Tax Policy – Michigan Vapor Tax Bill Gets It Half-Right

In line with the nationwide trend of taxing vapor products, the Michigan Senate has passed a new 18 percent tax on vapor products. These taxes are often intended to achieve a two-fold goal: deterring youth use and raising revenue. The Michigan bill is no exception.

On Wednesday, SB781 passed the Senate on a 33-5 vote. The bill would, if enacted, impose an excise tax on vapor products at a rate of 18 percent of wholesale value and $0.50 per ounce of alternative nicotine products. Alternative nicotine products are defined as noncombustible nicotine products intended for human consumption but does not include FDA-approved tobacco cessation products. Both new taxes would take effect January 1, 2021. The bill will now move to the Michigan House for consideration.

SB781 was passed alongside SB783, which includes language that specially allows flavored products. This is positive because outright bans on flavored products result in several issues. In the same way that exceptionally high tax rates on products can create the incentives for illicit activities, a ban certainly opens the door to contraband and bootleg activities. Thus, bans are likely to hurt public health by limiting adult smokers’ ability to quit cigarettes and fuel black market activity. Local bans in particular invite smuggling activity in the same way that occurs when localities have high tobacco excise taxes.  

Another positive element of the bill is the excise tax design for alternative nicotine products. As I have previously argued, such products should be well-defined and taxed by weight at relatively lower rates. SB781 does all of these things well.

On the negative side, the bill suggests taxing vapor products based on price (ad valorem). Vapor products with similar qualities and in similar quantities should have equal tax liability regardless of design or price, a principle ad valorem taxes ignore. 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 bill does weed out one of the common issues with ad valorem taxes on vapor products by specifically excluding devices and batteries from taxes.

A superior design would be a tax based on volume, as 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. For instance, in vertically integrated companies (some vape shops both manufacture and retail vapor liquid), taxable value must be computed to estimate tax liability. Taxing based on quantity rather than value makes it easier for governments to forecast revenue as it is not affected by changes in consumer brand preference or retail prices. Simple taxes lower compliance costs and make it easier for tax authorities to enforce the tax.

While the tax base is not ideal, the rate looks relatively sensible. To encourage harm reduction (consumers switching from more harmful cigarettes to less harmful vapor products), the products should be taxed relative to harm. Thus, excise taxes on vapor products should be relatively low compared to combustible tobacco products as cigarettes and vapor products are economic substitutes, which means that increased prices on either may encourage consumers to switch to the other. To further enhance the harm reduction element, Michigan lawmakers should consider including a Modified Risk Tobacco Product (MRTP) provision. Five states already have provisions in their tax code that automatically lower the tax rate for products designated MRTP by the Food and Drug Administration (FDA).

Finally, a guiding principle is that excise taxes should only be 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 general spending priorities. Unfortunately, SB781 does not respect this principle. Rather, it appropriates only the first $5.25 million (of $10 million in the first full fiscal year) to externality-related spending. The remainder of the revenue is allocated to the general fund.

All in all, SB781 gets it half-right for nicotine consumers and businesses in Michigan. By respecting the concept of harm reduction and protecting flavors, the bill does not encourage illicit trade or substitution from vapor product to traditional cigarettes. On the other hand, the tax design does encourage down-trading and could increase compliance costs for vertically integrated companies.

Source: Tax Policy – Michigan Vapor Tax Bill Gets It Half-Right