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Getting High on Excise Taxes

More and more states are turning to a perennial favorite, the excise tax, to weather the recession.

Desperate for revenue, state legislatures have been taking yet another look at their excise taxes: gas, alcohol and cigarettes, the perennial favorites. More than half the states increased one of the big three last year; four have raised them so far this year. But how many times can states revisit the assessment on a pint of whiskey or a gallon of gas? How high can they go on a pack of cigarettes? The answer to the latter is, pretty high. New York state just added $1.60 on a pack of cigarettes, bringing the full cost to $4.35 a pack, which should generate, legislators hope, $440 million in revenue for the state.

Where do excise taxes go from here? Can states keep raising the price on the ones they have? I put these questions to Joseph Henchman and Kail Padgitt from the Tax Foundation. Henchman is director of state projects and Padgitt, a staff economist. Here's an edited version of what they had to say about where excise taxes have been and where they're likely to go.

Let's start with the basics. What is an excise tax and how does it differ from a sales tax?

A sales tax is an ad valorem tax -- a percent of the price of the item is tacked on when the consumer buys the item. An excise tax is based strictly on quantity -- the consumer pays a flat amount per item.

Excise taxes started out historically as luxury taxes. The very first two excise taxes in the United States were taxes on carriages and on whiskey. A telephone excise tax started as a luxury tax; so did gasoline. In our country, things that start out as luxuries come to be enjoyed by most people.

Why do states keep turning to them?

Excise taxes are more stable than sales taxes, and sometimes they are easier to pass -- depending on how many users the tax effects. It's harder to raise the tax on beer than on cigarettes. In previous years, states could patch a hole in their budget by raising an excise tax, but states can't increase excise taxes to raise the kind of revenue they need now.

A lot of states raised excise taxes last year. Can excise taxes keep going up?

People are always pushing harder on these taxes. The revenue total from them hasn't started to decrease, but states that push very high start to see drops. That happens for two reasons. The higher the price, the less people consume the item. A high tax can also create the incentive to get around it. For instance, there can be bootlegging. Someone might fill a truck in Virginia full of cigarettes and drive up to New York City to sell the cigarettes -- without charging the New York excise tax on them. It's illegal. I do not recommend doing this but that's what can happen.

Are states looking around for new excise taxes? If so, where are they looking?

They are trying to expand into new areas. Those areas include sugary drinks and plastic bags. Some people are talking about salty and fatty foods. We've been hearing rumors of taxing hamburgers and pizza. [New York City Mayor Michael] Bloomberg referenced hamburgers but nothing came of that. People think those kinds of items will be the next big thing.

What's the reasoning here?

It all goes back to the bootleggers and Baptist story. States were looking for revenue and didn't want to say they were taxing something for the money but for moral reasons. Tax drinking so people won't drink so much. Tax cigarettes because smoking is bad for you. You don't want people to engage in these behaviors, so you tax ideas and put a moral veneer on them. The reason this argument breaks down, however, is that we seem to go after these activities when revenues are down -- not when something has changed and drinking or smoking are better or worse for you. Whether or not you agree with the moral argument, states are clearly going after "sin" taxes when they need revenue.

On your website, you write about another expansion, the "legalize and tax it" idea. What's that about?

Imposing an excise tax can lead to legalizing a product. One of the reasons Prohibition came to be passed in the first place was the rise of the income tax. It replaced revenue from excise taxes on liquor and made it possible to make liquor illegal. During the Great Depression, however, state and federal revenues were down quite a bit. There was income tax revenue, but they needed another source. This was one of the reasons Prohibition was repealed -- the need for revenue, from an excise tax on liquor in particular. And that made liquor legal and ended Prohibition.

Quite a few states have a tax on illegal drugs. In the 1980s, it was another way to penalize people who were arrested with drug offenses. They would be charged with tax evasion as well because they hadn't paid the tax on illegal drugs. States only get revenue from those arrested -- people don't report possession of illegal drugs and pay the tax.

But now there is a new wave of ideas -- to grab money, or decriminalize something and tax it.

In some ways, this is similar to the Nevada proposal to tax prostitution. The prostitution industry supported it because, in their minds, it was a step toward legitimizing their industry. It's the same with marijuana. California is proposing to impose an excise tax on marijuana. Estimates are that it would raise $1.3 billion per year. Marijuana users support the tax because it will help legitimize the industry. There would be a legal way to buy it without a prescription and that would reduce black market sales.

Gambling also falls under "legalize and tax it." Some states are adding more casinos or approving new gaming as a way to gain revenue. For two years now, Maryland has been struggling to add slots parlors. The state gets a very heavy take -- over half the revenue. There are plans for five slot parlors but there is only a bid on one. The state's take is too big.

One thing we see in a lot of these gambling operations, such as lotteries, is that the state take is higher than if anyone in the private sector could establish one. The state has a monopoly, and that's why we see higher gambling taxes than others.

Elizabeth Daigneau is GOVERNING's managing editor.
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