Cigarette Taxes in Ohio

In 2015, Ohio’s Governor Kasich proposed a budget that would reduce the income tax for both businesses and individual taxpayers. Ohio’s top marginal tax rate was 5.33 percent in 2014. Under the proposed budget, the rate would be reduced to 4.1 percent. In addition, almost all small businesses with less than $2 million in annual receipts would pay no income taxes. To offset this reduction in income tax collections, Governor Kasich proposed broadening and raising other taxes – including sales taxes. In his 2015 State of the State address, he said
A certain level of taxes is inevitable. … Those taxes must be generated in the least harmful way…. I think we should lean less on income taxes, which punish the economic growth that we all seek, and lean more on consumption taxes (Higgs, 2015a).
Towards this goal, the Governor proposed to:
• Raise the amount of taxes on cigarettes by $1 per pack as well as raise taxes on other tobacco products
• Increase the overall sales tax rate from 5.75 percent to 6.25 percent
• Broaden the number of taxable items and services to include cable TV, parking, market research, public polling, etc.
• Increase the oil and gas severance tax
• Reduce the amount of funding that retailers could collect from the State for their sales tax collection efforts
• Introduce many other small tax reforms
Under the tax cut proposal, Governor Kasich would reduce state tax collections by nearly $5.7 billion. However, the offsetting tax increases would be projected at $5.2 billion in the FY2016 and FY2017 budget, resulting in a net tax cut of over $500 million. Governor Kasich faced resistance to his plan from both sides of the political aisle. The chair of the coalition of Ohio’s largest chambers of commerce, Joe Roman, said
As currently proposed, this is not the right tax plan for Ohio…raising and expanding taxes on Ohio employers may make the state a less competitive place to do business (Higgs, 2015a).
Advocates of a more progressive tax structure, including Zach Schiller of Policy Matters Ohio, also attacked the proposal saying
Additional cuts to Ohio’s income tax proposed by Gov. John Kasich would detract from Ohio’s fiscal stability, and are unlikely to accelerate job creation as currently proposed… Instead of cutting taxes, Ohio should be looking for additional tax revenue to restore aid to local governments and pay for other unmet needs (Higgs, 2015a).
Despite most of the attention being focused on changes to the income and sales tax rates, the increase in cigarette and tobacco taxes was a substantial component of the proposal by generating $1 billion in increased revenue for the State. Because of the importance of the cigarette excise tax in the budget proposal, questions remained about the estimates. Was Governor Kasich’s estimate realistic? Would consumers cross the border to purchase lower-taxed cigarettes? What would be the long-term health consequences for a reduction in smoking rates? How would the combination of these and other factors affect Ohio’s fiscal outlook?
Biennial Budget
Biennial budgeting is the practice of preparing and adopting budgets for two-year periods. The biennial budget works on an odd-even system by which legislators submit and approve a budget that includes 24-month appropriations on an odd year and focuses on budget oversight in even years. During this oversight period, lawmakers can observe a program’s funding-based performance and whether or not changes should be made in the following budget’s appropriations. The justification for a biennial budget process that is often provided by advocates is that legislators are allocated more time for oversight operations and given greater preparation time for budget and appropriation decisions.
In early 2013, Governor Kasich released an executive budget proposal, which recommended several changes to the tax code. In particular, he advocated for a reduction in income taxes, a broadening of the sales tax base, and a reduction in the overall sales tax rate from 5.5 percent to 5.0 percent. Governor Kasich’s 2015 Executive Budget is the continuation of his 2013 proposal to reduce and eventually eliminate the income tax, but now includes an increase in the sales tax rate.
Phase out the income tax. It’s punishing on individuals. It’s punishing on small business. To phase that out, it cannot be done in a day, but it’s absolutely essential that we improve the tax environment in this state so that we no longer are an obstacle for people to locate here and that we can create a reason for people to stay here (Kasich, 2015).
If Governor Kasich’s proposal was fully adopted, over time income taxes would become less important to Ohio tax revenues and replaced with sales taxes.
You see, in a consumption-tax model, you’re in control; you only pay taxes on the purchases you choose to make. You’re the one who decides what you buy and how much you spend (Higgs, 2015b).
The table below shows how the $5.7 billion in total income tax cuts would be offset with increases in other taxes and fees. The plan shows that raising the state sales tax from 5.75 percent to 6.25 percent will generate over $1.5 billion – the most revenue of the proposed tax changes. However, the increase in the excise tax for cigarettes and other tobacco products will generate the second highest amount of revenue – at just under $1 billion. Because this amount reflects nearly 20 percent of the expected increase in revenue to offset the income taxes, accurately forecasting the increased revenue from cigarette excise taxes is an important exercise.
Table 1: Executive Budget Tax Plan (Figures in Millions of Dollars)
FY2016 F2017 Total
Elimination of Small Business Income Taxes -338 -358 -696
State Income Tax Rate Cut -2,029 -2,599 -4,628
Additional Tax Relief for Lower and Middle-Income Filers -184 -188 -372
Total Income Tax Cut -2,551 -3,145 -5,696

