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With few prospects for normal business development, indigenous communities turn to their inbuilt advantages, such as tax exemptionsIan Barrett

The Ontario Tobacco Research Unit estimates that 20 per cent of cigarettes consumed in Canada are illegal. Many of these cigarettes are made on or channelled through Canadian native reserves, sold to aboriginals and non-aboriginals in roadside "smoke shacks." With no federal or provincial taxes, they are much cheaper than cigarettes sold on the regulated market.

"Cracking down" on this astonishingly large black market has created a teachable moment for aboriginal policy.

The popular assumption seems to be that healthier economic activities would emerge on reserves if only law enforcement agencies snuffed out illegal cigarettes - in 2008, the RCMP recognized that manufacturing operations in first nations communities, based on the U.S. side of Akwesasne and Kahnawake in Quebec and Tyendinaga and Six Nations in Ontario, were the largest source of illegal tobacco in Canada. This puts mainstream Canadians in a conundrum. Cracking down on illegal tobacco is good because illegal tobacco is bad - but does that make the people selling it bad?

First nations are disproportionately involved in illegal tobacco, so it makes sense to examine some of the economic incentives created on reserves by aboriginal policy. It's easy to condemn these operations and call for immediate action, but more challenging to deal with the root causes.

First nations turn to these operations because they are profitable for their communities, where economic development opportunities tend to be very limited. High off-reserve tobacco taxes may be effective at curbing measured tobacco consumption, but they help create this underground economy for cheaper cigarettes.

There are other factors driving first nations into illegal markets.

The Indian Act makes most business decisions subject to the Minister of Indian Affairs, a burden that makes it that much more difficult for first nations entrepreneurs to operate and compete economically. The First Nations Tax Commission estimates it is 10 times more difficult to create wealth in its communities than elsewhere. Local governments use infrastructure to entice investors to develop their lands, which creates jobs and wealth. The FNTC says a typical Canadian community entices $5-million in private investment for every $1-million it invests in infrastructure improvements, but a typical first nation will entice barely a quarter of that, just $1.5-million from the same investment. In addition, for a variety of reasons, a typical first nation must commit three times as much tax revenue to finance the same infrastructure. The combination of these factors makes wealth 10 times harder to create.

Moreover, first nations entrepreneurs cannot enter the capital market because they do not own their own land; it is held by the Crown. This means they cannot pledge their land as collateral for loans to create legitimate businesses. In 2007, almost half of all small- and medium-sized enterprises were asked to provide some form of collateral.

With few prospects for normal business development, indigenous communities turn to their inbuilt advantages, such as tax exemptions. Unfortunately, this can also lead to extra-legal markets, such as illegal tobacco. Another example is casinos - those who criticize first nations for turning to the lucrative gambling business, with its addictions and organized crime associations, often fail to realize this is a response to the restrictions imposed by the Indian Act.

The Royal Commission on Aboriginal Peoples, which reported in 1996, acknowledged the burdens, warning that "under current conditions and approaches to economic development, we could see little prospect for a better future."

Like all communities, first nations want opportunities to relieve deprivation. But the regulatory frameworks they live under lock them out of the legitimate market economy. By all means, crack down on illegal tobacco, but understand the governmental structures that push people into these markets. Dealing with the systemic causes would put us well on the way to taking the wind out of many illegal activities.

Joseph Quesnel is a policy analyst with the Frontier Centre for Public Policy. He is the main author of Recognizing Good Governance on Prairie First Nations: The Fourth Annual Aboriginal Governance Index (