Are Cigarette Taxes Becoming Obsolete?

Published August 1, 2005

Excise taxes originated centuries ago when governments were small, life was local, its pace was slow, and “capital” referred to bulky and heavy objects. We now live in an increasingly service-oriented economy, where life moves fast on a global scale and where much capital is immaterial in nature.

Social and economic changes force us to ask whether excise taxes are obsolete. If they are, governments will increasingly find that excise taxes do more harm than good.

Cigarette taxes, because states have raised them precipitously during the past 10 years, provide a good test of the obsolescence theory.

Revenue Shortfalls

Excise tax increases often generate less revenue than originally projected. As taxes rise, people turn increasingly to other channels of commerce that they did not seek out when taxes were lower. They cross state borders to shop. They use the Internet to shop. They come across vendors who are selling lower-taxed, untaxed, or counterfeit cigarettes. And they do these things with increasing intensity as the tax rate rises.

The Master Settlement Agreement of 1998 set in motion a tobacco spending frenzy where legislatures boosted appropriations on programs from A to Z. Democratic polities face strong temptations to expand spending by borrowing. The Master Settlement Agreement opened a new opportunity for deficit finance, as states increased current spending by borrowing against future settlement revenues.

However, settlement revenues have declined about 20 percent from initial projections, which has increased the interest burden on state debt.

In New Jersey, for instance, lawmakers have sold bonds based on future revenues from the master settlement. Payment on those bonds depends on high sales of taxable cigarettes, but 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 rate increases, which in turn drive down settlement revenue and drive up interest on the bonds.

Underground Economy

Smuggling is a natural consequence of high taxation. It is well-known that organized crime is heavily involved in smuggling. The logistics of such high-volume operations in the underground economy require a good deal of organization.

High taxation is a close cousin to prohibition. The U.S. experience with alcohol prohibition is thus instructive. Prohibition did not eliminate the use of alcohol. It drove 70 percent of the market underground, where organized crime and its violent methods of resolving commercial disputes prevailed.

The antidote to the violence of the underground economy is sensible, low taxation.

Unreliable, Destructive

“Cigarette taxes are already an unreliable revenue source,” said Scott Hodge, president of the Washington, DC-based 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.”

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

Richard E. Wagner ([email protected]) is the Holbert R. Harris Professor of Economics at George Mason University in Fairfax, Virginia. He is the author of numerous volumes on excise taxation and tobacco taxes.

For more information …

Richard Wagner explored the problems with excise taxes in detail in “State Excise Taxation: Horse-and-Buggy Taxes in an Electronic Age,” Background Paper No. 48, published in May 2005 by the Tax Foundation. The full text is available online at