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Do cigarette taxes really work?
Study: when the tax on cigarettes reaches excessively high levels, it becomes counterproductive.
July 14, 2005: 10:28 AM EDT
By Jeanne Sahadi, CNN/Money senior writer

NEW YORK (CNN/Money) Many states have been hiking cigarette taxes for years, claiming that they discourage smoking and contribute much-needed tax revenues to state coffers.

But critics say that starkly higher tax rates have created a prohibition-like environment that fosters black markets and encourages otherwise law-abiding citizens to skirt the law.

What's more, according to one recent study, they don't raise nearly as much tax revenue as one might expect.

Every state imposes a cigarette excise tax, but the amounts vary widely from a high of $2.46 a pack in Rhode Island to a low of 3 cents a pack in Kentucky. (Until last year, Virginia had the lowest at 2.5 cents per pack, but that has since been raised.)

Meanwhile, there may also be a local excise tax as well. Smokers in New York City, for example, pay a local excise tax of $1.50 per pack on top of New York State's $1.50 excise tax.

A cigarette tax is often explained as a way to make up for the costs imposed on society by smokers and to discourage smoking. But cigarette excise taxes can (and often are) used to support other state-budget purposes.

Economist Richard E. Wagner of George Mason University contends that when a state's cigarette tax is significantly higher than a readily available alternative source, it is counterproductive in more ways than one.

It should be noted that in the early 1990s, Wagner received a grant from the Tobacco Institute to coauthor the book "The Economics of Smoking" and the Institute had asked him while he was a professor at Florida State University to testify before Congress.

However, Wagner said he did not receive any funding for the paper on which this article is based.

In "State Excise Taxation: Horse-and-Buggy Taxes in an Electronic Age," Wagner argues that a high cigarette tax:

Pushes smokers to cross state lines to purchase cigarettes or to break the law by buying them underground.

In recent years, the illegal trade of cigarettes has been growing via smuggling and Internet sales. Investigations by the Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF) have found that millions of dollars each year from such sales are funneled to organized criminals.

What's more, a General Accounting Office report notes that according to officials at the U.S. Immigration and Customs Enforcement Agency, states with high cigarette taxes are typically those that lose cigarette tax revenue to smuggling.

"As a result, data on taxed sales no longer track actual consumption in any useful way, and revenue estimates of future tax rate changes will be even less reliable than they already are," Wagner writes.

Reduces taxable sales and therefore state coffers.

Since smokers in states with high cigarette taxes are more inclined to look elsewhere for their fix, taxable sales are often lower than projected. It's estimated that over $1 billion is lost in state tax revenues to Internet tobacco sales and trips across state lines.

In addition, when taxable sales are reduced, that can reduce the payments a state receives from the tobacco companies as a result of the Master Settlement Agreement, since those payments are tied to the level of a state's cigarette sales.

A General Accounting Office study found that in 2004 the largest portion of states' settlement payments went to shoring up budget shortfalls.

Discriminates against low-income smokers.

Unlike the gas excise tax, which is levied on everyone who drives and is most typically used to pay for roads and other services drivers use, the cigarette tax is paid by a minority of people and is often used to support services used by everyone, Wagner notes.

The smokers who pay the tax are disproportionately lower income. Research has shown that there's a higher population of smokers among blue-collar workers and those without a college degree than among white-collar workers and those with college and graduate degrees.

What's the tipping point?

As smoking rates in the country have gone down, cigarette excise taxes have gone up.

In 1970, the highest tax levied by a state was 18 cents a pack (88 cents after adjusting for inflation) versus today's high of $2.46 a pack. Since then, the number of smokers in the United States has declined from 37.4 percent to 22.5 percent.

When it comes to raising a state's cigarette tax, "you have to think there's some ceiling as to how high you can go," said Harley Duncan, executive director of the Federation of Tax Administrators.

The assumption has been that when cigarette prices go up 10 percent, sales decline by 4 percent. And that held true as late as 2003, after several states raised their cigarette tax in response to declining state tax revenue, Duncan said.

But given the rise in Internet sales and cigarette smuggling, he thinks the equation needs to be revisited.

In addition, Duncan said, "Our job as tax enforcers is to see if there are actions that could be taken to reduce evasion, to prevent bootlegging."

Wagner might suggest a rethinking of tax rates. But the states' attorney generals have taken a different tact.

They, together with the ATF, are trying to curtail Internet sales by cutting deals with credit card companies and delivery services.

Just last week, DHL agreed to stop delivering cigarettes to consumers. And in March, major credit card companies agreed not to allow charges for cigarettes purchased online.  Top of page


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