How Americans Pay The Price For Vice With Tax

The Tax Foundation’s Ulrik Boesen discusses the excise taxes imposed on longtime vices like alcohol and cigarettes as well as more recently developed habits.

This post has been edited for length and clarity.

David Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: taxing vices.

It’s the most wonderful and taxing time of the year. All the time spent cooped up with family and watching holiday movies on repeat pushes many of us to turn to our vices for comfort. This indulgence also provides a steady stream of revenue to governments in the form of excise taxes, which are often used to fight the very thing that’s being taxed.

Here to talk about this is Ulrik Boesen, a senior policy analyst at the Center for State Tax Policy at the Tax Foundation, where he focuses on excise taxation. Ulrik, welcome to the podcast.

Ulrik Boesen: Thanks for having me. I’m excited to be here.

David Stewart: Why don’t we start off from a definition of what is an excise tax?

Ulrik Boesen: Excise taxes are normally narrow taxes that are levied on specific types of consumption of specific products. The common ones will be alcohol, tobacco, motor fuel. They’re normally levied with one or two reasons in mind. For the vice or sin taxes, the idea is to raise revenue to cover some costs related to the consumption, to internalize externalities, or to deter consumption.

For other excise taxes such as the motor fuel tax, it works like a user fee where we tax motor fuel as a proxy for how much you use the roads. The revenue from motor fuel taxes is then spent on maintenance and building the roads.

What sets them apart from other consumption taxes, like sales taxes, is that they’re specific to certain products or types of consumption where general sales taxes are levied on general consumption and is a general fund revenue tool.

David Stewart: How do we, as a society, decide what really needs to get this extra tax?

Ulrik Boesen: There are certain things in our society that would be considered to have some negative externalities associated with them. Again, common ones would be alcohol because it gets you drunk and it can lead to certain negative health effects, as well as tobacco because we know tobacco’s harmful to the body. Other examples are sports betting or marijuana.

These are all things that are not necessary consumption and are sort of sinful in the eyes of the morale of the country or Western society. Thus, it can be legitimate or perceived legitimate to levy a tax on them.

David Stewart: Are they effective at reducing behaviors?

Ulrik Boesen: When you increase the price through an excise tax, you decrease consumption. The price goes up. Demand goes down. That much is clear. Whether they’re as effective as some people want them to be is a bigger question. There’s still people smoking. There’s still people drinking. There’s still people betting. It’s not like they can eradicate behavior. They can limit demand.

David Stewart: When a government is deciding whether or not to tax something like this, what’s the more important factor? Is it a revenue or behavior issue that pushes the policy?

Ulrik Boesen: Let’s go back a little bit to when these products originally got taxed. Excise taxes are way older than the U.S., and originally they were raising general fund revenue. They were looking at what people consume and how to tax it.

Society was a bit different back then. We didn’t necessarily know how much people were making. We didn’t have W-2s and 1040s. All you could see and feel was commodity. It was easy to levy a tax on commodity and raise revenue that way.

Traditionally these were all revenue tools. That has sort of developed now and we levy them more because of the negative externality than because of general fund revenue. Revenue is obviously still a big part of it.

If we agree that certain consumption carries negative externalities like harm to the body or secondhand smoking or addiction, then there’s some cost to society. That cost comes in many forms, whether it’s Medicaid spending or cessation help to quit smoking. Obviously, you need revenue to cover that cost. You’re not going to levy a tax unless you want revenue. Otherwise it’d be easier to regulate it.

David Stewart: You’ve mentioned the alcohol and tobacco taxes. They seem to have a long history in the U.S. and elsewhere as taxes that are directed at vices. Are there any lessons that we can draw from this history as we’re going forward with policy?

Ulrik Boesen: Absolutely. As I said, they were introduced a long time ago. Alcohol taxes go all the way back to George Washington’s presidency. There’s the whole history of the Whiskey Rebellion where people didn’t want to pay the tax and he forced them to anyway. The nation’s first cigarette tax was introduced to pay for the Civil War. These are old taxes.

The takeaway from this is that they’re very narrow. An alcohol tax is just levied on alcohol. A tobacco tax or cigarette tax is just levied on tobacco or cigarettes, respectively. That means changes in consumption will have a huge effect on revenue.

Since the 1970s, cigarette consumption has gone down. Since the tax is narrow, so is the revenue. That revenue is earmarked for some general fund spending priority. That could be education, roads, whatever. They’re going to have less and less money from that tax each year.

