Download Fiscal Fact No. 120

(This paper is an updated version of Tax Foundation Fiscal Fact No. 65, available at http://www.taxfoundation.org/legacy/show/23045.html)

Fiscal Fact No. 120

While there exist a large literature and extensive policy discussion on the issue of cigarette taxation, smokeless tobacco has received comparatively little attention. In the past few years, however, controversy in many state legislatures has erupted over the proper way of taxing smokeless tobacco, if it should be taxed at all. The goal of this Fiscal Fact is to clarify the rationale for excise taxation in general from a neutral public finance perspective, and specifically to explain the proper method of taxation of smokeless tobacco products and how it compares to cigarette taxation.

The Fallacies of Current Tax Policy on Smokeless Tobacco Products

Even though the federal government taxes smokeless tobacco at a per unit rate based upon weight, most states tax it based upon the sale price. This can be seen in the following table of the tax rates on smokeless tobacco across the country.

Table 1

Smokeless Tobacco Tax Policy Is Highly Inconsistent Across States

State Tax Rate on Moist Snuff Tobacco (MST) Type of Tax Alabama 2 cents per typical can1 Per Unit Alaska 75% of wholesale price Ad Valorem Arizona 12.3 cents per ounce Per Unit Arkansas 32% of manufacturer’s price Ad Valorem California 46.76 percent of wholesale price2 Ad Valorem Colorado 40% of manufacturer’s price Ad Valorem Connecticut 40 cents per ounce3 Per Unit Delaware 54 cents per ounce Per Unit Florida 25% of wholesale price Ad Valorem Georgia 10% of wholesale price Ad Valorem Hawaii 40% of wholesale price Ad Valorem Idaho 40% of wholesale price Ad Valorem Illinois 18% of wholesale price Ad Valorem Indiana 24% of wholesale price Ad Valorem Iowa $1.19 per ounce Per Unit Kansas 10% of wholesale price Ad Valorem Kentucky 9.5 cents per unit4 Per Unit Louisiana 20% of manufacturer’s price Ad Valorem Maine 78% of wholesale price Ad Valorem Maryland 15% of wholesale price Ad Valorem Massachusetts 90% of wholesale price Ad Valorem Michigan 32% of wholesale price Ad Valorem Minnesota 70% of wholesale price Ad Valorem Mississippi 15% of manufacturer’s price Ad Valorem Missouri 10% of manufacturer’s price Ad Valorem Montana 85 cents per ounce Per Unit Nebraska 20% of wholesale price Ad Valorem Nevada 30% of wholesale price Ad Valorem New Hampshire 19% of wholesale price Ad Valorem New Jersey 75 cents per ounce Per Unit New Mexico 25% of product value Ad Valorem New York 37% of wholesale price Ad Valorem North Carolina 10% of wholesale price Ad Valorem North Dakota 60 cents per ounce Per Unit Ohio 17% of wholesale price Ad Valorem Oklahoma 60% of wholesale price Ad Valorem Oregon 65% of wholesale price Ad Valorem Pennsylvania No tax N/A Rhode Island $1.00 per ounce Per Unit South Carolina 5% of manufacturer’s price Ad Valorem South Dakota 35% of wholesale price Ad Valorem Tennessee 6.6% of wholesale price Ad Valorem Texas 40% of manufacturer’s price Ad Valorem Utah 75 cents per ounce Per Unit Vermont $1.49 per ounce Per Unit Virginia 10% of wholesale price Ad Valorem Washington 75% of wholesale price Ad Valorem West Virginia 7% of wholesale price Ad Valorem Wisconsin $1.31 per Ounce Per Unit Wyoming 20% of wholesale price (or 10% of retail) Ad Valorem

1 Alabama charges 1.5 cents per ounce of chew tobacco, and a varying rate on snuff tobacco per can, depending upon the size.

2 Adjusted annually by the California Board of Equalization

3 Connecticut charges a tax of 20 percent on other tobacco products besides snuff.

4 Kentucky charges a tax of 7.5 percent on other tobacco products besides snuff.

Source: Federation of Tax Administrators; various updates compiled by Tax Foundation

As Table 1 shows, the lowest tax burdens on smokeless tobacco are found in the tobacco-producing South, which also imposes the lowest tax rates on cigarettes, although tobacco taxes on whole have grown rapidly over the past decade. But why do some states tax smokeless tobacco so heavily and some so lightly? What is the rationale for some states (like Iowa, Wisconsin, and Arizona) recently switching from an ad valorem basis to a per unit (i.e. weight-based) basis?

To answer these questions and determine which states, if any, are practicing proper tax policy, we must develop a framework for explaining proper tax policy with regard to smokeless tobacco. Tobacco taxation policy should follow the framework of three crucial questions:

(1) Should products like smokeless tobacco have a special tax imposed?

(2) By what method should they be taxed, i.e. based on the sale price (ad valorem) or per unit?

(3) What is the proper level of taxation?

Should Tobacco Products Have a Special Tax?

Assuming that the role of government is to prevent individuals from harming one another, and not to prevent individuals from harming themselves, then special taxes on tobacco products should exist only if those products impose significant costs on third parties. A frequently cited example is the health care costs to other taxpayers associated with tobacco consumption.1 Another often-cited external cost of tobacco products, cigarettes in particular, is second-hand smoke-both in public places and in homes where children reside. Smokeless tobacco, however, imposes no such harm. Other costs unfairly imposed on society from tobacco consumption have been cited, such as the unattractiveness of witnessing certain behavior associated with chew tobacco, and the message children receive as a result of viewing adult tobacco consumption.

