The unintended consequences of cigarette tax increases

Sin taxes are levied on products that are believed to have a societal cost. And tobacco products are a frequent target for sin taxes. Yet ironically, high cigarette taxes create their own societal costs because they result in illicit interstate smuggling and criminal behavior.

A pack of cigarettes in Chicago includes a whopping $7.16 in state and local taxes, the highest of any jurisdiction. In Missouri, a pack is only taxed 17c, a difference of $6.99 per pack with Chicago, or $69.90 per carton. As a result, there is a robust street market for “loose squares,” or individual cigarettes, throughout Chicago. The Windy City is a profitable beacon for cigarette smugglers. And while Chicago is an extreme example, it is illustrative of the unintended consequences of cigarette taxes.

Nebraska lawmakers are considering a hike of $2.00 per pack to take Nebraska’s cigarette tax from 64c to $2.64. The unintended consequences of such a tax hike should be considered, especially in light of the well-established relationship between cigarette taxes and smuggling. In fact, Michigan’s Mackinac Institute uses government data to produce an annual study detailing the flow of smuggled cigarettes between states. Mackinac scholars ultimately conclude that cigarette taxes help smugglers, not health outcomes.

As much as $10 billion in tax revenue is lost per year due to smuggling. And Nebraska would find itself on the wrong end of the smuggling trade if it raised its cigarette tax by $2.00 per pack, as has been proposed. Nebraska would have the highest tax rate of the Great Plains states, creating an incentive for in-bound smuggling. The per-carton differential with other Plains states would be:

• $24.70 per carton with Missouri
• $20.40 per carton with Wyoming
• $11.10 per carton with South Dakota
• $12.80 per carton with Iowa
• $13.50 per carton with Kansas.
• And $7.00 per carton with Colorado.

Nebraska’s $24.70 price differential with Missouri would be especially challenging given their shared border near Nebraska’s population centers. Illicit trade would spring up overnight. Unfortunately, these interstate criminal distribution networks are well-established and Nebraska would simply be added as a new smuggling jurisdiction.

Such interstate trade is an obvious threat to public safety. Enforcement costs would rise, while commercial activity at Nebraska’s licensed retailers would inevitably fall. As a result, Nebraska’s 2,730 licensed retailers would receive property tax relief, but their sales of cigarettes and associated purchases would result in falling incomes, negating the benefit of tax relief.

Furthermore, cigarette taxes make a poor revenue source to fund a tax replacement. The $2.00 per pack tax is proposed as a part of a package to raise new state revenues in order to provide funds to lower local property taxes.

The purpose of the cigarette tax increase is to provide permanent property tax relief for Nebraskans. While property tax relief is the top goal for tax reform in Nebraska, cigarette taxes are not the right tool to get there. In short, cigarette tax revenue is a poor medium and long-term funding source to offset other taxes, particularly such a stable tax as property taxes.

According to the National Conference of State Legislatures, “Cigarette taxes are not a stable source of revenue” because such tax increases usually yield lower-than-expected revenues. Nebraska’s own experience has proven this trend that would work against providing property tax relief. State income from Nebraska’s cigarette excise tax was $42.8 million in 2022, nearly $10 million less than five years earlier, illustrating that cigarette tax revenue is a declining and unstable foundation for a property tax relief fund.

Property tax relief funds need to be stable and keep up with inflation like the property taxes that they will replace. Cigarette taxes are guaranteed to fall in real, inflation-adjusted terms, and also nearly certain to continue to fall in pure dollar terms. That’s because cigarette smoking has been falling steadily – from 21 percent of the population to 11.5 percent since 2005, resulting in Nebraska’s cigarette tax revenues falling by 3% per year. A precipitous tax increase of $2.00 per pack would cause a revenue pop in the first year followed by a steep rate of decline in subsequent years.

Sin taxes are a natural target for raising revenue when a state needs to fund a program. Yet tobacco taxes are a particularly unreliable revenue source given that they are levied upon a shrinking tax base. Furthermore, tobacco taxes result in illicit interstate trade that will undoubtedly ensnare Nebraska with unintended criminal consequences all in exchange for an unreliable revenue source.