FRANKFORT — Revenue from Kentucky's cigarette tax is in free-fall, but more Kentuckians kicking the unhealthy habit isn't the only reason for the decline. State officials say more and more people are turning to cheaper alternatives — little cigars and roll-your-own cigarettes — that aren't covered by the state's 60-cent-a-pack tax.
The little cigars look much like cigarettes but are wrapped in brown paper. They cost about $1.25 a pack, compared to about $3.25 for the cheapest pack of cigarettes.
The move to small cigars and roll-your-own cigarettes is a national trend. The U.S. Department of Justice estimates that states have lost $5 billion a year because people are using alternatives that have no state retail cigarette tax.
In Kentucky, state budget officials are predicting a 17.2 percent decline in revenue from the cigarette tax this fiscal year, which ends June 30. Last fiscal year, the state collected $262.4 million from cigarette taxes, down nearly 6 percent from 2010.
It's difficult to say how much of the decline is related directly to cheaper alternatives, but revenue officials say the loss from self-rolled cigarettes and small cigars is possibly in the millions of dollars.
When the legislature agreed to double the cigarette tax in 2009, the move was applauded by health advocates as a way to encourage more people to quit. It also bolstered the state's cash-strapped budget.
At first, cigarette tax revenue increased. But in June 2010, revenue from the tax began to dip.
At the same time, the state Department of Revenue, which collects tobacco-related taxes, saw retailers devote more shelf space to pipe tobacco and roll-your-own tobacco, said Richard Dobson, director of sales and excise taxes for the revenue department.
"We started looking at inventories," Dobson said. "The amount of product that is used for roll-your-own is increasing."
The department also observed more large, roll-your-own machines in tobacco shops and smoking stores. Dobson said the state estimates there are 20 or 30 commercial-size roll-your-own cigarette machines in the state.
People can buy pipe tobacco, which is taxed even less than roll-your-own tobacco, and put it into a machine at a retailer. The end result is a pack of cigarettes for a fraction of the cost of prepackaged cigarettes, said Greg Harkenrider, deputy director in the Office of the State Budget Director.
Several states have begun putting pressure on the makers of small cigars and roll-your-own cigarette machines.
Arkansas became the first state to outlaw the machines in April. And there are several pending lawsuits regarding roll-your-own cigarettes.
The federal Alcohol and Tobacco Tax and Trade Bureau, which oversees federal taxes on tobacco and alcohol, recently ruled that retail establishments with roll-your-own machines must pay the same federal manufacturing tax as cigarette manufacturers. That ruling is being challenged in the courts, Dobson said.
If the ruling is upheld, retailers also would pay into an escrow account that is part of the national tobacco settlement between the states and cigarette manufacturers.
Those who use roll-your-own machines have an unfair commercial advantage over cigarette manufacturers, said Ken Garcia, a spokesman for Phillip Morris USA, one of the nation's largest manufacturers of cigarettes.
"We believe these products should be taxed the same as packaged cigarettes," he said.
Giving people an incentive to switch to lower-cost tobacco has no public policy benefit, he said.
Dale Ferguson, who owns Fayette Cigar Store in downtown Lexington, said he wasn't convinced that roll-your-own cigarettes and small cigars are causing declining revenue.
Before Kentucky raised its cigarette tax, it had one of the lowest cigarette taxes in the Midwest. Stores on Kentucky's borders were selling a lot of cigarettes to people from other states.
It's doubtful those stores are selling as many cigarettes, Ferguson said, which could account for some of the decrease.
"I'm not sure if I agree with their conclusions," he said.
Regardless, financially struggling states probably will take a fresh look soon at revamping their cigarette taxes, said Sujit CanagaRetna, senior fiscal analyst for the Council on State Governments.
Since 2001, 47 states have raised cigarette taxes a combined 105 times. Such "sin taxes" are the easiest type to pass, CanagaRetna said.
"I think by early next year when state legislatures go into session, you'll see more states look at this issue," he said.