The takeaway is that excise taxes should not be a general fund revenue tool. They’re too narrow and they’re too volatile because they’re based on how a small percentage of the population consumes certain products. It can affect how much revenue is raised from them.

That’s what we really see more so with tobacco than with alcohol. The trend with tobacco is declining each year. Alcohol revenue has been a little more stable because alcohol consumption has been a lot more stable.

But even with alcohol, there’s a clear limit to how much revenue can be raised from it because you’re not going to have people necessarily drinking a lot more than they are today.

David Stewart: Speaking of people drinking things, one of the more recent sort of vice taxes that’s come about is the soda tax. Have we seen any effects from this? I assume it doesn’t raise a whole lot of revenue, but have we seen behavioral impacts from that?

Ulrik Boesen: Again, when you increase the price of something, demand does decline. We’ve seen that. Now at the same time, even without the tax, demand for sweet beverages is declining.

If we just look at adults that are heavy users, that has dropped from 13 percent to 9 percent over the last few years. For kids, that has dropped from 11 percent to 3 percent. That development was already happening without the tax.

The tax can sort of accelerate that, but I think that was just positive news that I wanted to share. People aren’t drinking as much soda.

But in Philadelphia, where they have the tax, demand has decreased. There’s also been some behavioral changes that we expect when you have a narrow tax that is only levied in a small jurisdiction. Soda sales in Philadelphia have gone down significantly, but in the surrounding counties, it has increased. People have gone out there to purchase it.

For me, the big question is: What’s the goal with this taxation? I’m thinking the goal is not for people to drink less soda. The goal is for people to not develop obesity-related disease. The question there has not been answered yet. It’s very hard to see if the amount of calories and sugar that people consume has declined.

It’s easy for people to just substitute other calories or other sugar if it’s only levied on soda. You can buy a Mars bar or pack of M&M’s instead if you’re craving sugar. There’s not yet any substantial evidence that a tax on sugary beverages has worked in terms of limiting obesity.

David Stewart: Are there definitional problems with instituting a tax like this?

Ulrik Boesen: Definitions are always key when you develop an excise tax. Going back to the Philadelphia example, it seems to me that that tax was developed in order to raise revenue. The reason I’m saying that is that they included low-calorie and low-sugar drinks into the tax. Instead of encouraging people to switch from high sugar to low, they encapsulated all of them, which looks more like a revenue tool.

As you said, who’s to say that the sugar tax won’t get people to buy a beer instead? Alcohol is taxed, but at a different rate. Thus, definitions are always key.

David Stewart: Another tax that seems to be coming up lately is taxes on marijuana. Even in this most recent election, we saw recreational marijuana get legalized. This one seems to be a little strange compared with the other taxes that we’ve talked about before, because with tobacco, you’re attempting to get usage down.

With soda taxes, you’re attempting to get usage down, though in some cases they’re trying to raise revenue.

But this seems to be the reverse of that, where they’re saying, “Let’s legalize something and potentially increase its consumption in order to raise revenue.” Is this as strange a situation as it seems to me?

Ulrik Boesen: Yes and no. I think the best comparison to what’s happening with marijuana right now is the years just following Prohibition. You have a massive illegal operation and massive illegal consumption that you want to move into a legal, regulated, and taxed environment. That’s a little bit different from what we see with the other excise taxes. 

I think that’s what makes it interesting with marijuana is that there’s this understanding. In order to be successful, the legal market will have to be able to compete with the illegal market.

That puts a limit on how high taxes can be because people have been going to their dealer for decades in some cases. They’re not going to change unless there’s a benefit to changing.

I think that’s an important understanding for lawmakers and for voters. This is not a bottomless pit of revenue. There’s sort of a natural cap, which will allow legal and licensed stores to compete with illegal unlicensed stores. I think that’s a very important point.

David Stewart: Are we seeing increases in levels of consumption in these states where it’s been legalized or does the level of demand seem to be the same regardless?

Ulrik Boesen: It’s very hard to estimate because I don’t think there’s anyone who had a very good number on the consumption in the illegal market. What we can see is the legal markets grow year over year. Whether that’s new consumption from people who didn’t previously consume more or if it’s people moving from previously illicit consumption to now legal consumption, I think that’s a good question.

I think for the most part, consumption is not increasing. It’s merely being moved into the regulated market.

