Milking the Cigarette Tax Cow

With many states now running large budget deficits, legislators are looking anew at higher cigarette taxes. Even though these taxes have been raised sharply in almost every state in recent years — on top of price increases mandated by the tobacco settlement — politicians still seem to think that this cow can be milked even more. However, several new studies suggest that there are diminishing returns to higher cigarette taxes. Evasion is now so great that revenues are starting to fall in some places.

Long ago, Adam Smith noted that it is possible for tax increases to reduce revenues. Said Smith, “High taxes, sometimes by diminishing the consumption of the taxed commodities, and sometimes by encouraging smuggling, frequently afford a smaller revenue to government than what might be drawn from more moderate taxes.”

New York City is probably the best example of where cigarette taxes, which now total $3.00 per pack, are so high that a tax cut would probably raise revenue. A new report from the Small Business Survival Committee notes that the city is getting less than half the revenue expected from last year’s increase from 8 cents to $1.50 per pack. (The state also levies a tax of $1.50, putting the total price per pack at $7.50 in New York City.)

The city had anticipated $250 million in additional revenue from the tax increase — a tenfold increase from the $27 million expected from the previous 8 cent tax. Since the rate was increasing almost 20 times, the city clearly anticipated that there would be a substantial falloff in demand. Since this lower demand would also affect state cigarette tax revenues collected in New York City, the state demanded that its lost revenues be reimbursed by the city. Hence, the city was forced to give the state 46 percent of the higher revenues.

Thus, out of the $250 million, New York City was only going to get $107 million of additional revenue even if everything went as planned. But according to the SBSC study, conducted by the Beacon Hill Institute, cigarette sales from legal sources fell much more than expected — by 189 million packs. This led to a further reduction in the sales of other products at corner groceries and other small businesses, resulting in lower incomes and profits. This forced stores to cut back on employment, resulting in a loss of about 10,000 jobs.

The loss of cigarette sales, ancillary product sales, and income to businesses and workers reduced New York City’s tax revenue by $64 million. Thus the city’s net revenue from its $250 million tax increase turns out to be just $43 million.

Some of the lost sales undoubtedly resulted from reduced demand — people quitting smoking or cutting back. However, it appears that smuggling, out-of-state purchases and sales on Indian reservations (where no taxes are collected) are the main reason. According to a new Cato Institute study, New York City has been waging a losing battle against cigarette tax evasion for 50 years. Well-organized smugglers buy cigarettes in North Carolina, where the tax is just 5 cents per pack, and resell them in New York for easy profits. According to the March 10 issue of U.S. News & World Report, such smuggling is even conducted by terrorists to fund their activities.

Another study by a group of convenience store owners looked at the impact of reduced sales throughout New York State. According to the study, which was conducted by economist Brian O’Connor, untaxed cigarette sales resulting from smuggling, cross-border sales, Internet sales and sales on Indian reservations cost the state as much as $609 million in revenue in 2001 and almost $900 million in 2002. This just represents lost cigarette taxes. Taking account of lost ancillary sales and income undoubtedly would increase the state’s overall revenue loss even more.

Cigarette Taxes and Tax Evasion

(z) Ranked by tax rate. Source: Mark Stehr (2003)

What is going on in New York is also going on throughout the United States. And the magnitude of the problem is in direct proportion to cigarette tax rates. States with high taxes have high evasion; states with low taxes have little evasion. According to economist Mark Stehr of Drexel University, the 10 lowest taxed states had cigarette tax rates averaging 10 cents per pack in 1999 and had untaxed consumption of 2.6 percent. By contrast, the 10 highest taxed states charged an average of 74 cents per pack and had untaxed consumption of 10.6 percent.

The record is clear that cigarette smokers are not sheep. They do not sit back passively and just pay exorbitant taxes. They take actions to minimize their burden, which have the effect of reducing revenues without reducing consumption. In some cases, such as New York City, lower taxes undoubtedly would actually raise revenue.