June 7, 2005

As Cigarette Taxes Rise, New Study Shows Revenue Estimates Failing as Customers Go Underground

for immediate release
For more information, contact the press office at 202-464-6200.

Washington, D.C.—States that hope to plug their budget gaps with cigarette tax revenue should seek a solution their taxpayers will support, according to a new study, Tax Foundation Background Paper No. 48, “State Excise Taxation: Horse-and-Buggy Taxes in an Electronic Age,” by Professor Richard Wagner of George Mason University.

“All excise taxes on particular products are obsolete,” says Wagner, “but because government is always slow to change, they will die a slow death. In the meantime they will cause a great deal of harm, both to taxpayers and to the state governments who rely on them.”

Among the selective excise taxes, states raise the most by taxing cigarettes, alcohol, gasoline and telecommunications. Of these, it is the cigarette tax that states have raised most precipitously during the last 10 years, despite abundant evidence that the high tax levels are creating a host of problems:

• Revenue estimates are rarely met, causing budget problems.
• Bonds sold against future master settlement revenues are unattractive except at preposterously high interest rates, and even then they are downgraded by the rating agencies.
• In a replay of Prohibition-era social decay, law-abiding citizens learn to break the law routinely, and states respond by adopting intrusive and sometimes abusive tactics to catch them.
• Organized criminals and terrorist cells begin trafficking in smuggled cigarettes, and the states spend prodigiously to catch them, with almost no success.
• Businesses and jobs, along with their tax revenue on income, sales and property, are lost to interstate competition.

The growth of these destructive consequences brings state governments to a crossroads, according to Wagner. In one direction: state governments that use invasive, threatening, expensive and ultimately futile tactics to enforce high tax rates. In the other direction: innovative, service-oriented state governments that know they must compete with their neighboring jurisdictions by levying reasonable taxes.

The inaccuracy of revenue estimates for tobacco tax hikes obviously creates difficulties for state fiscal planning.

“Cigarette taxes are already an unreliable revenue source,” said Scott Hodge, President of the Tax Foundation, “and that unreliability will surely get worse as tax rates climb and more customers are forced to shop for low-tax cigarettes from legal and illegal sources.”

New Jersey has compounded the problem by selling bonds based on future revenues from the master tobacco settlement. Payment on these bonds depends on high taxable cigarette sales, but at the same time the state has depressed those sales by raising its cigarette tax to $2.40 per pack, second highest in the nation. This creates a vicious cycle in which the state reacts to lower-than-expected revenue with sharp tax increases which, in turn, drive down settlement revenue and drive up interest on the bonds.

Background Paper No. 48 is available on the Tax Foundation’s web site. Its author, Professor Richard Wagner, is the Holbert R. Harris Professor of Economics at George Mason University in Fairfax, VA. He is the author of numerous volumes on excise taxation and tobacco taxes.

The Tax Foundation has monitored tax policy at the federal, state and local levels since 1937. Best known for its annual calculation of Tax Freedom Day®, the Tax Foundation is a nonprofit, nonpartisan 501(c)(3) organization.

(Download full study here.)