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Taxing Cigarettes to Fund Health Care:
How government becomes a partner in promoting undesirable behavior

7 Aug 2007 in Regulatory Economics, Regulatory Policy

There is a long pedigree in economics for taxing undesirable behavior as a way to change it. The author of this theory is Arthur Cecil Pigou, an early 20th Century British economist. So-called Pigouvian taxes remain popular among economists; see, for example, Greg Mankiw's views on carbon taxes to combat climate change. Thay also have been popular with governments because, unlike taxes on labor or investment, they distort incentives in generally desirable ways. That means they have the added advantage that they are useful for generating revenue without causing economic harm.

Pigouvian taxes have a dark side, however. Government becomes dependent on the revenue these taxes generate, and the more effective they are in achieving the desired change in behavior the more government revenue from the tax declines.

Passage by the House of Representatives of legislation that would raise the tax on cigarettes to fund an expansion of the State Children's Health Insurance Program (SCHIP) provide a timely illustration of the problem. In recent years, the states have become senior partners in the business of selling cigarettes. They collect billions of dollars annually in excise taxes and receipts from the settlement of certain legal claims. These revenues depend on sustained future cigarette sales. If smoking ended tomorrow, the states would experience a huge financial crisis.

Funding the expansion of health insurance by raising federal excise taxes on tobacco puts the federal government in the same awkward position.

H.R. 3162 (passed 225-204 on August 1, 2007) partially funds the expansion in SCHIP with increased taxes on tobacco. Estimates of budget outlays and programmatic effects are provided by the Congressional Budget Office. Estimates of revenue collections are provided by the congressional Joint Committee on Taxation. CBO estimates the bill will increase federal spending by $102 billion through FY 2017 (the standard 10-year budget horizon) and reduce by 1.9 million the number of persons (not all of them children) who are uninsured. JCT estimates the higher tax rates on tobacco in Section 1001 will raise an additional $52.8 billion through FY 2017.

INFORMATION QUALITY ISSUES

Neither CBO's nor JCT's estimates are transparent and reproducible; we cannot take them apart and put them back together again to see how they work. This is required by law for government agencies covered by the federal Information Quality Act and implementing guidelines issued by the Office of Management and Budget. (Both organizations are exempt because they are not "agencies" as that term is defined in the Paperwork Reduction Act, the statutory foundation for the Information Quality Act. Congress, in all its parts, is exempt, and CBO and JCT are congressional organizations.)

UPDATE August 9, 2007.

We requested the full analysis from the Joint Committee on Taxation.  It does not contain any additional information about how JCT derived its estimates.

PROJECTED REVENUES FROM HIGHER TOBACCO TAXES MAY NOT BE REALIZED

Because of this lack of transparency, we cannot determine what assumptions and data JCT used to estimate revenue increases. The key question is: By how much does demand decline in response to price increases resulting from the higher tax rates? Economists call this price elasticity of demand, the change in quantity demanded resulting from a change in price at a defined point of departure. For all normal goods (including tobacco), price elasticity is negative. Governments like to tax goods and services for which demand is inelastic (that is, between zero and -1) because consumers will not respond to the tax by significantly curtailing consumption, which would compromise revenue generation.

Typical estimates of tobacco price-elasticity are in the range of -0.3 to -0.5, but demand becomes less inelastic (that is, it approaches -1) over the long-run and for larger changes in price. The ratio of increased taxes to current prices is approximately 10% for cigarettes and varying amounts for other tobacco products. The tax rate on small cigars would increase from $1.828 to $42.00 per thousand (22,000%), and on roll-your-own tobacco from $1.10 to $7.47 per pound (579%). We doubt that the much higher tax rate on small cigars translates into a much higher price; $42 per thousand is just four cents each on products that sell for anywhere from 80 cents to $2.50 each. Roll-your-own tobacco may be such a specialized product that demand is both highly inelastic and less susceptible to substitution effects.

We expect that almost all of the projected revenue increase comes from sales of Class A cigarettes (defined as "small cigarettes" by statute). The tax increase is ($42.00/1000 - $19.50/1000) ÷ $19.50/1000 = $22.50/1000 = 2.25 cents per cigarette, or 45 cents per pack. R.J. Reynolds says the nationwide average price of a pack of cigarettes in 2006 was $4.05, with interstate differences amounting to a factor of almost 100% (range: $3.24 [South Carolina] to $6.35 [New Jersey]). Thus, the increased federal excise tax in H.R. 3162 is about 11% of the nationwide average price, but 14% of the price in South Carolina and 7% of the price in New Jersey.

