With many states now running large budget deficits, legislators are looking anew at higher cigarette taxes. Even though these taxes have been raised sharply in almost every state in recent years -- on top of price increases mandated by the tobacco settlement -- politicians still seem to think that this cow can be milked even more. However, several new studies suggest that there are diminishing returns to higher cigarette taxes. Evasion is now so great that revenues are starting to fall in some places.
Long ago, Adam Smith noted that it is possible for tax increases to reduce revenues. Said Smith, "High taxes, sometimes by diminishing the consumption of the taxed commodities, and sometimes by encouraging smuggling, frequently afford a smaller revenue to government than what might be drawn from more moderate taxes."
New York City is probably the best example of where cigarette taxes, which now total $3.00 per pack, are so high that a tax cut would probably raise revenue. A new report from the Small Business Survival Committee notes that the city is getting less than half the revenue expected from last year's increase from 8 cents to $1.50 per pack. (The state also levies a tax of $1.50, putting the total price per pack at $7.50 in New York City.)
The city had anticipated $250 million in additional revenue from the tax increase -- a tenfold increase from the $27 million expected from the previous 8 cent tax. Since the rate was increasing almost 20 times, the city clearly anticipated that there would be a substantial falloff in demand. Since this lower demand would also affect state cigarette tax revenues collected in New York City, the state demanded that its lost revenues be reimbursed by the city. Hence, the city was forced to give the state 46 percent of the higher revenues.
Thus, out of the $250 million, New York City was only going to get $107 million of additional revenue even if everything went as planned. But according to the SBSC study, conducted by the Beacon Hill Institute, cigarette sales from legal sources fell much more than expected -- by 189 million packs. This led to a further reduction in the sales of other products at corner groceries and other small businesses, resulting in lower incomes and profits. This forced stores to cut back on employment, resulting in a loss of about 10,000 jobs.
The loss of cigarette sales, ancillary product sales, and income to businesses and workers reduced New York City's tax revenue by $64 million. Thus the city's net revenue from its $250 million tax increase turns out to be just $43 million.
Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.
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