Hazard Of Earmarked Taxes

By Lowell L. Kalapa

(Released on 9/21/08)

About a month ago the Wall Street Journal ran a story about Maryland’s financial situation that has soured as lawmakers in that state had hoped a substantial increase in the cigarette tax would help balance the state’s budget.

Instead, the doubling of Maryland’s cigarette tax to $2 per pack last year to pay for expanded health care coverage caused a drop of 25% in state cigarette sales. Although some elected officials seemed to be genuinely happy that 30 million fewer packs of cigarettes were brought into the state this year, perhaps indicating that fewer were smoking, the fact of the matter is that Maryland was actually losing retail sales of cigarettes rather than deterring smoking in the state as smokers flocked across the state line into Virginia where the state tax on a pack of cigarettes is only 30 cents.

That concern caused Maryland lawmakers to make it a crime to carry two or more packs that weren’t purchased in the state. If caught with two or more packs that were purchased out of the state, the smoker could be fined. Of course, that raises the question of who is going to enforce that law. Thus, it is in the state’s financial interest that smokers continue to smoke as long as the cigarettes have been purchased in the state and the Maryland tax has been paid.

Maryland is not alone in this predicament. Lawmakers in New York City, and New York state lawmakers, have raised the cigarette tax so many times that the retail cost of a pack of cigarettes can be more than $9, more than twice the national average cost. The article reports that there is as much as a 75% gap between the retail sale of cigarettes and what observers believe is the level of consumption of cigarettes in the Big Apple.

With alternative ways of purchasing cigarettes, such as over the Internet and black market products, Hawaii may also experience a similar loss in retail sales of cigarettes as the tax rises to $2 per pack at the end of this month. And perhaps the tax increase would not be a bad way to discourage the use of cigarettes since the cost of the product would be that much more expensive. The problem is that a portion of the cigarette tax goes to fund specific programs or activities such as the Cancer Research Center and community health care facilities. Should retail sales actually decline greater than the increase in the tax rate (and the rate will increase annually until it reaches $2.60 in the year 2011) these specific programs may find themselves without the funds they need. Will they then come back to lawmakers and ask for an additional hand out?

A similar situation exists with respect to the conveyance tax which was recently increased with structuring that imposes the highest rate of tax on residential properties that are not owner occupied and are valued at more than $1 million. Non-residential property valued at greater than $1 million also bears the heaviest rate of tax for non-residential property. In Hawaii’s pricey real estate market, one would think that this would be a wonderful resource for government.

The problem is that the receipts of the conveyance tax are earmarked for specific programs like the cigarette tax. In this case, a portion goes toward the natural area reserve fund, a portion goes into the legacy land trust fund and another portion goes into the affordable rental housing trust fund. Since collections of the tax are dependent on the amount of activity in the real estate market and the values of the property transacted, the amount accruing to the various funds rises and falls with the fortunes of the real estate market.

For example, just after the tax was increased collections of the conveyance tax rose to just under $60 million annually. However, as the market has turned south it dropped to $46 million in fiscal year 2007 and to $43 million for fiscal 2008. This volatility in collections hardly makes for good planning, as one never knows how much the tax will bring in any one year. Similarly, because the collections of the tax are not directly responsive to the various programs it funds, there is no rhyme or reason as to the needs of the various programs funded by this tax.

Earmarking various taxes that have no direct relationship to those who pay the tax and those who spend those tax dollars jeopardizes the integrity of the state’s finances. Either the tax will produce more than the programs need or, as has been the case, it will not produce what is truly needed to fund the program. And raising the tax so high that it discourages the consumption and, therefore, the payment of the tax may not be very smart either.

Lowell L. Kalapa is the president of the Tax Foundation of Hawaii. Mr. Kalapa’s commentary is printed each week in the Maui News, West Hawaii Today, Garden Isle News, and the HawaiiReporter.com.