The Cigarette Tax Increase to Finance SCHIP

^Pr^ep^ar^{ed f}^o^r^M^e^m^b^ers^an^d^Com^mⁱ^t^t^ees^of^C^ong^r^e^ss

On January 15, the House passed H.R. 2, a bill which included increased tobacco taxes to finance
State Children’s Health Insurance Program (SCHIP). This legislation was similar to that passed in ^th
the In the 110 Congress (H.R. 976 and H.R. 3162) although the initial House proposal had
smaller tax increases.. H.R. 2 increases cigarette taxes, the primary source of tobacco tax
revenues from 39 cents to $1.00. According to the Joint Committee on Taxation, the cigarette tax
will raise $6.4 billion in federal revenues in FY 2010 with all federal tobacco taxes increases
raising $7.1 billion. A similar tax increase is contained in the Senate Finance Committee mark.
The analysis suggests that state and local governments will lose about $1 billion in cigarette tax
revenues and up to $0.5 billion in lost revenues from the tobacco settlement payments. The
legislation is now being considered in the Senate.
A justification is to discourage teenage smoking, but this effect is probably small; a reservation is
that the burden falls heavily on low-income individuals. Taxes on other tobacco products are also
increased, although cigarette taxes account for most tobacco revenues.
In the 110^th Congress, the President vetoed the 110^th Congress SCHIP proposal on October 3,
2008, the House failed to override the veto and a new bill, H.R. 3963 passed the House and
Senate, with no changes in the cigarette tax, but changes in spending rules, and the President
vetoed that version on December 12, 2008.

Introduc tion ..................................................................................................................................... 1
Tax Changes and Revenue Effects..................................................................................................1
Issues Surrounding Tobacco Taxes..................................................................................................2
Effect on Smoking and Health..................................................................................................2
Distributional Effects................................................................................................................4
Economic Efficiency.................................................................................................................4
Cigar Tax Increases.........................................................................................................................5
Author Contact Information............................................................................................................6

This report discusses proposals to raise the cigarette tax to help pay for reauthorization of the
State Children’s Health Insurance Program. This report describes current taxes, discusses
potential revenue gains, and discusses some of the basic issues surrounding a tax increase. It also
briefly discusses the tax increase on cigars. H.R. 2 passed the House on January 14, 2009 and it ^th
included the same cigarette tax as proposed in the 110 Congress, an increase of 61 cents per
pack, raising the tax from 39 cents to $1. The estimated revenues in the House bill were $64.7
billion for FY2009-FY2018, with $57.3 billion of the total from cigarettes. The Senate Finance
Committee mark includes taxes similar to H.R. 2 (very slightly higher across the board, with a

61.66 cents increase in cigarette taxes).

The vast majority of tobacco taxes are on cigarettes, which account for 94% of tobacco sales ¹
(totaling $75 billion in 2007). Federal cigarette taxes are $0.39 per pack, accounting for 94% of
federal tobacco tax revenue. There is a 4 cent tax on a package of small cigars. Large cigars carry
a tax of 20.719% of sales price, not to exceed $48.75 per 1,000 units, leading to a maximum tax
of almost 5 cents per cigar. Per ounce, the tax is 7 cents on pipe tobacco; 1 cent on chewing
tobacco; 4 cents on snuff; and 7 cents on pipe and roll-your-own tobacco. There are also taxes on
cigarette paper and cigarette tubes.
The 61-cent cigarette tax increase would lead to a tax about 2.5 times the current tax.; these same
proportions are proposed for snuff, chewing, tobacco and pipe tobacco. Roll your own tobacco’s
tax increases about eight fold and seven fold and the relatively small taxes on small cigars are
increased to those on cigarettes. Large cigars are the only tobacco product with a tax based on
price, but they also have a cap; the price-based tax rises in proportionally, but the cap increases by
much more, from 5 cents per cigar to $0.40 in the House bill ($0.4026 in the Senate Finance
Committee mark.
Tobacco tax receipts in the United States in FY2007 included $7.5 billion in federal tax, $16.2 ²
billion in state and local taxes, and $8 billion in payments from the Master Tobacco Settlement.
State and local taxes, therefore, were roughly 88 cents per pack and the tobacco settlement
payment is approximately the same as the federal tax, 43 cents per pack. Although the tobacco
settlement payments resulted from negotiations between the tobacco companies and the states to
settle state lawsuits, the payments function as if they were a national tobacco excise tax that is
allocated to the states, and any changes that alter consumption would affect these payments.
Some of the states have securitized their payments (exchanged the stream of payment for a fixed
up-front amount). According to estimates, about a quarter of payments are made to private ³
investors, rather than to state and local governments. As a percentage of sales revenues, the

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⁽^c^onti^nue^d.^..)

federal, state and local, and tobacco settlement payments are respectively 10.0%, 21.6% and

10.7%, for a total of 42.2%.