JCT did not disclose what values it used for price elasticity in its estimates. Nonetheless, the validity and reliability of JCT's estimates depends critically on whether its assumptions about price elasticity were unbiased. For example, one can easily overestimate by a lot the amount of additional tax revenue the government will collect by assuming no difference between short- and long-run price elasticity, or by using an unrealistically low absolute value for price elasticity.


Interstate differences in state excise taxes have resulted in significant disintermediation, with high-tax states losing considerable revenue to low-tax states. Reynolds reports paying $788.7 million in excise taxes to New Jersey in 2006 (July 2005 population: 8,717,925), which at the Garden State's $2.575 per pack tax means sales of approximately 306 million packs (35 packs per capita). In contrast, Reynolds paid $28.7 million in excise taxes to South Carolina (July 2005 population: 4,255,083), but at the Palmetto State's excise tax of 7 cents per pack this translates to more than 410 million packs sold (95 packs per capita). It is possible, but unlikely, that cigarette consumption by South Carolinians is about three times greater than by New Jersans. It is much more likely that a lot of cigarettes sold in South Carolina are consumed elsewhere.

Stories of interstate cigarette smuggling abound because the financial payoff is great. Smugglers vary from small-time entrepreneurs to organized crime to suspected terrorists. In any case, an increase in federal excise taxes should not lead to more interstate smuggling because the higher tax would affect all states. Sales by Indian tribes and over the Internet represent the final frontiers of jurisdictional tax competition. Tribes are exempt from state excise taxes, though states try (with limited success) to enforce tax compliance with respect to non-Indian buyers, and the States' problems with collecting taxes on Internet sales generally is well known.

Officials in high-tax jurisdictions complain about competition from Indian sellers, and more recently, Internet sales by non-Indian sellers. There is evidence supporting this observation. Austan Goolsbee and Joel Slemrod have argued that the practical effect of differential state excise tax rates is not reduced consumption but rising consumer willingness to evade state excise taxes by shopping from sellers in low excise tax jurisdictions. State governments that increased excise tax rates in hopes of raising significant revenue at the expense of tobacco consumers whose demand is highly price-inelastic have been frustrated that the intended targets of the tax increasingly seek out lower-taxed alternatives.

Federal excise taxes avoid interstate disintermediation, but at the expense of state revenues. Assuming constant price elasticity of -0.4, state excise tax revenues will decline by an average of 4.4% (2.8% in New Jersey, 5.6% in South Carolina). Reynolds reports the industry paid $14 billion in state excise taxes in 2006; a 4.4% decline in cigarette consumption means H.R. 3162 would cause a reduction in state excise tax revenue of about $616 million. (This is a small fraction of the approximately $10 billion per year in added revenue states would gain from H.R. 3162, but state officials who support the bill presumably are aware of this future revenue loss and have factored it into their decisions.)


Does H.R. 3162 violate the recently re-instituted "PAYGO" rule? We cannot tell whether the projected revenues from increased tobacco taxes will materialize because JCT did not reveal its assumptions about short- and long-run price elasticity. Under PAYGO, the House cannot consider a bill that has "the net effect of increasing the deficit or reducing the surplus." Gimmickry is commonplace in PAYGO accounting, however, for example by counting as offsetting revenues reductions in spending elsewhere that will not in fact occur, or as is possible in this case, counting tax revenues that will not in fact be collected.

In principle, a Member can challenge -- and prevent the House from voting on -- bills that fail the PAYGO test. In practice, however, a bill passes as long as forecasts from the Congressional Budget Office and Joint Committee on Taxation say it does. Both offices are, of course, creatures of Congress and subject to its management and direction. Neither office is statutorily required to issue economically credible estimates, nor is it subject to any of the information quality requirements mentioned above, such as transparency, reproducibility and objectivity, that apply to the Executive branch, nor is there any body formally constituted to peer review its work to ensure that its projections are valid.

PROBLEMS WITH USING PIGOUVIAN TAXES TO FUND PERMANENT PROGRAMS SUCH AS SCHIP

We take no position here on whether SCHIP is economically sound, nor whether the programmatic expansion proposed in H.R. 3162 makes good health care policy. Our purpose is to identify problems with the use of Pigouvian taxes (in this case, on tobacco) to fund an unrelated but permanent program (increasing by an estimated 1.9 million the number of persons with health insurance).


