The Economics of a Cigarette Tax Increase

The State of Nebraska is trying to find revenue to offset high local property taxes.  One of the more popular ideas is to increase the state cigarette tax.  However, this idea is riddled with many economic concerns and should be avoided.
 

Many proponents of increasing the cigarette tax have a greater social concern than raising revenue.  They believe that if we increase the price of cigarettes through a “sin tax,” then people will buy less of them and this will in turn promote better public health outcomes.
 

However, economists know that consumers have different responses or sensitivity to price changes.  This is known as the price elasticity of demand.  Cigarettes are a great example of this because they are an addictive product and academic research has proven that they are an inelastic good.  This means that consumers will not change their purchase decisions based on a price increase as much as they would for an elastic or normal good. 
 

At first, this would sound like a very good argument for using cigarette taxes in a tax reform package, since most smokers will continue to buy cigarettes no matter how high the tax goes.  Evidence from other states shows the reality is more complicated, though.
 

In the last decade, 85 percent of cigarette excise tax increases missed their revenue projections, with most states experiencing less revenue than expected.  This actually happened in Nebraska after the state’s 2002 cigarette tax increase.  Nebraska lost $121 million in cigarette excise tax revenue to neighboring states, falling 20 percent short of projections. 
 

Variations in the state cigarette tax rate often result in illegal smuggling or people going to lower-taxed states, such as Missouri and Wyoming, to purchase cigarettes.  The Journal of Health Economics found that up to 85 percent of the change in legal sales after a cigarette tax increase is due to tax avoidance and evasion, not by quitting smoking.
 

This makes increasing the cigarette tax an unreliable revenue source.  Today, under the current cigarette tax rate, cigarette sales in Nebraska have declined an average of 2.7% a year for the last ten years.  If the state were to increase this tax, we expect legal sales to drop even more.
 

Property tax reform is a key focus right now in the Legislature and for many across Nebraska. But research has found that higher tobacco taxes are likely to increase smuggling, creating an illegal tobacco market, without necessarily improving health outcomes.  It is clear this is not the right choice for Nebraska and the Legislature needs to look to other ways to generate revenue to pay for property tax reform.