by Robert Kleine, Vice President and Senior Economist
|This is the second in a series of reports on school finance reform. It discusses the effects of the statutory and ballot proposals on the taxation of cigarettes and other tobacco products and on state revenues.|
Public Act 327 of 1993 raises the state cigarette tax from 25 cents to 75 cents per pack if the March 15 ballot proposal is approved and to 40 cents per pack if it is not. In addition, a tax equal to 16 percent of the wholesale price of cigars, noncigarette smoking tobacco, and smokeless tobacco is imposed whether or not the ballot proposal is adopted. These increases take effect on May 1, 1994.
Under the statutory plan, the additional 15 cents per pack is allocated to the school aid fund (SAF). Under the ballot proposal, 6 percent of the proceeds (equal to about 4.5 cents per pack) is dedicated to improving health care, and the remainder of the increase is allocated to the SAF. (See Exhibit 1.)
The current 25‐cent cigarette tax generated $244 million in FY 1992 – 93 or $9.76 million per penny. Since 1989, the first full year after the rate was increased to 25 cents (from 21 cents) per pack, consumption and tax collections declined about 10 percent. Per capita consumption declined 7.7 percent from 1989 to 1992 but is still 9 percent above the national average. (See Exhibit 2.)
Michigan per capita consumption as a percentage of U.S. consumption has increased in recent years, as Michigan has not raised cigarette tax rates as much as other states. Since Michigan’s last increase in 1988, 34 states have raised tax rates an average 18.2 cents to 26.5 cents per pack in 1992 (latest data available), and 14 states increased the rate in 1993 alone. (See Exhibit 3.) Eleven states increased their cigarette tax rate at least 15 cents since 1988, and seven states increased their rates by 23 cents or more. The highest state cigarette tax rates are 60 cents per pack in Hawaii, 56 cents per pack in New York, 54 cents per pack in Washington, and 51 cents per pack in Massachusetts, where voters approved a 25‐cent increase in 1992. Under either the statutory or ballot proposal Michigan will have significantly higher cigarette taxes than surrounding states, although cigarette taxes in Ontario will continue to be much higher
As shown in Exhibit 2, state and federal taxes as a percentage of the retail price have declined from 44.5 percent in 1970 to 25.5 percent in 1992. The peak was 52.3 percent in 1965. If the tax rate is increased to 40 cents per pack, taxes will be about 31 percent of the retail price (based on 1992 data). If the tax is increased to 75 cents per pack, taxes will be about 40 percent of the retail price (assuming the price increase equals the increase in the tax rate), still below the 1975 level.
By adopting a 16‐percent tax on other tobacco products, Michigan joins 38 other states that levy such a tax. Like Michigan, most states levy the tax on the wholesale price of the products. The rates range from 2 percent in North Carolina to 64.9 percent in Washington. At least 22 states levy a higher rate than Michigan. The tax is expected to raise about $16 million in FY 1994 – 95.
A key question is how much will the proposed increases in the cigarette tax reduce consumption? This depends on the price elasticity of cigarettes. Price elasticity is defined as the percentage change in the quantity of cigarettes sold divided by the percentage change in price. An elasticity of ‑0.4, for example, means that a 10‐percent increase (decrease) in price would reduce (increase) by 4 percent the quantity of cigarettes sold.
When the price of cigarettes rises in a given state, legal sales within the state may go down for two reasons: (1) smokers buy fewer cigarettes, and/or (2) smokers buy out‐of‐state cigarettes. This latter reason is referred to as cigarette smuggling or bootlegging and will magnify the price elasticity of a high tax state.
We calculated simple price elasticities for the United States and for selected states using 1985 – 91 data. These calculations yielded an elasticity of ‑0.32 for the United States. This figure is not affected by interstate smuggling, which is not a factor when national data are used.
We also calculated elasticity estimates for ten states that raised cigarette taxes by large increments between 1985 and 1991 and three states that did not increase tax rates. The state elasticity figures, which do reflect cross‐border smuggling, are remarkably consistent, ranging from ‑0.20 in Iowa to about ‑0.45 in Connecticut and Texas. In nine of the states the price elasticity estimate is not significantly different from the U.S. estimate of ‑0.32.
From this analysis we conclude that an elasticity of about ‑0.35 should be used to estimate the revenue yield of a 15‐cent increase in the Michigan cigarette tax and an elasticity of about ‑0.45 should be used for a 50‐cent increase, to account for “sticker shock” and higher cross‐border smuggling.
An additional factor that must be reflected in the revenue estimates is the likelihood of a federal cigarette tax increase to finance health care reform, which would, of course, reduce consumption in Michigan. For the purpose of this analysis we have made estimates assuming no increase in the federal tax and a 75‐cent increase in the federal tax.
Assuming no increase in the federal tax, we estimate that the 15‐cent increase will raise about $138 million and the 50‐cent increase $380 million for the SAF. Assuming a 75‐cent federal tax increase, we estimate that the 15‐cent increase would generate only about $116 million and the 50‐cent increase would generate about $318 million for the SAF.
The net increases in revenue will be smaller, however, as the decline in consumption will reduce general fund revenue. Under the 15‐cent option the general fund will lose $5.5 million with no federal tax increase and about $31 million with a federal tax increase. Under the 50‐cent option the general fund will lose about $22 million with no federal tax increase and almost $55 million with a federal tax increase. County health departments, which currently receive a share of the cigarette tax, will also suffer a small loss of revenue.
One problem with a per pack cigarette tax is that it is a declining revenue source. Since peaking in 1978, per capita cigarette consumption has declined almost 25 percent (as of 1992), and future declines are almost certain. A better approach would be an ad valorem tax based on the wholesale price of cigarettes, which will grow as the price of cigarettes increases.
We simulated the difference between an ad valorem and a per pack tax (equal to 66 percent of wholesale price or 7.7 cents per pack in 1972) for the 1972 to 1992 period. The revenue from the per pack tax declined from $63.7 million in 1972 to $54 million in 1992, while the ad valorem tax revenue increased from $63.7 million to $282.6 million. Relying on a per pack tax could create some funding problems in the future, although the effect will be mitigated by the relatively small amount of revenue generated by the tax.
The changes proposed in the taxation of tobacco appear justified on several counts.
First, using tobacco is a health hazard, and raising taxes will reduce consumption and lower health care costs.
Second, polls indicate that there is strong support for an increase in tobacco taxes. This is probably because only about 25 percent of the population smokes, but significant support exists even among smokers.
Third, the revenue generated by the cigarette tax allows smaller increases in other more unpopular taxes, such as the income tax.
Four, extending the tax to other tobacco products eliminates the inequity between those who smoke cigarettes and those who smoke pipes or cigars or chew tobacco.
The major arguments against the tax are that it is regressive, hurting low‐income people more than high‐income people, it singles out a small segment of the population for taxation, and it is a declining revenue source. An increase in the cigarette tax is unlikely, however, to be a significant factor in deciding the fate of the ballot proposal, although tobacco interests may spend large sums to defeat it.