Cigarette and Other Tobacco Taxes 528 463 991
Sales Tax Rate Increase 651 902 1,553
Broadening Base of Sales Tax 432 496 928
Commercial Activity Tax (CAT) 290 401 691
Oil and Severance Tax 95 230 325
Reducing Used-Car & Watercraft Trade-In Discount 91 125 216
Reducing Sales Tax Discount to Vendors 26 36 62
Means Testing Income Tax Credits / Deductions ($100,000) 152 166 318
Eliminate Deduction for Early Beer and Wine Payment 1 2 3
0.5% Increase on Base Expanders 39 47 86
Total Revenue Changes 2,305 2,868 5,173

Total Net Tax Cut -246 -277 -523
(Kasich, 2015)


Excise Taxes
Excise taxes, which are often included in the price of a good, are levied on a per-unit basis. Excise taxes are in contrast to ad valorem taxes where the amount levied is proportional to the price of the good (e.g. a sales tax). Items that are typically subject to excise taxes include: gasoline, alcohol, and cigarettes. The latter two items are examples of “sin” taxes where legislators intend to reduce the consumption of the good by increasing the price indirectly through an excise tax. For example, former New York mayor Michael Bloomberg said
If it were totally up to me, I would raise the cigarette tax so high the revenues from it would go to zero (Cooper, 2002).
Excise taxes are imposed by federal, state and local governments and are not uniform throughout the United States. Because the retailer or wholesaler is statutorily responsible for paying the excise tax, these taxes are simply included in the price of the good or service and hence are often unobserved or unknown to the consumer.
Cigarette Excise Taxes in Ohio
In order for cigarettes to be legally sold in Ohio, a tax stamp must be affixed to every pack of cigarettes as evidence of payment of the tax. Ohio has levied an excise tax on the sale of cigarettes since 1931. Between 1995 and 2001, the Ohio cigarette tax was 24 cents per packet, but increased to $1.25 on July 1, 2005 and had remained at that level. In his 2013 Executive Budget proposal, Gov. Kasich proposed increasing Ohio’s cigarette tax from $1.25 to $1.85 per pack. However, this proposed increased was not approved by the legislature. Governor Kasich’s 2015 Executive Budget proposal again called for raising the cigarette tax – this time to $2.25 per pack. In 2014, the State of Ohio collected $758 million in receipts from taxes on cigarettes, a decline from $839 million in 2010. Revenue from cigarette tax collections represents the large majority of tobacco-based tax receipts.
Table 2: Ohio Cigarettes Tax Receipts in Millions (Fiscal Years 2010 – 2014)

Fiscal Year Net Tax Collected
2010 $838.8
2011 $803.7
2012 $771.9
2013 $774.2
2014 $757.7
(OBM, 2014)

Cigarette Excise Taxes in Ohio’s Neighboring States

All of Ohio’s neighboring states have implemented an excise tax on the sale of cigarettes. The table below shows the range in excise taxes in the six neighboring states. At $2.00, Michigan levies the highest excise tax while West Virginia and Kentucky taxes are much lower at 55 cents and 60 cents respectively.
Table 3: Excise Taxes in Neighboring States, 2014
State Excise Tax on a Pack of Cigarettes
Ohio $1.25
Indiana $1.00
Michigan $2.00
West Virginia $0.55
Kentucky $0.60
Pennsylvania $1.60
(Emanuel & Borean, 2014)

