New Jersey Proving it Can Overtax Economic Activity

Published November 1, 2007

New Jersey has secured another dubious distinction. It is the first state in the nation to experience a decline in cigarette tax revenues after increasing the cigarette tax.

This fact illustrates it is possible to overtax an economic activity. When their costs are increased, rational producers and consumers will protect their economic interests. Workers will move to jurisdictions that tax their labor and wealth less and consumers will purchase goods in venues where prices are cheaper.

It’s not only the cigarette tax that illustrates this point. Revenues from New Jersey’s two largest taxes–on income and sales–also suggest that tax hikes aren’t always as lucrative as expected.

To support the Fiscal Year 2007 state budget, Gov. [Jon] Corzine [D] successfully proposed increasing the cigarette tax by 17.5 cents, from $2.40 to $2.575 per pack. It was the fourth tax increase in a six-year period and it made New Jersey’s tax the highest state tax in the nation.

Rate Up, Revenue Down

Here was the result: In FY 2006, the cigarette tax raised more than $787 million. In FY 2007–after it was hiked by almost 7 percent–the tax raised only $764 million, or $23 million less than the previous year.

While this result may seem surprising, it should have been expected. Last year, the Center for Policy Research of New Jersey–using an economic analysis performed by the Willard Bishop firm–asserted that the Corzine administration’s revenue estimate for the tax increase could not be justified. The tax rate, the center reasoned, had reached a tipping point; even a slight increase likely would cause revenues to fall. In order to increase revenues, the tax rate had to be reduced.

The center’s statements, in part, relied upon a clear pattern in cigarette sales. As New Jersey increased its tax, cigarette sales declined. The financial impact of the decline, however, was masked by higher revenues resulting from the tax increases.

New Purchase Patterns

Some of the sales decline was due to smokers giving up an expensive habit, but that can’t explain its magnitude. Many smokers don’t buy cigarettes from New Jersey retailers. Instead, some purchase cigarettes in the states that border New Jersey, all of which have lower cigarette prices. While New Jersey’s sales are plummeting, Delaware’s are increasing. And it’s certainly not the case that more Delaware residents are becoming smokers. Also, some smokers make purchases via the Internet. Others even buy in the black market, which owes its very existence to New Jersey’s steep tax.

In addition to the cigarette tax increase, the FY 2007 budget also was balanced with a hefty sales tax increase and an extension of that tax to goods and services previously untaxed. Sales tax proceeds substantially underperformed the Corzine administration’s projections. Additionally, the income tax–the largest revenue producer–also failed to meet projections.

The only major tax to exceed expectations was the corporate business tax (CBT). It outpaced projections by at least a healthy $240 million.

Rate Down, Revenue Up

The CBT is distinguished from the other two major taxes in this way: In FY 2007, the CBT was cut. Corzine wisely allowed two provisions of the CBT to start their phase-out schedule. These provisions were part of former Gov. James McGreevey’s huge FY 2003 CBT increase and their promised phase-out had been delayed.

Contrast that with the two other taxes. In FY 2007, the sales tax rate was increased. The income tax rate was increased two years earlier.

New Jersey faces a $4 billion structural deficit. In other words, current spending and anticipated spending increases for truly fixed costs like debt service are expected to outpace revenue growth by $4 billion. While this structural deficit was growing, New Jersey was raising taxes.

According to Americans for Tax Reform, in the last five years, New Jersey increased taxes substantially more than any other state. Obviously, tax increases have not solved New Jersey’s fiscal problems. Indeed, the heavy reliance on cigarette tax increases actually worsened our fiscal difficulties.

New Jersey’s economy would benefit from some reverse psychology. Reducing the heavy tax burden would spur economic growth. And with economic growth comes tax revenue growth.

Of course, a plan to restore New Jersey’s fiscal health also should restrain the state’s extraordinary budgetary growth. For spending-addicted legislators, however, cutting the cigarette tax may be easier to accomplish.

Gregg M. Edwards ([email protected]) is president of the Center for Policy Research of New Jersey, Bloomsbury, which addresses public policy issues facing the state. This article originally appeared in the August 19 issue of the Asbury Park Press, Neptune, New Jersey. Reprinted by permission.