Smokers Lose, but Other "Sinners" Win

As we enter the third fiscal year of recession-crunched budgets, states continue to seek greater revenue from “sin taxes.” This is an expensive trend for smokers, who saw 18 states raise tobacco taxes in 2009 alone. But other “sinners” are often coming out ahead as a result -- assuming it’s a good thing that states are letting them “sin” more freely.

This is because states’ goal of generating more revenue from sin taxes doesn’t always just mean higher taxes -- it can mean legalizing once prohibited activities or relaxing restrictions on existing activities. Those who partake in previously disfavored sins (especially gambling and, in some parts of the country, drinking) get greater freedom as part of the government’s quest to generate revenue.

This is most readily seen in the gambling space. In 1980, casino gambling was illegal almost everywhere in the United States, and only 13 states had established lotteries. Today, every state except Utah and Hawaii has some form of legal gambling, usually with the government taking a large cut of the proceeds. A large majority of Americans live within two hours’ drive of a casino.

Recent budget pressures have led to further gambling expansions, often driven by regional competition. Pennsylvania, Ohio, West Virginia, Delaware and Maryland all significantly expanded casino gambling over the last three years, in the manner of falling dominoes. A key argument for legalizing slots in Maryland was that state residents were going to play in neighboring states. Meanwhile Delaware and Pennsylvania legalized table games in large part to draw customers away from Atlantic City.

We also see sin liberalization beyond gambling. Many states have relaxed “blue laws” that have restricted hours of alcohol sale over the last decade, in significant part to raise new revenue.

Even Utah has been aggressive about seeking new cash flows from alcohol sales. In 2009, the state legalized bars for the first time since prohibition. It also allowed bartenders to pour drinks in public view and may soon relax rules that make it hard for restaurants to get liquor licenses. All of these moves are in pursuit of more revenue, both directly from liquor sales and by encouraging tourist travel to Utah.

Meanwhile New York Governor David Paterson has been pushing his legislature to allow grocery store wine sales -- projected to generate $150 million in added state revenues the first year, mostly from license fees -- but the legislature has so far resisted. (Paterson would also legalize wrath, by lifting a ban on mixed martial arts competitions in New York State.)

Last year, Nevada brothel owners were in the odd position of encouraging the state to levy an excise tax on prostitution, in hopes that being a tax source would insulate them from future attempts to ban prostitution in the only state where it is legal. (The legislature declined, in part because the industry is so small.) But California residents may vote this November to legalize and tax marijuana, which would bring in a projected $1 billion in new annual revenues for the state.

And while the drive for sin revenues adds options for gamblers (and possibly for marijuana smokers), cigarette smokers just end up having to pay more. Last week, Governor Paterson forced through an increase in New York State’s cigarette tax by another $1.60, to a total of $4.35. New York City adds an additional $1.50 in tax, meaning the retail price of a pack of cigarettes will hit $11 in Manhattan -- $6.85 of which is taxes.

Taxes will also go up sharply on smokeless tobacco and cigars, which already saw an increase last year. The increase is supposed to raise $210 million in annual revenues for the state, but in practice cigarette tax hikes often run short of their revenue projections -- in part because high taxes have led to rampant bootlegging in New York’s cigarette market.

Sky-high cigarette tax rates highlight the tension between the desire to regulate activity and generate revenue. Sin taxes discourage sin -- but if they’re too effective in discouraging sin, revenues start falling. Where states’ objective is to generate revenue, they need to find the revenue-maximizing level of taxation while creating an environment where taxpayers still feel free to sin.

Part of the reason tobacco smokers lose out in the sin tax game is that many officials appear to be sincere in their desire to reduce smoking rates. A lower tax rate would reduce bootlegging and might even increase state tax revenues. But if the state’s goal is more to discourage smoking than to raise money, it may prefer policies that result in a high cigarette price level, even if much of the intended tax revenue is absorbed by criminals.

And even as they raise taxes, states are also making it increasingly difficult to smoke, expanding indoor smoking bans and even debating a ban on smoking at parks and beaches in New York City. (Mayor Bloomberg opposes a ban, for now.) If the government was really focused on generating cigarette tax revenues, they would make it easier to find places to smoke.

On other sin taxes, states show signs of aiming for revenue maximization. Most states entering the gambling business after Nevada and New Jersey have set relatively high tax rates on casino profits, in the mid-double digits instead of the single digits.

But when Illinois got greedy in 2002 and upped its maximum casino tax rate to 70%, casinos lost too much business to competitors in Indiana, and the state responded by cutting the tax. Around the country, most efforts to raise more money from gambling have been centered around legalizing new games, not increasing the state’s take from existing ones.

Indeed, it’s not uncommon to get in a New York subway car and be confronted by ads on one side urging you to stop smoking -- and on the other side urging you to buy lottery tickets.

If smokers want to stop bearing the brunt of state budget shortfalls, they perversely may need to convince legislators to think of them as more of a cash cow, not less. Or they could just hitch their fortunes to other, more-favored sinners. One of the few recent rollbacks of an anti-smoking law was in Atlantic City, where two years ago the city council enacted and then repealed a ban on smoking on casino floors.

Why the reversal? Because the ban was hurting gambling revenues too much, and the government’s prerogative to promote gambling trumped its desire to discourage smoking.

This piece originally appeared in RealClearMarkets

This piece originally appeared in RealClearMarkets