing bases have learned to exploit this loophole, and the fiscal cost of the double drawback has grown rapidly. The Joint Committee on Taxation estimates that closing the loophole for tobacco would raise over $12 billion over the next decade. My analysis found that JCT’s estimate is likely somewhat conservative, given the exponential growth in claims the last few years.
The original intent of the drawback system--which was to encourage exports and support domestic producers—has been effectively turned on its head.
Congress has the opportunity to restore that balance by capping excise tax refunds on exports at the amount actually paid. This obvious fix would save taxpayers billions, level the playing field for U.S. manufacturers, and restore the integrity of the drawback system. The House-passed language of the One, Big, Beautiful Bill Act includes language that would do precisely that and the Senate should maintain this provision in the tax bill it passes.
A tax system that hands cash to foreign firms as a refund for taxes they never paid is not defensible.
