South Dakota Misses the Mark in Analysis of Tobacco Tax

Ross Marchand

November 1, 2018

State governments often have little understanding of the fiscal or behavioral repercussions of the policy changes they’re trying to make when taxing and regulating products they don’t like.  This is never more evident than in South Dakota where a tax increase initiative known as Measure 25 is on the November ballot. Should the initiative be approved, South Dakota would see an increase in the state cigarette excise tax by $1.00 per pack (to $2.53 per pack), and an increase in the state tax on other tobacco products from 35 percent of the wholesale purchase price to 55 percent of the wholesale purchase price. But in examining the impact of higher taxation on cigarette usage and prices, the South Dakota Legislative Research Council (SDLRC) misses the mark entirely. 

An analysis by the Taxpayers Protection Alliance shows that (by way of a simple methodological error) SDLRC significantly overestimates how much Measure 25 would reduce tobacco consumption. These errors will only further distort a debate characterized by repeated falsehoods and hysterical accusations. Taxpayers and consumers deserve a rigorous, straightforward analysis from their government to make a reasoned choice in November. 

Revenue estimates typically begin by estimating total tax-paid cigarette sales following the tax increase. SDLRC uses the standard methodology of using a price elasticity of demand to estimate total tax paid sales following the increase. The price elasticity of demand is a measure of how much consumers will change their demand for tax-paid cigarette sales in response to a change in the price of tax-paid cigarettes. The SDLRC analysis assumed that the price elasticity of demand for cigarettes was -0.25. An elasticity of -0.25 indicates that SDLRC assumed that for every 10.0 percent increase in price, demand for tax-paid cigarettes would decline by 2.5 percent.

However, SDLRC made a mistake with respect to its price increase assumptions. SDLRC assumes that the proposed $1.00 per pack tax increase raises the price of cigarettes by 65.4 percent. According to The Tax Burden on Tobacco, the average cigarette sales price in South Dakota, including sales taxes, in FY2018 (as of November 2017) was $6.87. Even after allowing for prices to rise through 2020, and accounting for the impact of trade margins and sales taxes, a $1.00 tax increase will only raise prices by 16.9 percent. 

Using the 16.9 percent figure, rather than the 65.4 percent figure claimed by the government, leads to totally different results about tobacco consumption and taxation stemming from the tax hike. The government implies that 27.4 million packs of cigarettes will be sold by 2020 as the result of tax hikes, whereas 32.1 million packs would be sold if there was no tax increase. Plugging in the actual elasticity shows that tax-paid sales will only decrease to 30.7 million packs. But even these figures seem to be too low. In addition to using the wrong price elasticity, SDLRC strangely assumes that tax-paid sales will decline by 3.8 percent per year between 2017 and 2020. This is likely to be too great of a decline – particularly for South Dakota whose tax-paid sales have been declining at a much slower pace over the past ten years. Assuming instead that smoking will decline 1 percent per year between 2017 and 2020- in line with the average decline between FY2008 and FY2017, 33.2 million packs of cigarettes will be sold in 2020 (as opposed to the no-tax baseline of 34.95 million packs). 

In any case, smoking will remain far higher than what the SDLRC is claiming. The new figures imply that revenues will increase by $35 million compared to the 2020 status quo, to a new high of $83.9 million. This is a significant difference from SDLRC, which assumes instead that $69.4 million will be the new revenue total in 2020. 

But even this analysis fails to show black market activity that can and does occur when the government taxes “sin products” at a higher rate. History has shown that while governments expect a big financial windfall from revenue increases, large revenue increases rarely happen.  Clearly, though, the analysis shows that the policy change will do little in getting tobacco users to quit. Policies should be used to provide consumers with an exit ramp off of smoking, instead of punishing them to fatten potential revenues.