Cigarette Consumption Patterns and Trends
The table below shows a comparison of the smoking rates among adults between the years 2005 and 2010. An individual was defined as a smoker if he or she reported smoking at least 100 cigarettes over their lifetime and were currently smoking every day or on some days. Using data from the National Health Interview Survey the table reveals that between 2005 and 2010, the overall smoking rate declined from 20.9 percent to 19.3 percent. When estimating the effect of the increased tax rate on tax collection estimates, Governor Kasich’s staff forecasted the trend in tobacco consumption for years in the budget.
The smoking rates vary dramatically by socioeconomic characteristic. In 2010, fewer than 10 percent of Asians were smokers, while over 30 percent of Native Americans and Alaskan Natives were smokers. Males are more likely to smoke than females. 45 percent of individuals with only a GED smoke, but only 6 percent of those with an advanced degree smoke. Individuals who are below the poverty level are also more likely to smoke than those who are above the poverty level. Finally, across the US, the Midwest region has the highest concentration of smokers.
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Table 4: Adult Smoking Rates
2005 2010
Characteristic Males Females Total Males Females Total
Age Group
18-24 28.0 20.7 24.4 22.8 17.4 20.1
25-44 26.8 21.4 24.1 24.3 19.8 22.0
45-64 25.2 18.8 21.9 23.2 19.1 21.1
>=65 8.9 8.3 8.6 9.7 9.3 9.5
Race/Ethnicity
White 24.0 20.0 21.9 22.6 19.6 21.0
Black 26.7 17.3 21.5 24.8 17.1 20.6
Hispanic 21.1 11.1 16.2 15.8 9.0 12.5
AI/AN 37.5 26.8 32.0 —- 36.0 31.4
Asian 20.6 6.1 13.3 14.7 4.3 9.2
Multiple Race 26.1 23.5 24.8 28.4 23.8 25.9
Education
0-12 years (no diploma) 29.5 21.9 25.5 28.5 21.8 25.1
GED 47.5 38.8 43.2 46.4 44.1 45.2
High School Graduate 28.8 20.7 24.6 27.4 20.6 23.8
Undergraduate Degree 11.9 9.6 10.7 10.2 9.5 9.9
Graduate Degree 6.9 7.4 7.1 7.1 5.4 6.3
Poverty Status
At or Above 23.7 17.6 20.6 20.2 16.4 18.3
Below 34.3 26.9 29.9 33.2 25.7 28.9
U.S. Census Region
Northeast 20.7 17.9 19.2 18.5 16.3 17.4
Midwest 27.3 21.3 24.2 22.9 20.8 21.8
South 25.3 18.5 21.8 23.9 18.3 21.0
West 20.1 13.9 17.0 18.8 13.0 15.9