The proper use of a Pigouvian tax is to internalize an externality -- that is, get prices "right" and walk away. In this case, tobacco users are presumed to impose costs on others, such as adverse health effects from second-hand smoke. A properly designed Pigouvian tax requires first developing an unbiased estimate of the monetized value of the tobacco externality. We've seen no evidence that the higher tax rates proposed in H.R. 3162 were based on any such analysis. Indeed, because the stated purpose of the bill is to provide stable programmatic funding it is appropriate to infer that "getting prices right" is not the objective of the tax increase. Hence, the existence of an externality resulting from tobacco use is not a legitimate justification for raising the federal excise tax. The purpose of the tax increase is to generate revenue, and that purpose is damaged if the tax leads to a significant reduction in tobacco use.

This is the typical pattern for Pigouvian taxes in practice: They are used to generate revenue, not to internalize externalities. The initial taxpayer reaction to the tax is reduction in the taxed activity, which causes revenues to fall below forecast, which necessitates increases in the tax rate, which leads to further reductions in the taxed activity, ad infinitum. There is a tax rate that maximizes revenue, but it will almost certainly be much higher than the tax rate that internalizes the externality. Moreover, legislators often are tempted to raise tax rates in excess of the amount that maximizes revenue because they fail to take account of the behavioral effects taxes have on taxpayers.

In the case of SCHIP, its projected funding depends on smokers not deciding to quit. If they did, and SCHIP expenditures were capped by tobacco tax revenues, SCHIP would fail for lack of revenue.


This is the darkest implication of using tobacco taxes to fund an expansion in government-paid health insurance: H.R. 3162 makes the federal government an even larger partner in the tobacco business. The image graphic on the right, which is published by R.J. Reynolds, says the government's current average share of the revenue from a pack of cigarettes ($2.09) is more than half of its average retail price ($4.05). (We have not found any claims from the tobacco industry's many opponents suggesting that Reynolds' figures are wrong. We have found many statements supporting higher taxes, which implies that they believe the government's share should be larger.)

Subsequent to the Master Settlement Agreement with the Big Four cigarette producers, the states effectively became partners in the tobacco business. Though the litigation was legally premised on the recovery of costs that states had borne to provide health care to smokers, and it was written ostensibly to promote programs aimed at reducing youth smoking, only a small fraction of MSA receipts have been devoted to anti-smoking programs.

Anti-smoking activists seem surprised by this turn of events, but it was the predictable result of Pigouvian taxation (to which MSA receipts are analytically similar). MSA receipts became a source of revenue in support of general governmental expenditures, and the states then faced a financial incentive not to use the proceeds to fund programs that might reduce the future flow of tax revenue.

How large is this incentive? Citing the consulting firm of Orzechowski and Walker (whose annual reports are not available on the Internet), R.J. Reynolds says total payouts under the MSA through 2006 totaled $62.2 billion. Reynolds criticizes states for allocating less than five percent of the amount to fund anti-tobacco programs, and instead using the receipts to fund all sorts of unrelated public programs, some of dubious merit.

Anti-smoking activists are similarly critical. Last December, the Campaign for Tobacco-Free Kids issued a report which concluded that the states had devoted 9% ($598 million) of $7 billion in 2006 MSA receipts (and just 3% of $21.7 billion in total revenues from tobacco) to fund programs aimed at preventing smoking (page ix). CTFK provides a map (reproduced below) showing how the states measure up to what they call "the CDC minimum" commitment to anti-smoking programs. (The "CDC minimum" comes from a policy document issued in 1999 by the Center for Disease Control's Office on Smoking and Health ["Best Practices for Comprehensive Tobacco Control Programs"], which advocated states spend varying amounts by state in the range of $5 to $20 per resident per year.)

		States that have funded tobacco prevention programs at a level that meets the CDC’s minimum recommendation.
		States that have committed substantial funding for tobacco prevention programs (more than 50% of CDC minimum).
		States that have committed minimal amounts for tobacco prevention programs (less than 25% of CDC minimum).
		States that have committed no tobacco settlement or tobacco tax money for tobacco prevention programs.

Yet, states' limited interest in funding anti-smoking programs -- especially if these programs are effective -- is a predictable result of what happens when states become dependent on revenues from Pigouvian taxes. Effective anti-smoking programs reduce smoking, but they also reduce future state revenues from tobacco excise taxes and MSA receipts. Washington State (which Oregon and Washington State public health employees consider exemplary but the CTFK says is underfunded) is instructive. Washington State received $557.4 million in 2006 from tobacco taxes and MSA receipts, and spends about $28 million on anti-smoking programs. If doubling this expenditure reduced smoking by just 20%, the net effect on state finances would be a budget gap of about ($28 million + [.2 x $557 million] =) $140 million.

