New Federal Tax on Cigarettes Could Hurt State Tax Revenues

Published June 1, 2009

State budget officials nationwide are bracing for the fiscal impact of a 156 percent increase in the federal tax on cigarettes.

On April 1 the federal excise tax on cigarettes soared from 39 cents to $1.01 a pack. State budget officials fear the tax hike could cut cigarette sales and consumption, reducing state tobacco tax revenues. In 2007 states relied on $15.26 billion in tobacco tax revenues in order to balance their budgets.

According to the National Taxpayers Union, in 2008 Texas and New York each took in $1.5 billion in tobacco tax revenue. Three other states took in more than $1 billion each.

Despite fearing the possible impact of the federal tax hike, more than 20 states are considering new tobacco tax hikes to cover projected budget deficits this year.

“Kentucky and Arkansas have already hiked their SETs [state excise taxes]; proposals are gaining traction in Illinois, Wisconsin, Florida, New Jersey, and South Carolina,” said Josh Culling, state government affairs manager for the National Taxpayers Union. “SET hikes in Virginia, Mississippi, and Utah, among others, failed this session.”

Regressive Tax

Culling added, “These tax increases are significantly flawed for a number of reasons. They’re a regressive tax hike on the poor; they tend not to meet their revenue projections, leading to deficits and other tax hikes in the future; and they drive business over state lines.”

Tobacco use and sales already have been declining, and many experts agree the federal cigarette tax increase will continue the declines. This will lead to less tobacco tax revenue than projected by both federal and state governments.

Patrick Fleenor, chief economist for the Tax Foundation, estimates the higher federal cigarette tax will reduce state and local revenues by $2.3 billion in fiscal 2010, the first year the tax is fully in effect.

“The bulk of these losses will result from $1.6 billion in lost excise tax revenue,” Fleenor said.

Advocates for hiking tobacco taxes often use public health arguments to push the tax increases through. Culling says those arguments often are misleading because, “while politicians will tell you they want to hike cigarette taxes for public health reasons, these hikes are entirely revenue-raising decisions. The vast majority of states are facing significant budget deficits, and hiking taxes on a small, politically unpopular minority is an easy way to raise some extra cash. Heaven forbid governments tighten their belts.”

Revenue Shortfalls

Between 2003 and 2007 only 16 of 57 state tobacco tax hikes met or exceeded their revenue estimates. Opponents of cigarette tax increases say the revenue will continue to dry up because the tax base is narrow, tobacco use is declining, and high tax rates are already driving an increase in cigarette smuggling and untaxed purchases.

Culling says nonsmokers need to be wary of such targeted tax increases because they will eventually fall back onto all taxpayers.

“The number one reason nonsmokers should care about cigarette taxes: They are unstable revenue sources that rarely meet their revenue projections. This leads to deficits and more tax hikes [on income, retail sales, and other goods] in the future,” says Culling.

Fleenor agrees, saying politicians are going after smokers because “they make up only about 20 percent of the population, making them an easy target.”

Growing Black Market

Fleenor also warns of a growing black market created by excessive cigarette taxes. He compares the wide impact of excessive tobacco taxes to that of Prohibition: “Even during Prohibition nondrinkers were still affected, and the same goes for smokers now. This is not just an issue that smokers need to worry about, because this will affect all taxpayers in the end.

“Until 1998 and the implementation of the first federal tobacco levy, cigarette smuggling was primarily an interstate issue. Since that time, with each additional federal tobacco tax hike, international smuggling has become a more prevalent concern,” Fleenor said.

As state budget negotiations across the country take place, tobacco tax revenues and possible increases in tobacco taxes are already front and center in nearly half the states.

John Nothdurft ([email protected]) is a legislative specialist in budget and tax policy at The Heartland Institute.