Total 23.9 18.1 20.9 21.5 17.3 19.3
(CDC, 2011)
Between 1965 and 2010, the percentage of smokers fell from over 40 percent to under 20 percent. If current patterns continue, the smoking prevalence is projected to fall to approximately 17% in 2020 (CDC, 2013). Despite an increase in smoking rates among high school students in the early 1990s, the recent decline in smoking rates among students is similar to adults. Unless there are significant shifts in cultural attitudes and norms, the number of smokers will likely continue to decline in the near future.
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Consumer Responses to Taxes
Economic theory demonstrates that an increase in cigarette taxes results in fewer purchases of cigarettes. As the price of a good increases, the quantity demanded of that good should decrease – holding everything else constant. For example, Cebula (2013) found that a 10 percent increase in the price of cigarettes resulted in a two percent decline in cigarette consumption. The average retail price of a pack of cigarettes by state is shown below.
Table 5: Average Retail Price for a Pack of Cigarettes in 2014
Rank State Retail Price
50 Virginia $5.25
50 Missouri $5.25
48 Tennessee $5.30
… … …
33 Ohio $5.88
… … …
3 Massachusetts $9.95
2 Illinois $11.50
1 New York $12.85
(Maranjian, 2014)
The table shows that the price of a pack of cigarettes can vary dramatically within the United States. At $5.25, a pack of cigarettes is cheapest in Virginia, but the price more than doubles to $12.85 in New York. The elasticity of demand for cigarettes (i.e. the degree of price sensitivity) is not necessarily constant across this wide range in prices. Nevertheless, research studies show that the demand for cigarettes is relatively price inelastic. Consumers reduce their demand for cigarettes in the face of higher prices, but not to a large extent. In addition, empirical studies of the most common excise taxes in the U.S. (e.g. taxes on alcohol, cigarettes, and gasoline) – usually conclude that the costs of the taxes are nearly fully shifted to consumers. That is, the economic incidence, or burden, of a tax can be effectively paid by either consumers or producers of cigarettes. Because of relative price insensitivity to cigarettes, much of the burden of increased taxes is borne by the consumer.
Substitution for Other Products
Research has shown that consumers substitute for other tobacco products in response to increases in cigarette prices (e.g. Ohsfeldt, et al., 1998; Pekurinen 1989). In one study, Evans and Farrelly (1998) used data from the 1979 and 1987 United States National Health Interview Survey (NHIS) and found that smokers engaged in a variety of compensating behaviors after a tax increase on cigarettes. Specifically, smokers (particularly younger smokers) in high-tax states consumed longer cigarettes and cigarettes with higher tar and nicotine content than those consumed by smokers in lower-tax states. Consumers may also stockpile cigarettes in anticipation of a future tax increase. Stockpiling behavior varies by demographic with higher-educated areas stockpiling in anticipation of a tax increase. Finally, a tax hike on cigarettes may also lead smokers to shift their interest to other type of drugs, such as alcohol or marijuana, which may create a similar physiological response.
Cross-State Purchases
Because many of Ohio’s neighboring states have lower excise taxes than Ohio, consumers may purchase their cigarettes across state lines. In fact, Chiou and Muehlegger (2014) suggest that consumers engage in border-crossing due to differential taxes across jurisdictions. The consumers most likely to travel are heavy smokers, who consume large quantities (cartons) of cigarettes. Over half of Ohio’s residents live in regions of the State that contain a bordering county, including residents of the Cleveland, Cincinnati, and Toledo metropolitan areas.
Table 6: Population of Largest Cities in Ohio
Combined Statistical Area (CSA) Population (2010 Census)
Cleveland 3.5 MM
Columbus 2.3 MM
Cincinnati 2.2 MM
Dayton 1.1 MM
Toledo 0.7 MM
(Census Bureau, 2010)
The table above shows that Cincinnati, a neighboring city to Kentucky, is particularly vulnerable to cross-state purchases as a result of the excise tax in Kentucky being only $0.60.
Health Consequences of Smoking
Individual
Smoking is one of the leading preventable causes of death in the United States as complications from cigarette smoking result in more than 480,000 deaths each year in the United States (CDC, 2015). Smoking complications causes more deaths each year than all of these combined:
• Human immunodeficiency virus (HIV)
• Illegal drug use
• Alcohol use
• Motor vehicle injuries
• Firearm-related incidents
In addition, smoking causes about 90% (or 9 out of 10) of all lung cancer deaths in men and women. More women die from lung cancer each year than from breast cancer, and about 80% (or 8 out of 10) of all deaths from chronic obstructive pulmonary disease (COPD) are caused by smoking. Life expectancy for smokers is at least 10 years shorter than for nonsmokers. Medical evidence has also shown that smokers are more likely than nonsmokers to develop heart disease, stroke, and lung cancer.
Quitting smoking cuts cardiovascular risks. Just 1 year after quitting smoking, the risk for a heart attack drops sharply. Within 2 to 5 years after quitting smoking, the risk for stroke could fall to about the same as a nonsmoker’s risk. If one quits smoking, the risks for cancers of the mouth, throat, esophagus, and bladder drop by half within 5 years. Ten years after one quits smoking, his/her risk for lung cancer drops by half.
Public
A negative externality is a cost that is suffered by a third party as a result of an economic transaction. Externalities are also known as spillover effects, and a negative externality may be sometimes referred to as an external cost. Second hand smoke is the most common negative externality that can impose negative health effects on bystanders (ACS, 2014). Second hand smoke consists of both side stream smoke and mainstream smoke. Side stream smoke is from the lighted end of a cigarette, pipe, or cigar. Side stream smoke has higher concentrations of cancer-causing agents (carcinogens) and is more toxic than mainstream smoke. In addition, it has smaller particles than mainstream smoke which make their way into the lungs and the body’s cells more easily. Non-smokers who breathe in second-hand smoke take in nicotine and toxic chemicals by the same route smokers do. As a result of smoking, billions of dollars are spent in the United States treating smoking-related effects. The table below shows the health care expenditures in 2009 for cigarette smoking. More than 10 percent of hospital expenditures, or $67 billion, is attributable to smoking. In addition, 7.6 percent of all health care expenditures are attributable to smoking.
Table 7: Aggregate Health Care Expenditures, 2009
Type of Service Smoking Attributable Fraction (%) Expenditures (billions)
Hospitals 10.3 67.0
Ambulatory Care 4.9 21.0
Nursing Home Care 7.9 10.6
Prescription Drugs 9.5 25.5
Other Services 3.3 8.2
Total 7.6 132.5
(US HHS, 2015)
The table below compares the healthcare expenditures by former and current smokers. It provides evidence to suggest that in the short-run, the costs incurred by former smokers are far less than the costs incurred by current smokers.
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Table 8: Aggregate Health Care Expenditures, by Age Group and Gender, 2012
Former Smokers Current Smokers Total
Age Group Males Females Subtotal Males Females Subtotal
35-44 0.5 0.3 0.8 3.0 2.4 5.4 6.2
45-54 2.9 1.1 4.0 10.7 8.8 19.4 23.4
55.-64 8.6 5.5 14.1 17.4 12.8 30.2 44.3
65-74 15.4 11.2 26.7 15.0 10.0 25.0 51.7
>= 75 18.6 17.6 36.2 4.9 8.3 14.2 50.4
All Ages 46.0 35.7 81.7 52.0 42.2 94.2 175.9
(US HHS, 2015)

