California Tax Bills Asking for Trouble

Published September 2, 2015

Legislation permitting counties to increase the excise tax on cigarettes was approved by the California Senate Thursday, August 27. Another bill — introduced the day before — would hike the state excise tax by $2.00 per pack. The state legislature should prevent both bills from passing.

If the local excise tax option is adopted, the law will almost assuredly lead to higher excise tax burdens in some if not most counties. (Counties would need to have to submit an increase to a public vote.) This will increase price differentials between counties (and differentials with other states and nations) and invariably be followed by the lawlessness associated with cigarette tax avoidance and evasion, among other unintended consequences. Local excise taxes will only compound the damage done by a statewide hike. Worse, research shows that the health benefits of excise tax hikes are weak, and perhaps even counterproductive.

Local excise taxes on cigarettes are not a new invention. We see them used prominently in New York City ($1.50) and Chicago ($1.18) and by Cook County ($3.00), Illinois to name a few. Scholarly research on contraband smokes in these jurisdictions — and others — should serve as a warning to the California Legislature.

A 2013 study of cigarette consumers in South Bronx, New York by university scholars found that 76.2 percent of discarded cigarette packs there did not bear tax stamps from both New York state and New York City, suggesting massive local tax evasion.

A 2007 study of cigarette packs discarded around the Chicago area — this before recent excise tax hikes — indicated that many came from other jurisdictions, Indeed, the study’s author notes that “Chicago littered packs were slightly more likely to have an Indiana stamp than a Chicago stamp.”

In 2008 we looked at wholesale cigarette sales on a county-by-county basis in Michigan, Wisconsin and Indiana. With information we received from a major Midwestern wholesaler, we examined changes in purchases by Michigan retailers before and after cigarette excise tax increases in each state.

We found that sales to Michigan retailers increased by 53.2 percent when Indiana raised its excise tax by nearly $1.00 or 79 percent. This change in sales is explained by the fact that Michigan retailers understand customer sensitivity to tax-induced price changes. The incentive for Michigan smokers in border counties to smuggle cigarettes in from Indiana dropped when Indiana raised its taxes.

If SBX2–9 is adopted, many counties may vote for higher taxes and will be giving their local residents an incentive to cross into another county for cheaper cigarettes.

Lost in the debate is the cost of enforcing countywide excise tax hikes in the face of large-scale smuggling. The federal government can’t prevent people from illegally crossing into California; how will government at any level keep illicit smokes from crossing the state’s porous county borders and through its busy ports? Suppose Los Angeles County imposes a countywide excise-tax increase of $2.00 per pack but Orange County declines to lift its rate. Does anyone rationally believe that illicit cigarettes will not roll into LA en masse from Anaheim or another city?

We have also built a statistical model designed to estimate statewide cigarette smuggling rates. We estimate that California’s state smuggling rate through 2013 was equal to 31.5 percent of the total market already. If a $2.00 statewide per-pack hike is adopted it will rocket to 63.0 percent of the total market, easily eclipsing New York as the state with the most smuggled cigarettes.

The irony of the excise tax hikes — sold as a way to improve health — is that the illicit behavior resulting from high cigarette taxes may actually undermine the health benefits lawmakers hope to achieve.

A 2008 study by economist Michael Lovenheim looked at casual smuggling of cigarettes and found that the percentage of cigarette consumers who smuggle is between 13 and 25 percent. He concludes that “the central implication of this study is cross-border smuggling confounds many of the potential health and revenue gains from cigarette taxation.” He is not the only scholar to come to such a conclusion.

Lawmakers bent on raising excise taxes are well-intentioned but misguided. Raising excise tax rates will increase lawlessness without necessarily bringing meaningful public health benefits.

Michael D. LaFaive ([email protected]) is director of the Morey Fiscal Policy Initiative at the Mackinac Center for Public Policy.

Todd Nesbit ([email protected]) is a senior lecturer in economics and competitive Markets at The Ohio State University and an adjunct scholar at the Mackinac Center for Public Policy.

An earlier version of this story appeared at the Mackinac Center for Public Policy’s website at Reprinted with permission.