Are Excise Taxes on Beverages a Good Substitute for Income Taxes?

March 29, 2021

Excise taxes are commonly employed to deter consumption or internalize societal costs, but in West Virginia, Gov. Jim Justice (R) is proposing to increase the excise tax on soft drinks to pay for part of an income tax reform.

He’s not alone in considering ways to raise revenue as state lawmakers look to a time after the pandemic and ponder how their tax codes impact taxpayer behavior. It seems almost certain, for example, that the post-pandemic world will include more remote work opportunities, which will allow taxpayers more freedom to shop for competitive tax environments with less considerations of the physical location of their employer. In West Virginia, the only state to lose population over the past 70 years, several plans are in the works to reduce or even repeal the individual income tax.

The governor’s proposal has one uniquely interesting element: increasing excise taxes on soft drinks. West Virginia’s soft drinks tax is a curious corner of the state’s tax code, but the excise tax celebrates its 70th anniversary this year. Since 1951, the state has levied the tax of one cent per 16.9 fluid ounces, 80 cents per gallon of syrup, and one cent per ounce of dry mixture. Under Gov. Justice’s plan, the rate would increase 600 percent to six cents per bottle of 16.9 fluid ounces, $4.80 per gallon of syrup, and six cents per ounce of mixture. This increase is estimated to raise $62.5 million.

Excise taxes can function well when internalizing societal costs, called externalities, or when establishing a user-pays system. However, excise taxes are poorly suited to sustainably generate operating revenues. By definition, such taxes are narrow and selective, and they lack revenue stability, especially when imposed on declining markets. According to a recent study, soda consumption has been declining for years among all age groups.

While higher taxes can boost revenues in the short run, the governor’s reform may introduce greater uncertainty over a longer time horizon, and by relying on excise taxes to make up lost revenue from lower income tax rates, West Virginia risks being without revenue needed to fund essential services. 

Over the last few years, there has been much talk about imposing sugar-sweetened beverages (SSB) taxes to deter consumption and internalize societal cost, but West Virginia’s tax has a much broader base than current SSB tax proposals as well as currently levied local SSB taxes. In the state, almost all beverages are included in the base—including many unsweetened beverages. The only exceptions to the tax are bottled plain water, naturally carbonated water, unsweetened fruit juice, and unsweetened milk. This tax design removes any consumer incentive to substitute to unsweetened beverages from sugary drinks and makes little sense if the tax is intended to internalize externalities associated with sugar consumption. Historically, however, this tax has primarily existed to generate revenue, and that would certainly be true under Gov. Justice’s plan.

One can understand the inclination to rely on a beverage tax, since West Virginia ranks high in soft drink consumption. Still, excise taxes tend to be regressive, and some more so than others. When it comes to soft drinks, somewhat atypically, consumption increases as income declines—rather than the other way around. This results in higher consumption among young people, low-income earners, racial and ethnic minorities, and those without a college education.

In 2017, about 38 percent of West Virginians consumed soda at least once per day, and almost 80 percent of residents consumed soda. On a national level, residents were about three times as likely to consume soda daily if they had not finished high school compared to college graduates.

By itself, the fact that some excise taxes have regressive effects is not an argument against levying them, as a user-pays system or the internalization of meaningful externalities can be good policy, but the effect does underscore the importance of not relying on regressive excise taxes to generate significant tax revenue above and beyond the legitimate aims of excise taxation.

Gov. Justice and state House Republicans have laid out their proposals for a more competitive tax code in hopes of attracting new residents to the state, and Senate Republicans are working on a plan as well. The governor’s plan would raise the sales tax rate, broaden the sales tax base (including to business inputs), raise certain excise taxes, and impose a “luxury tax” on certain purchases. The House Republican plan phases in income tax annual rate reductions without revenue offsets. A Senate Republican proposal has yet to be released, but discussions thus far appear to involve offsetting revenues from other taxes.

So to answer the question posed, whether excise taxes on beverages are a good substitute for income taxes: Policymakers should be very cautious about relying too heavily on excise tax increases to pay down tax reductions elsewhere. Ideally, revenue offsets would come from more stable, broader-based revenue sources.

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The tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.

An excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and make up a relatively small and volatile portion of state and local tax collections.

An individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. Individual income taxes are the largest source of tax revenue in the U.S.