SBE Council Small Business Fact of the Week

Tobacco Tax Evasion

Many state and local elected officials seem to think that tobacco taxes can be jacked up ever higher, that revenues will always rise to pay for more government spending, and that there are no negative effects for the economy.

For example, as part of a massive proposed expansion of government health care programs, California lawmakers are pondering a $1.75 per pack increase in the state's tobacco tax.

But do things always work out the way the politicians assume when it comes to tax increases? Of course not.

Consider several points from an October 2007 analysis of higher cigarette taxes in New York City by the New York City Independent Budget Office. In 2002, the state raised its cigarette tax by $1.50 and the city did so as well, with the total tax hike in New York City registering $3.00.  The IBO reported the following:

• "[C]hanges in the city's cigarette tax required legislation by the state. The state wanted compensation for revenue it expected to lose as smokers cut back on taxed purchases in response to the nearly 18-fold increase in the city tax. [It was being increased from 8 cents to $1.50.] Under the final legislation, 46 percent of annual city cigarette tax revenues are redirected to the state."

• In a 2006 survey, 27 percent of city smokers and 34 percent of smokers across the rest of the state reported buying lower taxed or non-taxed cigarettes. Outside of New York City, cigarettes often are easy to purchase on Indian reservations, and 75% of smokers buying lower taxed or non-taxed cigarettes outside New York City reported doing so. Among city smokers who purchased lower taxed or non-taxed cigarettes, 71% bought across state lines.

• "As the combined city and state tax rate grew by 90 percent between city fiscal years 2002 and 2003, total taxed city sales fell sharply from about 343 million cigarettes packs to 197 million packs, a decline of 42 percent."

• After accounting for the 46% of revenues going to the state, city revenues went from $30 million in 2002 to almost $160 million in 2003, the first year of the higher tax. Revenues subsequently declined to $123 million in 2006.

• Also in 2006, the IBO estimated that if all of the cigarettes bought in New York City were taxed, the city would have brought in an additional $43 million. However, the IBO also noted that research shows that smoking surveys underestimate actual smoking, so tax evasion could be even higher.

• "The majority of New York City smokers buy their cigarettes from convenience and grocery stores, supermarkets, pharmacies, gas states, and discount stores..."

So, when we're talking about lost business due to higher taxes, small businesses tend to be the ones hit hardest.  Government revenues certainly increase, but not as much as expected, and they tend to subsequently decline with less smoking and more tax evasion. Yet, government spending keeps chugging along, which means that other taxes will have to be increased.

For good measure, the IBO report does not attempt to quantify any of the additional costs to government in terms of fighting criminal activity related to tax evasion.

Higher taxes always come with costs, with small businesses and consumers often paying the price.

Raymond J. Keating, Chief Economist