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High, Low, or No Cigarette Tax?

by Elaine Schwartz    •    Sep 11, 2010

Recently, Connecticut legislators were pleasantly surprised because an increase in the cigarette tax generated more revenue than they expected. You might say that the results were predictable. However, if a state increases taxes, it is possible that consumers will stop buying the item or go somewhere else to get it.

If a person who smokes lives in New York where the cigarette tax is $4.35, would he travel to Pennsylvania to pay $1.60 or further to Virginia where the tax is $.30? According to a 2008 study from Harvard’s Kennedy School, to save $1.00 on a cigarette purchase, a person will travel 2.7 miles when each extra mile costs that consumer $.37.

The Economic Lesson

All of this is about much more than cigarettes. It relates to recession generated diminishing state tax revenue. States need to pay for roads and teachers and police. They have current salaries and pension payments for retired workers. 

Income taxes and sales (excise) taxes are primary sources of most states’ revenue. However, with tax revenue down because of the recession, states are trying to figure out how to raise more money (or to spend less). Arizona has even tried to sell its state capitol building. Other possibilities are “sin” taxes on cigarettes, soda, and alcohol. The question, though, is how high can taxes go before they backfire. Too high and people avoid them; too low and they miss potential revenue.

An economist would say the sales tax debate is about the price elasticity of demand. If price changes a lot and the quantity we buy remains the same, as with medication and gasoline, then our demand is inelastic. By contrast, if price swings have an impact on buying, then our response is elastic. With soda, within a certain price range our demand is inelastic. Once we reach a 35% increase, though, we switch to an elastic response. Connecticut’s revenue increase implies that cigarette demand is inelastic.

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