It is no secret that many developed nations would like to eliminate cigarette smoking altogether and as quickly as possible. One of the most effective ways of curbing consumption has been to raise excise taxes on cigarettes. Higher taxes lead to higher cigarette prices, which encourages consumers to buy fewer of Philip Morris International (PM -0.65%) and Altria Group's (MO -0.26%) products.

However, there is a limit to the effectiveness of taxation in discouraging consumption. Once taxes push prices up enough, evidence suggests that consumers turn to the untaxed and unregulated black market to buy cigarettes -- a behavior that is not good for tobacco companies, governments, or consumers. As the black market grows, Philip Morris finds itself in an unlikely alliance with governments to keep demand in the legal channels.

Illicit trade directly linked to taxation
Illicit cigarettes usually take the form of either counterfeit products that look like real brands (e.g., counterfeit Marlboro) or legitimate products that are sold tax-free. Some 525 billion cigarettes -- or 8.4% of worldwide consumption -- escaped taxation in 2012, including 30 billion cigarettes in the United States and 315 billion cigarettes internationally. Illicit trade in the European Union, or EU, increased 43% from 2000 to 2010 and represents about 8.2% of the EU cigarette market.

The profit on illicit sales can be enormous. Without excise taxes, Philip Morris would generate an 87% gross margin and Altria would earn a 68% margin. Including the tax, however, Philip Morris' margin drops below 30% and Altria's below 40%. Illicit sales can undercut the retail price and still earn a huge margin.

There is a direct link between illicit cigarette share of the total market and excise taxes on cigarettes. For instance, Bulgaria experienced a 647% increase in illicit trade between 2000 and 2010. Although illicit sales increased from 2000 to 2008, the biggest jump came right after a large excise tax increase in 2008.

Ultimately, countries that already have high cigarette taxes cannot raise the tax faster than the purchasing power of the smoking population. Smokers tend to be poor, so they cannot afford to pay more for cigarettes nor can they easily give up the addiction. When cigarette prices exceed poor consumers' budgets, consumers turn to the black market in droves.

Illicit trade hurts all stakeholders
The unregulated black market is bad for tobacco companies, governments, and consumers alike. The effect on tobacco companies is obvious: the 8.4% of the market that consists of illicit sales is lost revenue for tobacco companies. Counterfeit cigarettes bearing Philip Morris' brands represented 28% of the illicit EU market in 2010, suggesting Philip Morris is losing substantial business to the black market.

Governments also lose revenue to the black market; EU member nations lose up to 10 billion euros per year in taxes, and the United States loses an estimated $5 billion per year in tax revenue avoided by illicit sales.

Tobacco companies and governments clearly have much to gain from eliminating black-market goods, but so do consumers. If a government's intention is to ween its citizenry off of harmful products (and there is reason to believe this isn't every government's full intention), then discouraging the illicit cigarette trade should be its top priority. Counterfeit products may not contain adequate warning labels and may be sold indiscriminately to underage smokers.

What it means for Philip Morris and Altria
Between regulated Marlboro and illicit cigarettes, governments should encourage the consumption of Marlboro. The numerous government-funded studies and press stories that have appeared within the last few years suggests that developed countries are ready to fight back against the black market. But this may require some tough choices.

For instance, high taxes are the key driver of black-market sales. Honest governments will recognize the limits to taxation -- excise taxes should not outgrow the poorest consumers' purchasing power. In addition, forcing packages to be dull and undifferentiated makes it easier for counterfeiters to copy popular brands; allowing for more intricate designs would cut down on counterfeiting.

Developed countries are unlikely to roll back excise taxes, but the illicit cigarette trade may discourage them from raising taxes much higher than current levels. This would be welcome news for Philip Morris and Altria investors -- and, ultimately, more tax revenue for government coffers.