State governments don't get a lot of fiscal good news these days, so it was surprising this week when the state of Connecticut announced that a recent $1-a-pack tax increase on cigarettes raised $5 million more than the state had projected. As economists would predict, the daunting total of a $3-a-pack tax in Connecticut—the fourth highest burden in the country—did reduce the sale of cigarettes. Some smokers reacted to the tax by quitting, with others finding different ways around the tax.
But the surprising fact is that not that many quit smoking or evaded the tax—not enough, anyway, to cause the state to collect less in cigarette taxes than it would have without the hike. This experience is not unique to Connecticut. Over the last decade or so, several states and jurisdictions have experimented with massive cigarette tax increases, as much as 100 percent or more over the existing rate. California, for example, still has a relatively low state cigarette tax, but in January 1999, it ballooned from 37 cents a pack to 87 cents. In 2002, New York City raised the tax on a pack of cigarettes from 8 cents to $1.50, an astronomical hike of nearly 1,800 percent.
Yet according to anti-tobacco activists—who are backed up by economic studies—in every single instance, these huge tax hikes have led to states collecting more revenue, even as many smokers swear they won't pay them. Cigarettes may not quite be what economists call "perfectly price inelastic," but millions of American smokers are willing to pay much higher taxes than economic theory would suggest they should.
At the heart of nearly every tax debate in America is some version of the Laffer curve, a fancy way of describing a point of diminishing returns. An income tax of 0 percent produces no revenue; an income tax of 100 percent, it is presumed, causes people to change their behavior so as to avoid the tax, also producing nothing. Some ideal point in between will yield the maximum possible revenue.
In the late 1970s and the 1980s, this very old idea was applied to income tax and burst into prominence as part of the supply-side economics revolution. And since that time, many public officials have espoused the idea that cutting taxes will increase economic activity—and therefore create higher revenues—while raising taxes will have the opposite effect.
Cigarette taxes don't seem to behave this way (or, at a minimum, we've yet to hit the point at which even huge tax hikes lead to lower revenues). Indeed, in many states, the very notion of tax representing a portion of the underlying cost of a pack of cigarettes—the way that, say, a tip represents a portion of the cost of a restaurant meal—has ceased to have much meaning. When you're paying, as New York City smokers now do, $12 for a pack of Marlboros, nearly all of that is tax; the product is, economically, an afterthought.
To hear some economists and cigarette-tax foes tell it, this situation should never have come about. They have long argued that higher taxes would encourage more and more people to find ways to evade or break the law. This could be as simple as driving to a place where the taxes are lower. A smoker living in eastern Washington state, where the state tax is well above the national average at $3.025 per pack, could save a lot of money by crossing the border into Idaho, where tax is well below the national average at 57 cents per pack. And thanks to the mega-increases in cigarette taxes in recent years, the average tax difference between neighboring states is more than three times higher than it was in the early 1980s.
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