Colorado May Repeal Cigarette Sales Tax Exemption

April 17, 2009

In Colorado cigarettes have been exempt from the state’s 2.9% general sales tax since the middle of the 20th century. Now the Denver Post reports that Democrats in the state’s legislature are pushing a plan to eliminate that sales tax exemption, which they say will raise $38 million for a state currently facing a $300 million budget shortfall.

The proposal to subject cigarettes to the general sales tax is a move in the direction of sound tax policy. In principle general sales taxes are meant to tax consumption in order to provide general revenue for state governments. The principle of tax neutrality requires that all consumption be treated in the same manner, that is, that all consumption be subject to the general sales tax. Every sale, be it a product or service, that is exempt from sales tax forces up the tax rate on non-exempt sales and implicitly favors exempt purchases over non-exempt purchases. The special tax treatment of certain purchases distorts consumers’ buying preference in favor of tax-exempt purchases and away from non-exempt purchases, violating the principle of neutrality. Buying cigarettes is consumption and it should be subject to the same general sales tax apllied to hammers and hamburgers.

The question of cigarette excise taxes is another issue. Excise taxes are in theory designed to offset some externality, or harm done to society, from a certain activity. To the extent that smoking imposes an externality on society there should be a cigarette excise tax in the amount necessary to offset this harm. No more, no less. It can be argued whether or not Colorado’s $0.84 per-pack excise tax reflects the cost imposed on society by a pack of cigarettes, but that is not the point right now. Excise taxes and sales taxes are two very different types of taxes with different purposes and different standards for their application. The two should not be confused.

One issue to note however, is that assuming the excise tax was set at the rate required by any externalities, the sales tax should apply to the total cost of the cigarettes including the excise tax. The reason for this is that the excixe tax represents additional consumption of, for example, future government-provided health care or other people’s breathable air, the costs of which are not included in the pre-excise tax price of the cigarettes.

Also it should be noted that Colorado has a Taxpayer Bill of Rights (TABOR) that limits the ability of the legislature to raise taxes. A recent Supreme Court ruling says that the Colorado legislature can amend provisions like tax exemptions and credits without the voter approval required by TABOR, and the repeal of the cigarette sales tax exemption would rely on this ruling. Assuming the proposal does not violate TABOR rules, sound tax policy would dictate that cigarettes be taxed under the general sales tax just like any other purchase, regardless of the current budget situation.

(This blog post was edited slighly after the original posting)

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