The Joint Committee on Taxation projected an FY2010 revenue gain of $6.4 billion from the 61
cent increase. CRS estimates suggest there will be a loss of revenue to the states approaching $1.5 ⁴
billion.

There are many alternative sources of revenue (or offsetting spending) for funding the child
health program. Are tobacco taxes the most desirable source of revenue? Compared to other
taxes, the incentive effects may be desirable. At the same time, the burden falls heavily on lower
income people, which may be of concern. Thus, there is a trade-off between the objective of
discouraging smoking, and particularly discouraging youth smoking, and the distributional effects
of the tax. The remaining issue involves an economic efficiency question relating to arguments
that have been made that additional taxes are appropriate to cover costs smokers impose on
others. A number of economic studies have questioned that proposition. The following sections
discuss these issues.
A large body of literature has suggested that increases in the price of tobacco reduce smoking.
However, this response is not very large (in economists’ parlance, the response is relatively
“inelastic”). Most of the evidence has found the price elasticity to be between 0.3 and 0.5 in
absolute value, meaning that a 10% increase in price would cause a 3% to 5% decrease in the ⁵
number of cigarettes smoked. For older adult smokers, about half of this effect was due to fewer

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^$1.^{5 b}^illi^on.
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⁽^c^onti^nue^d.^..)

smokers (a participation response) and about half due a reduction in smoking (a quantity
response). For younger smokers, the participation response was more important. There is some
evidence that the response declines with age and that it rises with income, and that it is higher for ⁶
women, African-Americans, and Hispanics. A recent study, however, found no variation with ⁷
income.
Some recent studies suggest that the response may be less, or that the benefits of reducing
smoking may be less. There is some evidence that the response has been declining, an
unsurprising outcome since, given a decline in smoking, the remaining smokers are more resistant
to price signals. In addition, there is evidence that elasticities might be overstated in studies that
compare state smoking levels because states with higher taxes may also have populations more ⁸
hostile to smoking. Also, recent studies found that smokers may respond to price increases by
increasing the intensity of smoking by buying cigarettes with more nicotine and tar, inhaling more
deeply and smoking closer to the filter, which could have deleterious effects since more intensive ⁹
smoking can be more harmful.
Due to the limited effects on adult smoking, some arguments have been made that the increased
taxes on adults are necessary over the interim to discourage teenage smoking. Evidence has
suggested that teenage smoking is more responsive to price; the original responses were estimated
at elasticities over one, but subsequent analysis led to an estimate of around 0.7 and a number of ¹⁰¹¹
recent studies have confirmed this general range. Other studies have found smaller responses, ¹²
or a very small response by younger teenagers. One recent study replicated the 0.7 elasticity

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^W^o^r^k^ing^P^a^pe^r¹⁰⁹⁰^{6, N}^o^v^e^m^b^e^r²⁰^04.
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^effect^s.
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^Ec^onom^ic^R^e^s^e^a^r^c^h^W^o^r^k^ing^P^a^p^e^r⁸³³^{1, J}^une²⁰^01;^H^a^na^R^o^s^s^aⁿ^{d Fr}^aⁿ^k^C^h^a^l^ou^pk^a^,^T^h^{e E}^f^f^ect^o^f^Ci^g^a^r^et^t^e^P^rⁱ^ces
^{on Yo}^{uth Sm}^okⁱⁿ^g^,^I^m^pa^cT^e^eⁿ^{, R}^e^s^e^a^r^c^h^P^a^pe^r^Se^rⁱ^e^s^N^o^.^7,^Fe^br^u^a^r^y²⁰⁰¹^.
¹¹^W^illia^m^Ev^aⁿ^{s a}^{nd Ly}^{nn Hua}ⁿ^g^,^Cⁱ^gar^e^tte^T^a^x^e^s^an^{d Te}^eⁿ^Sm^okⁱ^ng:^N^e^w^Evⁱ^d^eⁿ^c^e^fr^om^P^ane^ls^of^Re^pe^ate^d^C^r^os^s
^Se^c^tions^,^W^o^r^k^ing^P^a^pe^r^,^Uⁿ^iv^e^r^s^ity^of^Ma^r^y^l^a^{nd, A}^p^r^{il 1}⁵^,¹⁹^98.
¹²^J^ona^thaⁿ^G^r^ube^r^,^Y^out^h^Sm^okⁱⁿ^g^{in t}^h^e^U^.^S^.^:^Pr^ic^e^s^an^{d P}^o^lic^ie^s^,^N^a^tiona^{l B}^u^r^e^a^u^of^Ec^on^om^ic^R^e^s^e^a^r^c^h^W^o^r^k^ing
^P^a^pe^r⁷⁵⁰⁶^{, J}^a^nua^r^y²⁰⁰^0.

