Austan Goolsbee
University of Chicago, GSB,
American Bar Foundation and NBER
Joel Slemrod
University of Michigan and NBER
This paper documents the rise of the Internet as a source of cigarette tax competition for states in the United States. Using data on the cigarette tax rates, taxable sales and individual smoking by state from 1980 to 2001 merged to data on the rise of Internet use, the paper documents that there has been a substantial increase in the sensitivity of the sales of cigarettes in a state to changes in the state's cigarette tax. It then shows that this increase in sensitivity is directly correlated with the rise of Internet usage across states and that the increase in the Internet may have almost doubled the tax sensitivity of within-state cigarette sales. Data on cigarette usage, however, documents that Internet growth has not made actual smoking any more sensitive to tax rates. If anything, rising Internet usage has made it less sensitive to tax rates as smokers now have another way to avoid high taxes. The impact of the Internet appears to be concentrated entirely in the amount of smuggled cigarettes. Overall, with the tax sensitivity of taxable cigarette sales having almost doubled, this has lessened the revenue generating potential of recent cigarette tax increases by 33 percent compared to the traditional, older demand estimates. Given the continuing growth of the Internet and of Internet cigarette merchants, the results imply serious problems for state revenue authorities.
We wish to thank Jonathan Gruber, James Poterba, Raj Chetty, and participants at seminars at UC Berkeley, the University of Chicago, and the NBER Summer Institute for helpful comments and Jane Dokko, Peter Katuscak, Pablo Pena, and Svetla Tzenova for research assistance, and the American Tax Policy Institute for financial support. Goolsbee also wishes to thank the National Science Foundation (SES0312749) for financial support.I. Introduction
Cigarette taxes have always given policymakers a benign tradeoff . On one hand, demand for cigarettes is thought to be inelastic so that raising taxes can generate a lot of revenue with a relatively low ratio of excess burden to revenue collected. On the other, since cigarettes are one of the leading causes of health problems in the country, to the extent that taxes fail to raise revenue (i.e., when they get people to consume fewer cigarettes), they save lives.
The rise of the Internet, however, has begun to seriously threaten that happy tradeoff because, by purchasing cigarettes online, consumers have been able to evade state cigarette taxes. The Internet has the potential to wreak havoc on both sides of the equation. When people can buy online, raising taxes may generate little revenue while at the same time doing nothing to improve health. Instead, people simply become more sensitive to where they choose to buy their cigarettes.
This has become an issue of first-order importance in the last several years as many states have significantly raised their cigarette taxes to help close their budget deficits. Since January, 2002, some 30 states and the District of Columbia have increased their cigarette tax rates, expecting to raise significant revenues based on the view that demand for cigarettes is relatively inelastic. This paper will examine whether the rise of the Internet has made taxed cigarette purchases more responsive to tax rates.
Cigarettes are a natural place to look for the impact of tax evasion because state excise tax rates on cigarettes are particularly high relative to other consumption taxes and because avoidance and evasion, both informal and organized, is rampant. For example, Internet cigarette merchants located on Native American reservations (where state excise taxes levied on wholesalers do not apply) and in states with very low cigarette taxes have dramatically increased. Little to no taxes are being paid on these sales although, in theory, the state tax rates still apply. Technically, consumers are required to pay the taxes individually and fill out a Cigarette Use Tax form for any cigarettes on which the wholesaler did not remit tax. Almost no one does. Indeed, the state of New York has recently attempted to ban Internet cigarette merchants completely, and has argued that it alone loses some $500 to $600 million per year of revenue from Internet, 800 number, and Indian reservation sales (REA, 2002).
In this paper we make use of survey data on Internet use by state and across time, state administrative data on taxed cigarette sales, and survey data on actual smoking to investigate how the growth of the Internet has affected the level and elasticity of taxed cigarette sales and of smoking. The results suggest that the rise of online shopping has dramatically increased the sensitivity of in-state purchases to state tax rates. The mean price elasticity of taxed cigarette sales has risen most in those places where the Internet has grown the fastest (holding other things equal) and, in magnitude, may have almost doubled in the last several years. The data on cigarette usage, however, reveal no indication that growth of the Internet has made smoking more sensitive to taxation than it was before people were able to evade local taxation. The overall impact of Internet growth on cigarette excise tax revenue thus far appears to be modest, but the impact on the ability of tax increases to generate additional revenue has been sizable. We predict that the tax increases of 2001-2003 would have generated about 25 percent more revenue had the Internet merchants not existed. In some states this is as high as 40 percent.
The paper proceeds as follows. Section II discusses the cigarette retail industry and the role of the new Internet sites. Section III presents the methodology of our paper and describes the data we use. Section IV presents the basic results on taxed cigarette sales. Section V shows tests of robustness. Section VI documents the differential effect of Internet use on usage versus taxable sales, and clarifies the importance of smuggling. Section VII discusses the revenue implications of our findings, and Section VIII concludes.
