British tobacco manufacturers are fuelling the black market by deliberately over-supplying their products to European countries, MPs have warned.
UK firms are supplying more tobacco to European countries than their markets need and is then finding its way back into the UK market without tax being paid, costing the country £1.9 billion a year, the Committee of Public Accounts said.
HM Revenue and Customs (HMRC), Britain's tax office, is failing to tackle firms who "turn a blind eye to the avoidance of UK tax" through over-supply, which in some countries in 2011 exceeded demand by 240%, the Committee added.
Under supply chain legislation, tobacco firms have a legal obligation not to aid smuggling but HMRC has not fined any UK tobacco manufacturer for over-supplying products and has issued only one letter of warning.
Committee chair Margaret Hodge MP said: "The department (HMRC) has also failed to challenge properly those UK tobacco manufacturers who turn a blind eye to the avoidance of UK tax by supplying more of their products to European countries than the legitimate market in those countries could possibly require.
"The tobacco then finds its way back into the UK market without tax being paid.
"The supply of some brands of hand-rolling tobacco to some countries in 2011 exceeded legitimate demand by 240%.
"HMRC must be more assertive with these manufactures.
"So far it has not fined a single one of them."
Under the 2010 Spending Review, HMRC did plan to launch a project to test how well manufacturers were preventing the over-supply of tobacco products to high-risk countries, such as Spain, Belgium, the Netherlands and Luxembourg.
But during the planning stage, HMRC realised that UK officials could not exercise their powers in another country in that way and the project was scrapped.
The Committee also said HMRC was failing to deter potential tobacco smugglers through its use of prosecution powers.
Tobacco fraud cost taxpayers £1.9 billion in 2010/11, the Committee said, with 9% of cigarettes and 38% of hand-rolling tobacco sold in the UK estimated to be sold on the black market.
But the group of MPs said there were "only" 265 prosecutions for tobacco smuggling in 2012/13 and prosecutions for organised crime fell from 62 to 51 in the last year.
HMRC does not know what level of enforcement action is needed to deter would-be offenders, the group of MPs added.
Ms Hodge said: " HMRC is in the dark about the deterrent effect of its enforcement action.
"Despite the seriousness of tobacco fraud, in 2012/13 there were only 265 prosecutions for tobacco smuggling and, in the last year, prosecutions for organised crime actually fell from 62 to 51."
She added: " Tobacco smuggling is not a victimless crime.
"Each year it constitutes a theft of revenue to the tune of some £1.9 billion, 20% of the total sum collected through tax.
"It undermines drives to cut smoking and is also linked to the activities of organised crime."
The group of MPs recommended HMRC and Border Force should publicise prosecutions and other enforcement action more widely to deter potential offenders.
The Committee said HMRC had made some ground tackling tobacco smuggling, with estimates showing a drop for illicit tobacco products between 2000/01 and 2010/11.
The expansion of HMRC's network of overseas intelligence officers has been particularly successful, preventing £226 million of lost tax in the last two years for an initial investment of £4.6 million, it added.
but the group of MPs found HMRC's proposals to tackle tobacco smuggling in the 2010 Spending Review investment were "over-optimistic" with three of the five projects delivering no benefit by March 2013.
An HMRC spokesman said: " We have more than halved the size of the illicit market in cigarettes. In the last two years alone nearly 3.6 billion illicit cigarettes and over 1000 tonnes of rolling tobacco have been seized resulting in 432 prosecutions.
"Disrupting criminal businesses is at the heart of HMRC's strategy to clamp down on this illicit trade. The tobacco smuggling gangs are constantly adapting to the huge downward pressure HMRC puts them under. This pressure has caused the long term decline of this illegal trade.
"Additional investment has been made by this Government to tackle tobacco smuggling, and our officers posted overseas have made a significant contribution to the drive against smuggling as the PAC recognises.
"The Government is reinvesting nearly £1 billion in HMRC to continue the fight tackling evasion, fraud and avoidance."