David Stewart: Have we learned any lessons from some of the states that have already legalized marijuana in the design of the tax? Are there important factors in how you design the tax for how successful it is?

Ulrik Boesen: I think the lessons we have now are not so clear on tax design. I think we have some indications about effective tax rates and what they can and cannot be. Some of the very successful states like Colorado and Oregon have effective tax rates between 17 percent and 25 percent of retail price. The outlier is Washington state which has an effective tax rate of over 40 percent, but still very successful.

Excise taxes are levied because there’s a negative externality that we want to internalize. Market price is not reflecting the actual cost of consumption. For marijuana, that’s related to the amount of marijuana you consume. The more you consume, the more externalities. Most states, 14 out of 15 states, levy a price-based tax. It means they tax marijuana based on how much the consumer pays.

In my book, that’s wrong because the price does not reflect the cost to society related to consumption. We tax cigarettes per cigarette. We tax tobacco by weight. We tax motor fuel by gallon. We tax alcohol by volume for this exact reason. It’s the amount that you consume that acts as a proxy for the externalities.

I think that may be an issue. It’s not been an issue yet because this is a new market. It’s going to grow year over year. You’re going to keep seeing increasing revenue because more and more people are entering the legal market. You can’t really see what’s happening in the numbers behind that.

What happens when a state legalizes is that prices are going to be high in the beginning. It’s going to be a lot of demand and not that much supply. That equals higher prices. As the market develops, those prices are going to start to come down. If you have a price-based tax, the amount of revenue that you raised per ounce or gram sold is going to decline along with the price.

Let’s just assume that the federal government then decides, “OK. We now have a significant amount of states that have legalized recreational marijuana. Why don’t we legalize it at a federal level?” That will have a very important effect because due to its Schedule I status right now, it is illegal for me to buy marijuana in Colorado or California and take it across state lines. I would be committing a federal crime.

That means for the 15 states that have legalized, it must be grown, cultivated, processed, sold, and consumed within state borders. The federal government then decides, “OK, we’re going to legalize. We’re going to deschedule the product.” That opens the door for interstate commerce.

There’s a few places in the country that can probably produce all the THC that’s in demand nationwide. It won’t take 16 or 17 states to do that. That can probably be done in one state. Then economy’s to scale.

You develop how this stuff is cultivated and price plummets. All of a sudden, it’s much cheaper for wholesalers to get their hands on this. They can sell it cheaper to consumers. Now all the states that have a price-based tax are going to be scrambling because what’s today $200 an ounce, may be $50 an ounce or some other figure. Their tax revenue is going to fall through the floor. That’s the issue of the price-based tax. It’s too volatile.

If you have a quantity-based tax, that’s not going to happen. Price fluctuations, at least if they go down, are not going to limit consumption. It might just increase it and their revenue will go up. The only state that has such a tax today is Alaska. I think that’s unfortunate.

A few of the states have built in sort of weight-based elements in their tax. California is one, Colorado and Nevada are others. That’s a good first step, but they should probably go all the way and just tax marijuana by quantity, whether that’s by weight or by THC content. I think it’ll be up to them.

There’s benefits with both, but price is an unusual way to levy an excise tax. It’s going to be very volatile in the years to come.

David Stewart: Moving beyond this new market for taxation of marijuana, are there other things out there, other vices or items that we are currently not taxing that could be taxed and could be revenue generators?

Ulrik Boesen: I want to be careful not to give lawmakers too many good ideas, but there are certain things that probably will get a tax levied on them in the future. A few things are already happening.

Sports betting is one thing. A little bit similar to marijuana where state by state it’s getting legalized and taxed. It’s been happening off market for a number of years. Now states are sort of legalizing because they were finally allowed when the Supreme Court decided that they were allowed to do so.

Vapor products and nicotine taxes. Vapor products are not so new anymore. We normally like to say that they entered the market in the mid-2000s. They were very small back then, but now they’re becoming a considerable part of the nicotine and tobacco market. Again, I think we’re at about half the states now that post a tax on nicotine products. Those are sort of the fastest moving categories of new taxes.

I think vapor taxes especially have given some trouble to legislators. Some consider them to be on par with cigarettes in terms of harm. The consumption among teenagers and high schoolers has created this sort of panic that they must be taxed like cigarettes because we can’t have another generation addicted to nicotine. I think there’s some disconnect there between why we levy excise taxes and the proposals that we’ve been seeing. A principle excise tax should be levied to sort of correspond to the harm that consumption generates.

