May 16, 1997

States and Taxpayers Hurt By Proposed Federal Increase

It's been argued publicly that a new tobacco tax (such as that contained in S. 526) could be used to pay for an expanded children's health insurance program (such as S. 525, the Child Health Insurance and Lower Deficit Act), reduce smoking and reduce the deficit. Win, win, right? Yet, what's not been put before the public is the other side of the story, that is, the adverse effects that such a tax would have on existing programs at both the federal and state levels.

Most importantly, the proposed tobacco tax will adversely affect states as their revenues drop from dampened sales caused by the substantial (43 cents per pack) new federal tax. Even by conservative estimates, the effect of S. 526 amounts to a loss to States of at least $6.5 billion (over five years) from reduced tobacco sales.

Federal programs would be affected also. Tobacco is used in the calculation of the consumer price index (CPI), and since the tax would increase the cost of tobacco, this will raise the CPI. A sizeable portion of the federal budget (spending and taxes) is adjusted according to the CPI, and so, while the tax bill earmarks one-third of the revenues (total revenues are expected to amount to $30 billion) to deficit reduction, any deficit reduction expected from the tax first must have subtracted out from it this inflationary effect. CPI's bottom-line impact: an estimated cost of $4 billion over five years: that is $1.4 billion (over five years) in lost federal tax revenue and another $2.6 billion (over five years) in increased federal outlays.

These two bills would have a profound impact on health policy as well. While S. 525 (the child insurance bill that S. 526, the tax bill, would fund) is billed as a voluntary federal program, the states' loss of revenue from reduced tobacco sales likely would compel them to participate in the program. Meanwhile, the program itself contains numerous mandates that would increase costs to the states. In essence, states would find themselves losing twice, once from lost tobacco tax revenue, and then from incurring increased costs from the program's mandates.

Finally, there is a question of future implications and the real possibility of a vicious cycle. Once the federal government makes use of a dramatic increase in the tobacco tax, what will stop further intrusions into states' revenue sources? And once a federal mandatory spending program is instituted, what will keep it from continuing to grow as have so many others? Taken together -- (1) the loss of income to state governments; (2) the effect on the federal budget through the CPI; (3) the cost of the mandates on state governments; and (4) the real possibility of further federal intrusion into state revenues -- there is good reason for pause.

The Hatch-Kennedy Proposal: S. 526 and S. 525

S. 526 would add a tax on cigarettes of 43-cents-per-pack and of varying amounts on other tobacco products beginning October 1, 1997, which sponsors claim -- and the Joint Committee on Taxation (JCT) concurs -- will raise $30 billion in federal revenue over five years. This tax represents a 179-percent increase from the current 24-cents-per-pack federal tax on cigarettes; a 569-percent increase on chewing tobacco -- from 36 cents to $2.41 per pound; and a 4,975-percent increase on snuff -- from 12 cents to $6.09 per pound. This increase in federal revenue is intended to offset the cost of S. 525, the Child Health Insurance and Lower Deficit Act, which distributes two-thirds ($20 billion) of the money to states to establish programs to increase insurance coverage among their uninsured child population. Sponsors intend the remaining $10 billion would go to deficit reduction.

The tax bill is intended to cover program costs and to actually reduce the size of the deficit. This is an improvement over many of the existing uninsured child proposals -- such as President Clinton's -- which make no attempt to offset their cost and thereby increase the deficit by a corresponding amount. Yet, while the intention of the Hatch-Kennedy bills to offset the costs of the program to insure uninsured children is admirable, the bills' actual effects leave much to be desired.

The Effect of S. 526 on States and Local Revenues: A Loss of $6.5 Billion

The effect of the tobacco tax at the state and local level would be significant because states depend to a great degree on excise tax revenue. The current federal cigarette tax is 24 cents per pack, while the average local tax is 35 cents per pack. According to the U.S. Census, states collected $7.4 billion from tobacco taxes in 1995, while county and municipal governments collected $181 million in 1996.