University of Chicago, GSB,
American Bar Foundation and NBER
Joel Slemrod
University of Michigan and NBER
This paper documents the rise of the Internet as a source of cigarette tax competition for states in the United States. Using data on the cigarette tax rates, taxable sales and individual smoking by state from 1980 to 2001 merged to data on the rise of Internet use, the paper documents that there has been a substantial increase in the sensitivity of the sales of cigarettes in a state to changes in the state's cigarette tax. It then shows that this increase in sensitivity is directly correlated with the rise of Internet usage across states and that the increase in the Internet may have almost doubled the tax sensitivity of within-state cigarette sales. Data on cigarette usage, however, documents that Internet growth has not made actual smoking any more sensitive to tax rates. If anything, rising Internet usage has made it less sensitive to tax rates as smokers now have another way to avoid high taxes. The impact of the Internet appears to be concentrated entirely in the amount of smuggled cigarettes. Overall, with the tax sensitivity of taxable cigarette sales having almost doubled, this has lessened the revenue generating potential of recent cigarette tax increases by 33 percent compared to the traditional, older demand estimates. Given the continuing growth of the Internet and of Internet cigarette merchants, the results imply serious problems for state revenue authorities.
We wish to thank Jonathan Gruber, James Poterba, Raj Chetty, and participants at seminars at UC Berkeley, the University of Chicago, and the NBER Summer Institute for helpful comments and Jane Dokko, Peter Katuscak, Pablo Pena, and Svetla Tzenova for research assistance, and the American Tax Policy Institute for financial support. Goolsbee also wishes to thank the National Science Foundation (SES0312749) for financial support.I. Introduction
Cigarette taxes have always given policymakers a benign tradeoff . On one hand, demand for cigarettes is thought to be inelastic so that raising taxes can generate a lot of revenue with a relatively low ratio of excess burden to revenue collected. On the other, since cigarettes are one of the leading causes of health problems in the country, to the extent that taxes fail to raise revenue (i.e., when they get people to consume fewer cigarettes), they save lives.
The rise of the Internet, however, has begun to seriously threaten that happy tradeoff because, by purchasing cigarettes online, consumers have been able to evade state cigarette taxes. The Internet has the potential to wreak havoc on both sides of the equation. When people can buy online, raising taxes may generate little revenue while at the same time doing nothing to improve health. Instead, people simply become more sensitive to where they choose to buy their cigarettes.
This has become an issue of first-order importance in the last several years as many states have significantly raised their cigarette taxes to help close their budget deficits. Since January, 2002, some 30 states and the District of Columbia have increased their cigarette tax rates, expecting to raise significant revenues based on the view that demand for cigarettes is relatively inelastic. This paper will examine whether the rise of the Internet has made taxed cigarette purchases more responsive to tax rates.
Cigarettes are a natural place to look for the impact of tax evasion because state excise tax rates on cigarettes are particularly high relative to other consumption taxes and because avoidance and evasion, both informal and organized, is rampant. For example, Internet cigarette merchants located on Native American reservations (where state excise taxes levied on wholesalers do not apply) and in states with very low cigarette taxes have dramatically increased. Little to no taxes are being paid on these sales although, in theory, the state tax rates still apply. Technically, consumers are required to pay the taxes individually and fill out a Cigarette Use Tax form for any cigarettes on which the wholesaler did not remit tax. Almost no one does. Indeed, the state of New York has recently attempted to ban Internet cigarette merchants completely, and has argued that it alone loses some $500 to $600 million per year of revenue from Internet, 800 number, and Indian reservation sales (REA, 2002).
In this paper we make use of survey data on Internet use by state and across time, state administrative data on taxed cigarette sales, and survey data on actual smoking to investigate how the growth of the Internet has affected the level and elasticity of taxed cigarette sales and of smoking. The results suggest that the rise of online shopping has dramatically increased the sensitivity of in-state purchases to state tax rates. The mean price elasticity of taxed cigarette sales has risen most in those places where the Internet has grown the fastest (holding other things equal) and, in magnitude, may have almost doubled in the last several years. The data on cigarette usage, however, reveal no indication that growth of the Internet has made smoking more sensitive to taxation than it was before people were able to evade local taxation. The overall impact of Internet growth on cigarette excise tax revenue thus far appears to be modest, but the impact on the ability of tax increases to generate additional revenue has been sizable. We predict that the tax increases of 2001-2003 would have generated about 25 percent more revenue had the Internet merchants not existed. In some states this is as high as 40 percent.
The paper proceeds as follows. Section II discusses the cigarette retail industry and the role of the new Internet sites. Section III presents the methodology of our paper and describes the data we use. Section IV presents the basic results on taxed cigarette sales. Section V shows tests of robustness. Section VI documents the differential effect of Internet use on usage versus taxable sales, and clarifies the importance of smuggling. Section VII discusses the revenue implications of our findings, and Section VIII concludes.
