Tax Policy – Kentucky Legislature Passes Flawed Excise Tax on Vapor Products

Early this month, state legislators in Kentucky passed a revenue package (HB351) which includes an excise tax increase on vapor products. The bill divides vapor products into two categories, open tank systems and cartridge-based systems, with two tax rates. Governor Andy Beshear (D) is expected to sign the bill.

Cartridges will be taxed at $1.50 per unit and open vaping systems will be taxed at 15 percent of wholesale value. According to Kentucky’s Legislative Research Commission, the tax will raise $25 million over the next two years. Most of this revenue will fund other non-vaping-related measures within the revenue bill.

One of the arguments for imposing a hefty tax on cartridge-based systems is the increased use among youths. A survey of high schoolers, published in the fall 2019, found that 27.5 percent of students had vaped at least once in the prior 30 days, though only 10 percent of students were considered regular users (defined as vaping 20 days out the prior 30). While youth uptake is a very real concern, tax policy is not the appropriate way to address it.

There are several issues with the design of Kentucky’s new vapor products tax. First, cartridges are taxed at a higher rate than cigarettes. One cartridge can be compared with one pack of 20 cigarettes, but the rate for a cartridge is $1.50, whereas cigarettes are taxed at $1.10 per pack. This discrepancy goes against the concept of harm reduction, which is the approach that it is more practical to reduce harm associated with use of certain goods than avoiding it completely through bans or punitive level taxation. In the context of vapor products and cigarettes, it is important because the risk profiles for the two products are wildly different. Public Health England, an agency of the English Ministry for Health, concludes that vapor products are 95 percent less harmful than cigarettes.

Harm reduction is connected to excise tax design because cigarettes and vapor products are economic substitutes. With excise tax policy, increases or decreases in tax rates of certain goods can affect consumption of other goods that might be substitutes. That is to say, the effectiveness of cigarette excise taxes goes up when cheaper substitutes are widely accessible—and vice versa. In fact, research that looked at the effect of vapor taxes in Minnesota concluded that 32,400 people who would otherwise have quit smoking traditional cigarettes still smoked them as a result of the tax.

Hence, lawmakers should consider taxing nicotine products relative to their harm—not taxing harm-reducing products higher than more harmful combustible tobacco products. This is not a new concept to lawmakers in Kentucky, as it is already recognized by Kentucky law. There is a provision in the state’s tax code that cuts tobacco and vapor taxes in half if the FDA classifies a product with a modified risk tobacco product (MRTP) order. Fortunately, this provision survives; earlier versions of HB351 would have repealed it.

Second, the excise tax levied on open tank systems is non-neutral as it is based on value (ad valorem). Taxing the value of a good hurts consumer choice and product quality as it incentivizes manufacturers and retailers to concentrate their efforts on selling lower-priced products to limit tax liability. It incentivizes 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.

It should be a guiding principle that excise taxes are only levied when appropriate to capture some externality or to create a “user pays” system—not as a general revenue measure. Due to their narrow base, they are not a sustainable source of revenue for recurring spending priorities.

As lawmakers thread the needle between protecting adult smokers’ ability to switch and barring minors’ access to nicotine products, they would be well-advised to remember the policy spillover effects. Tax policy is not conducted in a vacuum and limiting access to vapor products with high taxes could hurt tobacco-related public health priorities.

For a complete guide to taxation of nicotine products, click here.

Source: Tax Policy – Kentucky Legislature Passes Flawed Excise Tax on Vapor Products