There is a lot of consensus around the fact that consuming nicotine through heated vapor is less harmful than through a cigarette or cigar. That should indicate that you should tax them at a lower rate. That’s not always the case, unfortunately, but it’s a discussion worth having. Every time a smoker becomes a vaper, that’s good news for public health. I think you should encourage that through taxation.

There are other products in the nicotine market that I think will get some attention in the coming years. One product is heated tobacco. Instead of burning the tobacco, you warm it up and it releases nicotine for consumption. Another less known product is a nicotine pouch. It’s basically consumed like chewing tobacco, but there’s no tobacco in the product. You have a little pouch that you put in your mouth and it allows you to absorb nicotine.

Again, there’s some legitimate arguments for why you should tax it, but it’s still a small market. I don’t necessarily think lawmakers realize it’s out there. But I think that will be a discussion in the coming years as fewer people smoke and many smokers look for alternatives and less harmful ways to consume nicotine. Both tobacco and the nicotine industry are trying to provide them with healthier options.

David Stewart: Are there any areas where there’s been discussions about imposing vice taxes, where you would say, “Just don’t go there. That’s not going to end well?”

Ulrik Boesen: There’s been discussion of whether you should put an excise tax — which could also be called the severance tax — on water extraction. In parts of Florida, companies will extract natural water, bottle it, and sell it. That’s considered to be detrimental, by some, to the environment. There was a federal proposal I think earlier this year to levy a tax on that operation. If you levy a tax on it, it’s not going to be as profitable and maybe it won’t happen.

The issue I think is that’s an extremely narrow tax. You’re only levying on one type of extraction of water. Water extraction for bottling is not the main usage of water in this country. Irrigation by agriculture is much bigger. Bottling water from public waterways or other bottling operations will not be covered. Only the ones that directly pump up water from natural sources.

I think that’s one example of trying to apply an excise tax to something where it makes no sense. If this is really an issue, what you should be calling for is regulation, not taxation. I couldn’t tell you if it’s good or bad or what’s going on. I can just tell you an excise tax will not fix what’s going on because it’s so narrow and it won’t encompass all the ways that we use that water. It’s just one tiny part of it.

Another one that’s been thrown around are financial transaction taxes. That’s not necessarily considered a sin tax or a vice tax. One of the reasons they want to levy this tax is because of what they consider to be undesired speculative trading. Most people have heard of high-frequency trading or these people that trade millions of trades every day on small margins make a lot of money.

One way to eliminate that is to levy a tax on every transaction. If you increase your transaction costs by 100 percent, your operation’s no longer profitable and you drop out of the market. That’s because some consider that to be undesired trading that is problematic and can cause bubbles or volatile markets that’s undesired and this tax would help fix that. I guess in that way that could also be considered a sin tax.

David Stewart: When it comes to vice taxes, is there a way to be too successful?

Ulrik Boesen: I think so. I think one good example is with tobacco taxes. As I said, it’s one of our oldest taxes and it’s one that we have tremendous data on. Some states, especially some cities, levy exceedingly high excise taxes on cigarettes including Washington, D.C., New York City, and Chicago.

One very clear and obvious effect of that is that people stop buying cigarettes, but they don’t stop consuming cigarettes. They don’t stop smoking cigarettes. They just buy them elsewhere.

In the state of New York, over 50 percent of cigarettes consumed are not purchased and taxed within the state. I think that’s a cautionary tale for other lawmakers. You don’t want to push too much of these taxes because people will react. The smaller that the taxing jurisdiction is, the higher the risk of the inflow from other places. We see that from tobacco and soda taxes.

I’m sure some people would even drive to fill their tank in areas where gas is cheaper. Right? That’s just what people do. If they can save a little bit of money, they’d like to do it. I think people in New Jersey like to drive to Delaware to get groceries without sales tax. That’s how we are.

I think that’s an important lesson to take away from excise taxes as well. If there’s an option to avoid them, people will. Whether that’s on buying tobacco from the neighboring state, buying marijuana from the illegal market, or driving outside the city to get soda from a non-taxed area. That’s an important thing to keep in mind if you’re a lawmaker trying to develop good excise tax policy.

David Stewart: I hope you haven’t given anybody ideas they haven’t had already. This has been great. Thank you for being here.

Ulrik Boesen: Thank you for having me. I enjoyed it.