Finally, the table below shows the annual value of lost productivity due to smoking. An individual who dies before the end of their working years no longer contributes to the economic growth of the country. However, those individuals who die before retirement age because of smoking, are also not receiving Social Security, Medicare, and other social obligations that they may be eligible to receive as a result of their age.
Table 9: Average Annual Value of Lost Productivity ($ in thousands) Attributable to Death from Cigarette Smoking, Adults 35-79 Years of Age, 2005-2009
Disease Males Females Total
Cancers $27,760,852 $16,698,524 $44,459,376
Cardiovascular and Metabolic Diseases $31,856,004 $12,875,069 $44,731,073
Pulmonary Diseases $9,963,054 $8,402,054 $18,365,108
All Causes $105,641,174 $45,085,339 $150,726,514
(US HHS, 2015)

Criticism of Excise Taxes
Disproportionate Effect on Poor
Previous data showed that low-income individuals (or those below the poverty line) have higher rates of smoking. As a result, an excise tax increase would fall more heavily on poorer individuals. Some have argued that a higher price might actually be just what is needed to cause these individuals to quit smoking altogether, but other research suggests that cigarette smokers are relatively price insensitive.
Black Market Activities
The Mackinac Center for Public Policy analyzed data to estimate smuggling rates for each state in 2012 (LaFaive and Nesbit, 2014). The Center finds that smuggling rates rise in states after large cigarette tax increases are passed. Smuggling rates have dropped in some states, however, where neighboring states have higher cigarette tax rates. If there is an increase in black market activities, the increase in taxes might not be as high as expected.
In addition, an increase in black market activity can result in higher criminal activity. In 2014, an individual who was selling “loose” cigarettes in New York City, was approached by police officers. As a result of the confrontation, the individual, Eric Gardner, was killed. His death sparked national interest (Richardson, 2014).
Laffer Curve
The Laffer curve illustrates the relationship between tax rates and tax revenue. In most instances, when taxes are increased, government tax revenue increases. However, if the tax rate is too high, the Laffer curve shows that tax revenues can decrease. For example, in 2015 France reduced its top marginal income tax rate from 75 percent to 45 percent as a result of some economists arguing that tax revenues actually declined from those individuals who were originally taxed at the highest rate of 75 percent (Hartley, 2015).

After reading the article answers to the following questions

1) Identify and discuss the potential negative externalities for cigarette smoking.

2) Why do some critics argue that the cigarette excise tax acts as a “regressive” tax in which low-income individuals bear a higher burden of taxation than high-income individuals? Are these critics right?

3) What factors would cause the estimated tax collections to differ from the projected increase of $991 million dollars?

4) Ohio has an excise tax on alcohol of 40.3 cents for every 24 pack of beer purchased. If the price of cigarettes increases, what do you think will happen to the level of alcohol consumption in Ohio? Increase, decrease, or stay the same?

5) The case presented the economic costs due to smoking. Are there any economic benefits (in addition to excise taxes) that accrue to the state because of smoking?

 

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