To the extent that tobacco imposes undue costs on society, specific taxation of the product may be warranted. But a government official who merely desires to influence individual consumption decisions because of his own anti-tobacco sentiment cannot be justified by an appeal to principles of sound tax policy unless one wants to go down the road of paternalistic tax policy whereby activities deemed unhealthy (like fatty foods, soft drinks, alcohol, tobacco, etc.) are subject to heavy taxation.

By What Method Should Tobacco Products Be Taxed?

There are two methods of levying an excise tax on any product. The first and most common type of excise tax is a per-unit tax. In this case, the tax is independent of the price of the product. The other type of excise tax is an ad valorem tax, which is akin to a typical general sales tax where the tax is a percentage of the sale price.

Regardless of the rationale for the government’s attempt to limit tobacco consumption via taxation-whether it is through the proper framework of controlling for negative costs imposed on others or through the authoritarian/paternalistic method of trying to control individual decisions-tobacco products should be taxed via a per-unit tax. The harm caused by a unit of tobacco is essentially unrelated to its price. A $5 pack of cigarettes would not impose any cost to society or harm any individual more than a $2 pack of cigarettes would. With respect to cigarettes, most tax-levying officials have properly understood this because every state imposes the tax based on the number of cigarettes, not based upon the sale price.

However, with respect to smokeless tobacco, most states have gone in the opposite direction of sound tax policy, and have imposed ad valorem taxes, which are based upon the sale price of the smokeless tobacco. Only nine states impose the tax on a per-unit basis even though the federal government taxes moist smokeless tobacco based on weight, which is essentially a tax on quantity, and is the proper way of taxing the product.

It is not logical to base the tax on the value of the product. A $6 can of premium smokeless tobacco does no greater harm to the user or to society than a $2 brand of generic smokeless tobacco, but under the current system in most states, the premium brand is charged a tax three times that of the generic brand. Much of the effect of this ad valorem tax is merely to encourage more consumption of the inexpensive brand, thereby making irrelevant much of the government policy designed to limit the quantity of tobacco consumed.

What is the Proper Level of Taxation?

Now that we have defined the conditions under which a government is justified in imposing a special tax on tobacco and explained how that tax should be levied, the obvious question is what the level of taxation should be. In standard economic theory, a tax designed to compensate for a negative externality imposed on society should be levied on a per unit basis and should equal the difference between the social cost of the good (the cost to society at large) and the private cost (the cost to individual consumers). Therefore, if the social cost of tobacco consumption is greater than the total private cost, then the tax should be set at a level that will make the two costs equal, thereby improving overall societal well-being. The problem that governments face is calculating the social cost of tobacco and comparing it to the private cost. Often, those with certain agendas try to overstate the difference between the private cost and the social cost of tobacco in order to impose their principles of morality on everyone else. What constitutes a true cost to society is therefore always a subject of disagreement and should be carefully calculated. Policymakers should be clear about the factors involved in their calculations when they recommend a level of taxation. At the very least, the relative taxes imposed on tobacco products should be in accordance with their negative costs imposed on society. Specifically, if one pack of cigarettes imposes the same external costs on society as does one can of chew, then their respective tax amounts should be the same. Again, this is irrespective of the price of the product.

Tobacco Products as a Revenue Source

Recently, many policymakers have begun to look towards tobacco products merely as a source of tax revenue. Such policies are unfortunately inconsistent with sound tax policy. Arbitrarily choosing one product to raise revenue from without any account of the negative social costs the product imposes would be seen by many as a violation of individual liberty and would more appropriately be under the heading “regulatory policy.” Many advocates of this type of revenue source tapping will use the excuse that “people shouldn’t consume tobacco products in the first place.” But under such logic, one would ban tobacco products, not impose heavy taxes upon them. Such an inconsistency exposes the true motive behind the politicians’ heavily taxing tobacco products: they want to raise revenue by imposing a tax on a minority of the citizens.

Summary

Even if the goal of policymakers is to reduce tobacco consumption, in a free society this should be done solely for the purposes of correcting for social costs unfairly imposed on others, not to impose some individuals’ moral agenda on everyone else. Taxes should not be used to impose morality; social engineering through the tax code is never sound tax policy. Because the proper purpose of tobacco taxes is to correct for market imperfections, taxes should be levied only up to the point at which the tax per unit equals the difference between the social cost of a unit of tobacco and the private cost of a unit of tobacco. This can only be accomplished with per-unit excise taxes because the dollar value of the tobacco consumed is irrelevant with respect to reducing overall consumption of tobacco.

Notes

1 Some economists will note that any health care cost imposed on society is technically a transfer that has been created by government through a quasi-socialized health care system. Moreover, while it is commonly assumed that individuals’ unhealthful habits must necessarily impose health care costs on society, this is not at all the case. A field of economics known as social cost accounting attempts to discern the aggregate fiscal effects of different types of behavior, and its findings are often counterintuitive. Smoking, for example, has been found to not impose health care costs on nonsmokers. To the contrary, current federal, state, and local fiscal regimes have been found to transfer tens of billions of dollars from smokers to nonsmokers. See, for example, Patrick Fleenor, “Who Bears the Ancillary Cost of Tobacco Use?,” Tax Foundation Background Paper, No. 36 (January 2001).