using one statistical approach, but in using another the authors consider superior, they found ¹³
essentially no response of the initiation of smoking to price. Another paper found a weak and ¹⁴
insignificant effect after controlling for anti-smoking sentiment. While much evidence suggests
that teenagers are more responsive to prices, these recent studies raise some questions about the
effectiveness of tax increases on teenage smoking, especially among young teenagers.
The evidence on smoking indicates that higher prices will decrease smoking participation and
quantity. It is possible, however, that other types of interventions, such as stricter regulations on
sales to teenagers, counseling, education, and assistance with smoking cessation might be more
effective.
It is generally recognized that cigarette taxes are one of the most regressive taxes, that is, a tax
that falls more heavily on lower income individuals as a percentage of income. Indeed, it is
probably the most regressive of the federal taxes. Smokers tend to smoke a fixed amount of
cigarettes, so that they pay a fixed amount of tax. (Since the tax is a fixed amount per pack, lower
income individuals who buy cheaper brands still pay the same amount of tax.) In addition,
smoking is more prevalent among lower income individuals.
To illustrate, in 1998 the Joint Committee on Taxation estimated that a 76 cent tax increase
(brought about through a proposed federal tobacco settlement) would raise the effective tax rate
on average by 0.3% of income, but would increase the burden of those with incomes below
$10,000 by 2% of income and the burden of those in the $10,000-$20,000 income by 0.6% of ¹⁵
income. Since this rate applies to all families, those families with smokers would pay more. For
example, a family with one smoker who smokes 1.5 packs a day would pay, with a 76 cent tax, an
additional $417 in taxes, which is 4.2% of a $10,000 income and 8.4% of a $5,000 income.
To the extent the burden of the tax falls on low-income families and the individuals in those
families continue to smoke, low-income children in some families could be harmed even though
the child health care provision helps low-income children in general.
A final issue that may arise relevant to cigarette taxes is the argument that higher taxes should be
imposed on smokers because they impose costs on others largely through higher health care costs
paid for through government and private insurance plans, lost days at work, and some other costs.
Some economists have questioned this argument, however, because smokers’ premature deaths,
while harmful to smokers and their families, reduce costs of certain government programs such as

¹³^P^h^il^ip^{DeCicca, Do}ⁿ^a^l^d^Ken^k^el,^an^d^A^l^an^M^a^thⁱ^o^{s, “}^P^u^ttiⁿ^g^Ou^{t t}^h^{e Fires: W}^{ill Hig}^h^{er T}^a^x^e^{s Red}^u^{ce th}^{e On}^{set o}^f
^T^een^a^g^{e S}^m^o^kⁱⁿ^g?,^”^J^ournal^{of P}^o^litic^a^l^Ec^o^nomy^{, v}^o^l^.¹¹⁰^,^Fe^br^u^a^r^y²⁰⁰²^{, p}^p^.¹⁴^4-¹⁶⁹^.
¹⁴^P^hⁱ^lⁱ^p^DeCi^cca,^Doⁿ^a^l^d^Ken^k^el^,^A^l^an^M^a^t^hⁱ^o^s,^Yooⁿ^-^Jeon^{g S}^hⁱⁿ^,^an^d^Jae-Yo^un^{g L}ⁱ^m^,^Yout^{h Sm}^okⁱ^{ng, C}ⁱ^g^a^r^e^tte
^P^rⁱ^ces,^aⁿ^d^Aⁿ^tⁱ^-smo^ki^ng^S^eⁿ^tⁱ^m^en^t^{, N}^a^ti^ona^{l B}^u^r^e^a^u^of^Ec^on^om^ic^R^e^s^e^a^r^c^h^W^o^r^k^ing^P^a^pe^r¹²⁵⁴^8,^A^u^g^u^s^t²⁰⁰^6.
¹⁵
^{Joint C}^o^m^m^itte^e^{on T}^a^x^a^tion,^D^e^s^c^rⁱ^ption^a^nd^an^aly^s^is^of^r^e^v^e^nue^-^r^e^l^ate^d^pr^ov^is^ions^of^S.¹⁴¹⁵^r^e^la^ting^to^the^nati^oⁿ^a^l
^tob^a^c^c^o^p^o^lic^y^as^m^odi^fie^d^by^the^m^aⁿ^age^r^’^s^am^eⁿ^dm^eⁿ^t^{, J}^C^X-^45-^{98, J}^une^3,¹⁹^98.