H.R. 3162 extends the dark logic of Pigouvian taxation to the federal government, though with two important differences: The federal government need not balance its annual budget, and PAYGO is triggered by CBO and JCT forecasts of revenues and expenditures, not what actual revenues and expenditures turn out to be. H.R. 3162 does not limit the increase in SCHIP expenditures to the proportion of forecast tobacco tax revenues actually realized. Such a constraint would make Congress even more sensitive to the prospect of raising tobacco taxes so high that consumption declined significantly.

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TOBACCO TAX RATES IN CURRENT LAW AND PROPOSED IN H.R. 3182, SECTION 1001
Product	Existing Tax Rate ($/unit)	Units	Proposed Tax Rate ($/unit)	Units	Percentage Increase in Tax Rate
Small cigarettes [1] (Class A)	$19.5000	1000 cigarettes	$42.0000	1000 cigarettes	115%
Large cigarettes [2] (Class B}	$40.9500	1000 cigarettes	$88.2000	1000 cigarettes	115%
Small cigars [3]	$1.828	1000 cigars	$42.0000	1000 cigars	21,980%
Large cigars [4]	At least 18.06 but not > $48.7500	% 1000 cigars	At least 44.63 but not > $1.0000	% cigar	~150%
Cigarette papers [5]	$0.0122	50 papers	$0.0263	50 papers	116%
Cigarette tubes [6]	$0.0244	tube	$0.0526	tube	116%
Snuff	$0.5850	pound	$1.2600	pound	116%
Chewing tobacco	$0.1950	pound	$0.4200	pound	115%
Pipe tobacco	$1.0969	pound	$2.3600	pound	115%
Roll-your-own tobacco	$1.0969	pound	$7.467	pound	529%
[1] Weighing not more than 3 lbs per thousand. See 26 USC 5701(b)(1). [2] Weighing more than 3 lbs per thousand and less than 6-1/2 inches long. See 26 USC 5701(b)(1). [3] Weighing not more than 3 lbs per thousand. See 26 USC 5701(a)(1). [4] Weighing more than 3 lbs per thousand. See 26 USC 5701(a)(1). [5] Less than 6-1/2 inches in length, or "taxable at the rate prescribed, counting each 2-3/4 inches, or fraction thereof, of the length of each as one cigarette paper." See 26 USC 5701(c). [6] Less than 6-1/2 inches long, or "taxable at the rate prescribed, counting each 2-3/4 inches, or fraction thereof, of the length of each as one cigarette tube." See 26 USC 5701(d).

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SEC. 1001. INCREASE IN RATE OF EXCISE TAXES ON TOBACCO PRODUCTS AND CIGARETTE PAPERS AND TUBES.