The effect of any tax is to reduce the demand for whatever is taxed from what it would otherwise have been. According to the JCT's assumptions, the substantial 23-percent price increase from a 43-cents-per-pack federal tax hike would result in a marked decline in sales: estimated 1998 cigarette sales would fall from 23.6 billion to 19.6 billion packs. This is a 17-percent decrease in demand.

Here's how we figure the loss to state and local governments. For simplification purposes, we assume that demand for tobacco products would not increase (despite population increasing) over the three years between 1995 and 1998 (when the tax would begin to take full effect). Then, we apply the 17-percent consumption decrease to the $7.4 billion 1995 state revenues and the $181 million 1996 municipal revenues and get an annual decrease of $1.3 billion. Over five years the loss to state and local coffers would be $6.5 billion.

Unfortunately for bill proponents, this loss of state and local revenue would directly impact state-run health and education programs, particularly those states that "earmark" tobacco taxes for these programs.

16 States Earmarking Tobacco Taxes for Health or Education

Alaska - education	Michigan - health and education
Alabama - education	Minnesota - health
California - health	Missouri - education
Florida - health	Nebraska - health
Idaho- health	New Mexico - health
Illinois - education	Pennsylvania - health
Kentucky - health	Tennessee - education
Massachusetts - health	Texas - education

These lost revenues will not easily be replaced. Higher tobacco taxes at the state or local levels would depress sales even further. Further, competition between states and localities to maintain competitive tax rates (and thus prevent lost sales from consumers crossing boundaries into less-taxed localities) would act to prevent tax increases.

CPI Effects Eat $4 Billion of Would-Be Deficit Reduction

In addition to the tax impacting on demand for tobacco products, it would indirectly affect both federal spending and federal revenues through its effect on the CPI-adjusted programs. CPI calculations include the cost of tobacco. The CPI is in turn used to make adjustments in both retirement COLAs and tax bracket indexation. The current average price per cigarette pack is $1.86, and so the one-time increase of 43 cents per pack amounts to a 23-percent increase. This would have a significant impact on the overall cost of tobacco (under the reasonable assumption that the increase will be fully passed to the consumer) and create a one-time spike in the CPI, thus increasing entitlement spending and decreasing federal revenues (as tax brackets, etc. were increased).

The one-time cost of the CPI effect would be $3.54 billion (split roughly 65/35 between outlays and revenues). Furthermore, because the one-time increase would add to the future base for these programs, the one-time increase itself would have to be inflated by the estimated inflation rate for the following years. The Congressional Budget Office estimates inflation to be 3 percent per year for the following four years, thus the one-time spike would amount to a $3.98 billion total over five years (and $4.62 billion over ten years).

Thus the total deficit effect of S. 526 -- assuming the cost of the health program remains at $20 billion -- would be only 60 percent of the deficit reduction that sponsors claim, or $6 billion rather than $10 billion.

States Face Risks and Costs Participating in New Child Health Program

The combined effect of S. 525 and S. 526 likely would be to increase gross federal outlays by at least $20 billion over five years (this assumes there is no federal cost associated with the program beyond the block grant amount; a full estimate will have to be done by the Congressional Budget Office). All of these new outlays would be classified as mandatory spending -- the fastest growing part of the federal budget (Sec. 2824, page 20 of S. 525 requires "budget authority in advance of appropriations Acts, and represents the obligation of the Federal Government to provide payments to the States..."). The deficit effect would be a decrease of $6 billion (see CPI discussion, above) because of the deficit reduction component of S. 526.

In contrast, the effect of these two bills would be very different on the state and local governments. Because of the loss of excise-tax revenues, states likely would find themselves compelled to participate in S. 525's block grant program. In order to make up the lost revenue -- in 16 states, that's a loss of resources earmarked for health or education programs -- states would need to make up the shortfall, and the block grant money in S. 525 would be an obvious source.