Social Security, Medicare, and Medicaid.¹⁶ These calculations do not account for more subjective
effects such as irritation to others, although such problems might be better addressed through
private market mechanisms (provision of smoking and non-smoking commercial establishments)
and regulation. Some disputes about the magnitude of environmental tobacco smoke remain.
If smokers are not imposing costs on others, or imposing costs that are less than existing taxes,
and if they are making rational decisions to engage in an activity which, while damaging to their
health, is nevertheless pleasurable, then an additional tax would not increase economic efficiency.
It is not clear, however, whether young smokers, where smoking is generally initiated, are able to
fully assess the costs of smoking.

Although taxes on other products are a small part of total tobacco taxes, there has been some ^th
controversy about the increases for cigars in 110 Congress proposals and their potential ¹⁷
disruption of the industry , as reported in the media. Small cigar taxes increase by a factor of 27.
They are apparently viewed by some as substitute for cigarettes who argue they should bear the
same tax. Small cigars constitute less than 1/10 of 1% of cigarette sales. For large cigar taxes,
which are currently a maximum of 5 cents, the tax could rise to as much as $10 in the original ^th
Senate Finance Committee proposal in the 110 Congress. The ceiling was lowered to $3 on the
Senate floor in the 2007 legislation and the ceiling in the House bill was $1 in 2007. H.R. 2 has a
ceiling of $0.40, which although much lower is eight times the previous maximum.
According to tax data, large cigar sales above the current 5 cents cap (premium cigars) account
for about half the total. According to the Cigar Association of America, the average
manufacturer’s price is about $1.90 for these premium cigars; the average tax on these cigars ^th
would be almost a dollar (0.5313 times $1.90 minus $.05) in the original 110 Congress Senate
proposal, but much smaller in the House bill because of lower rate and cap and smaller in the
final proposal. Most state cigar taxes are based on value and would apply to the federal tax; they
are estimated by the Cigar Association of America at about 30%. If retail prices are twice the
manufacturer’s price the price of large cigars under the cap in the original Senate proposal would
have risen by 20.8% and the price of large cigars over the cap, while varying considerably, would
have averaged a 33% increase. Prices would rise more if there is also a retailers markup on the
tax. The ceiling of $0.40 would result in much more modest effects.
There is less information on the effects of other tobacco products on health or the behavioral
response. If the purpose of the tax on cigars is to account for health costs, a per unit rather than a
price based tax would seem appropriate. Cigars may differ from cigarettes in that a larger share
may be likely to be smoked only occasionally and would therefore be less harmful to health. They
may also be less concentrated at lower incomes. The occasional usage (lack of addictiveness) may
mean a larger price response, but the usage by higher income consumers may mean a smaller
response.

¹⁶^S^{ee W}^.^Ki^p^Vi^scu^sⁱ^,^“T^o^b^acco^T^a^xes,^{” In}^T^h^{e E}ⁿ^cycl^o^p^e^dⁱ^{a o}^f^T^a^xa^tⁱ^oⁿ^an^{d T}^a^{x P}^o^lⁱ^c^y^{, E}^d^{. J}^o^s^e^ph^J^.^Cor^d^e^s^,
^R^obe^r^t^D^.^Ebe^l^{, a}^{nd J}^a^ne^G^.^G^r^a^v^e^lle^{, W}^a^s^h^ing^t^{on, D}^C^,^U^r^ba^{n I}ⁿ^s^t^itute^,²⁰^05.
¹⁷^S^{ee f}^o^{r exa}^m^p^l^{e Ja}^mes^T^h^o^rⁿ^e^r,^Ci^gar^m^a^k^{ers i}ⁿ^{a P}^aⁿⁱ^c,^St^{. Pe}^te^r^s^bur^g^Tim^e^s^{, J}^u^ne¹⁷^,²⁰^07,
^http:^//w^w^w^.s^ptim^es^.c^o^m^/200^7/⁰⁷^/17/^B^u^sⁱ^ne^s^s^/^Cⁱ^g^a^r^m^a^k^e^r^s^_^in_a^_pa^ni.s^h^t^m^l^a^{nd Sa}^r^a^{h L}^u^e^c^k^{, “}^D^oe^s^the^C^o^uⁿ^tr^y
^Need^{a $}¹⁰^Ci^{gar T}^a^x^?”^W^a^{ll Str}^e^e^t^J^our^nal^{, J}^u^ly^19,²⁰⁰⁷^,^{p. D}⁷^.

^J^aⁿ^e^{G. Grav}^elle
^Senⁱ^o^r^Sp^{ecialist i}ⁿ^Ecoⁿ^o^m^ic^P^o^licy
^j^g^rav^e^l^l^e^@^c^rs^.l^oc.^g^ov^{, 7-}⁷⁸²⁹