Lawmakers in Washington are exploring an unusual way to affect nicotine consumption and increase taxes on tobacco products sold in the state. Instead of increasing the excise tax rate, which is currently $3.025 per pack of 20 cigarettes, sponsors of HB 1550 are suggesting increasing the Business & Occupations (B&O) tax on tobacco manufacturers and wholesalers by 1,000 percent.

Today, tobacco manufacturers and wholesalers pay the standard 0.484 percent rate, but if HB 1550 is enacted, that rate would grow to 4.884 percent.

This would not be the first time Washington state lawmakers have introduced differentiated rates into their B&O tax, but it would represent the highest rate across all industries. There may be justification for excise taxes on tobacco products, as consumption of these products does cause negative externalities like secondhand smoke, but there is no obvious legitimacy for differentiating corporate taxes based on industry. Corporate taxes should be as neutral as possible by applying to a broad base and at low rates. Such a tax is also more stable.

Washington state’s B&O tax is a gross receipts tax, and while these taxes have plenty of issues, their role is raising revenue from business activity. If lawmakers want to internalize externalities associated with tobacco consumption, they should look to excise taxes. Incidentally, excise taxes on tobacco products are already quite high in the state, and additional increases may result in unintended consequences. In 2018, over 40 percent of cigarettes consumed in Washington were not taxed by Washington due to casual (cross-border shopping) and organized smuggling, and new or higher taxes could bolster an already flourishing market for untaxed cigarettes.

However, even if gross receipts taxes are levied neutrally across industries, they deviate from sound tax policy by levying a tax on the same economic value multiple times in the production process. This phenomenon is known as tax pyramiding, which distorts economic activity and can magnify effective tax rates. HB 1550 would thus increase prices of tobacco products and vapor products significantly by taxing them multiple times before reaching retailers.

Levying what would in effect be an excise tax through the state’s general business tax also creates ample opportunity for tax avoidance. Wholesalers in nearby states or retailers on tribal lands would not be subject to the tax, which could shift economic activity without achieving much public health benefit.

In addition to the B&O tax, the bill includes changes to the state’s vapor products excise tax. If the bill were enacted, this tax would be levied at the retail level at 45 percent of retail price, one of the highest effective rates in the country. Although several states have higher statutory rates on vapor products, most levy these taxes at the wholesale level. The new tax would take effect January 1, 2022.

The proposed tax would be a significant increase to the existing levy on volume at a rate of $0.27 per milliliter for closed tanks and $0.09 per milliliter for open tanks containing more than five milliliters. In addition to increasing the tax burden on the state’s vapers and vapor businesses, the change also would make the tax design less equitable. A price-based (ad valorem) design results in inequitable treatment because products with similar qualities and in similar quantities should have equal tax liability regardless of design or price. Ad valorem taxes also incentivize downtrading, which is when consumers move from premium products to cheaper alternatives. Downtrading effects do not reduce harm and have no relation to any externality the tax is seeking to capture.

The volume-based tax was superior because volume is a better proxy for the harm associated with consumption (the negative externality). In addition to capturing the externality, it is the administratively simplest and most straightforward way for governments to tax a good as it does not require valuation and as such does not require expensive tax administration. 

Limiting addiction to nicotine is a laudable goal, but lawmakers should exercise caution with the methods employed. Using gross receipts taxes on businesses to effectively levy an excise tax introduces complexity to an already flawed tax design. It is better to let the excise tax internalize externalities and the business tax raise general revenue.