1. Small Cigarettes- Paragraph (1) of section 5701(b) of the Internal Revenue Code of 1986 is amended by striking `$19.50 per thousand ($17 per thousand on cigarettes removed during 2000 or 2001)' and inserting `$42 per thousand'.
2. Large Cigarettes- Paragraph (2) of section 5701(b) of such Code is amended by striking `$40.95 per thousand ($35.70 per thousand on cigarettes removed during 2000 or 2001)' and inserting `$88.20 per thousand'.
3. Small Cigars- Paragraph (1) of section 5701(a) of such Code is amended by striking `$1.828 cents per thousand ($1.594 cents per thousand on cigars removed during 2000 or 2001)' and inserting `$42 per thousand'.
4. Large Cigars- Paragraph (2) of section 5701(a) of such Code is amended--
   1. by striking `20.719 percent (18.063 percent on cigars removed during 2000 or 2001)' and inserting `44.63 percent', and
   2. by striking `$48.75 per thousand ($42.50 per thousand on cigars removed during 2000 or 2001)' and inserting `$1 per cigar'.
5. Cigarette Papers- Subsection (c) of section 5701 of such Code is amended by striking `1.22 cents (1.06 cents on cigarette papers removed during 2000 or 2001)' and inserting `2.63 cents'.
6. Cigarette Tubes- Subsection (d) of section 5701 of such Code is amended by striking `2.44 cents (2.13 cents on cigarette tubes removed during 2000 or 2001)' and inserting `5.26 cents'.
7. Snuff- Paragraph (1) of section 5701(e) of such Code is amended by striking `58.5 cents (51 cents on snuff removed during 2000 or 2001)' and inserting `$1.26'.
8. Chewing Tobacco- Paragraph (2) of section 5701(e) of such Code is amended by striking `19.5 cents (17 cents on chewing tobacco removed during 2000 or 2001)' and inserting `42 cents'.
9. Pipe Tobacco- Subsection (f) of section 5701 of such Code is amended by striking `$1.0969 cents (95.67 cents on pipe tobacco removed during 2000 or 2001)' and inserting `$2.36'.
10. Roll-Your-Own Tobacco-
    1. IN GENERAL- Subsection (g) of section 5701 of such Code is amended by striking `$1.0969 cents (95.67 cents on roll-your-own tobacco removed during 2000 or 2001)' and inserting `$7.4667'.
    2. INCLUSION OF CIGAR TOBACCO- Subsection (o) of section 5702 of such Code is amended by inserting `or cigars, or for use as wrappers for making cigars' before the period at the end.
11. Effective Date- The amendments made by this section shall apply to articles removed after December 31, 2007.
12. Floor Stocks Taxes-
    1. IMPOSITION OF TAX- On cigarettes manufactured in or imported into the United States which are removed before January 1, 2008, and held on such date for sale by any person, there is hereby imposed a tax in an amount equal to the excess of--
       1. the tax which would be imposed under section 5701 of the Internal Revenue Code of 1986 on the article if the article had been removed on such date, over
       2. the prior tax (if any) imposed under section 5701 of such Code on such article.
    2. AUTHORITY TO EXEMPT CIGARETTES HELD IN VENDING MACHINES- To the extent provided in regulations prescribed by the Secretary, no tax shall be imposed by paragraph (1) on cigarettes held for retail sale on January 1, 2008, by any person in any vending machine. If the Secretary provides such a benefit with respect to any person, the Secretary may reduce the $500 amount in paragraph (3) with respect to such person.
    3. CREDIT AGAINST TAX- Each person shall be allowed as a credit against the taxes imposed by paragraph (1) an amount equal to $500. Such credit shall not exceed the amount of taxes imposed by paragraph (1) for which such person is liable.
    4. LIABILITY FOR TAX AND METHOD OF PAYMENT-
       1. LIABILITY FOR TAX- A person holding cigarettes on January 1, 2008, to which any tax imposed by paragraph (1) applies shall be liable for such tax.
       2. METHOD OF PAYMENT- The tax imposed by paragraph (1) shall be paid in such manner as the Secretary shall prescribe by regulations.
       3. TIME FOR PAYMENT- The tax imposed by paragraph (1) shall be paid on or before April 14, 2008/
    5. ARTICLES IN FOREIGN TRADE ZONES- - Notwithstanding the Act of June 18, 1934 (48 Stat. 998, 19 U.S.C. 81a) and any other provision of law, any article which is located in a foreign trade zone on January 1, 2008, shall be subject to the tax imposed by paragraph (1) if--
       1. internal revenue taxes have been determined, or customs duties liquidated, with respect to such article before such date pursuant to a request made under the 1st proviso of section 3(a) of such Act, or
       2. (B) such article is held on such date under the supervision of a customs officer pursuant to the 2d proviso of such section 3(a).
    6. DEFINITIONS- For purposes of this subsection--
       1. IN GENERAL- Terms used in this subsection which are also used in section 5702 of the Internal Revenue Code of 1986 shall have the respective meanings such terms have in such section.
       2. SECRETARY- The term `Secretary' means the Secretary of the Treasury or the Secretary's delegate.
    7. CONTROLLED GROUPS- Rules similar to the rules of section 5061(e)(3) of such Code shall apply for purposes of this subsection.
    8. OTHER LAWS APPLICABLE- All provisions of law, including penalties, applicable with respect to the taxes imposed by section 5701 of such Code shall, insofar as applicable and not inconsistent with the provisions of this subsection, apply to the floor stocks taxes imposed by paragraph (1), to the same extent as if such taxes were imposed by such section 5701. The Secretary may treat any person who bore the ultimate burden of the tax imposed by paragraph (1) as the person to whom a credit or refund under such provisions may be allowed or made.

SEC. 405. PAY-AS-YOU-GO POINT OF ORDER.

1. the most recent baseline estimates supplied by the Congressional Budget Office consistent with section 257 of the Balanced Budget and Emergency Deficit Control Act of 1985 used in considering a concurrent resolution on the budget; or
2. after the beginning of a new calendar year and before consideration of a concurrent resolution on the budget, the most recent baseline estimates supplied by the Congressional Budget Office consistent with section 257 of the Balanced Budget and Emergency Deficit Control Act of 1985.
   

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How government becomes a partner in promoting undesirable behavior

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