Excise tax avoidance: the case of state cigarette taxes

Area of Science:

• Welfare economics
• Public finance
• Applied econometrics

Background:

• Cigarette taxes are a key tool for internalizing external costs like healthcare expenses.
• Consumers may avoid high cigarette taxes by purchasing in lower-tax jurisdictions, complicating optimal tax calculations.

Purpose of the Study:

• To extend the optimal Pigouvian tax formula to include tax avoidance behavior.
• To estimate the impact of cross-jurisdictional tax avoidance on optimal cigarette excise tax levels.

Main Methods:

• Developed an extended optimal Pigouvian tax formula incorporating tax avoidance.
• Estimated a structural endogenous switching regression model for border-crossing and cigarette prices.
• Conducted illustrative calculations using empirical estimates.

Main Results:

• Optimal cigarette excise taxes are, on average, at least 20% lower than standard Pigouvian taxes when tax avoidance is considered.
• Tax avoidance behavior is highly responsive to price differentials between jurisdictions.
• Shifting from avoidable state excise taxes to a federal tax could offer benefits.

Conclusions:

• Standard Pigouvian tax calculations overestimate optimal cigarette excise taxes due to unaddressed tax avoidance.
• Policy recommendations for cigarette taxation must account for consumer responses to price differences across jurisdictions.
• Federal cigarette excise taxes may be more effective than state-level taxes in mitigating avoidance.