Yet, in order to receive money under S. 525, states would have to submit to numerous mandates required by that bill. According to the Senate Assistant Majority Leader's office, S. 525 would place more than 30 new mandates on a participating state. Any state plan would have to be approved by HHS. States would be required to provide the entire Medicaid benefit package to all eligible children and would be prohibited from receiving a waiver to allow modification of its child eligibility requirements. Other mandates include: requiring states to enter into contracts with community health centers and traditional providers; establishing an outreach system; providing cost-sharing assistance; and creating an appeals process. Those states currently funding abortions under their state-run Medicaid program also would be required to do so under S. 525's programs.

S. 525 contains a mandate on participating States to spend additional resources to match federal spending: States would have to pay at least 50 percent of administrative costs, 40 percent of their current Medicaid costs (poorer states must only pay 30 percent now), and no less than 10 percent of program costs.

Finally, states would be left holding the bag once the new mandated benefit programs are put in place. The federal government would only provide a limited contribution, and if the costs of the new state mandates exceeded it, states would be responsible for the entire difference. In this sense, it becomes a kind of backdoor per capita cap -- which President Clinton espoused in his latest budget but which the nation's governors have strenuously rejected. Even if federal dollars are sufficient to run the new program, the proposal would require states to pay additional money for program and benefit increases in other child health areas -- thus requiring additional state taxes or spending cuts in other state priorities.

A New Precedent: Intrusion into States' Revenue Sources?

The precedent of raising federal excise taxes at the expense of the states could be the most costly aspect of the Hatch-Kennedy proposal to the states. Tobacco taxes are important revenue sources for state and local governments. It is hard to imagine that if this revenue source proves successful, that the federal government would not again look to it. Furthermore, success with a large tobacco tax could open the way for federal increases in so-called "sin taxes" or in excise taxes overall. All of these -- like the tobacco tax -- are vital revenue sources for the states.

Unconsciously then, the overall Hatch-Kennedy proposal could constitute a new wrinkle in unfunded mandates, whereby the cost for federal initiatives is passed on to the states. Rather than an outright foisting of the costs onto the states, the federal government ostensibly pays a large portion. However, the federal money is raised from an important state revenue source, which in turn acts to force states into accepting mandated new spending.

Cause for Pause

S. 526 demonstrates that as much as proponents might wish to disregard the fact, a tax is still a tax. As such, it has both the deleterious economic and the fiscal aspects of all taxes. Like any tax, S. 526 will reduce the demand on the good being taxed. Even if one believes that decreased demand for tobacco is positive from a societal view, it still has negative fiscal effects for the states.

There is also the general negative fiscal effect of tax increases: they consistently fail to match government spending, in particular mandatory spending such as that envisioned by the Hatch-Kennedy proposal. The fact that there have been budget deficits since 1969 and the projection of growing deficits in the future demonstrate this fact. Together, S. 526 and S. 525 could well become a micro version of the macro budget problem of revenues' failure to match outlays. First, the requirement for state spending -- both via mandates and matching funds -- means that from the outset, grants to the states are only part of the total funding that sponsors of Hatch-Kennedy envision. Second, with less money flowing to state treasuries from reduced excise-tax revenues, it will be even more difficult to carry out the aims of S. 525 at the state level. Shortfalls are inherent in the model and these shortfalls raise the question as to how long it will take before program spending is increased at the federal level.

The revenue effect of S. 526 also undercuts sponsors' claims that S. 525 is a voluntary program. First, it should be remembered that the technically "voluntary" nature of a federal program does not preclude the imposition of mandates. Medicaid is a case in point. Many of the "options" for states to expand Medicaid eligibility have become mandates over time, and at the same time, the cost of the program has grown dramatically. However, in the case of the Hatch-Kennedy proposal, the forces pushing states toward joining will be even more powerful. There can be no doubt that state revenues will fall as the new federal tobacco tax depresses demand. States will be faced with the choice of making up this loss elsewhere or accepting S. 525's mandates. These mandates will further increase state spending. Because of maintenance-of- effort requirements contained in S. 525, the spending will have to come out of other programs or from increasing taxes.

Nor should the overall amount of the block grant pool obscure the fact that states may well have to pay more at the same time that their revenue base is eroded. First, because grant money will be distributed according to the amount of uninsured children, high-tobacco-tax states (which will feel a disproportional loss of tobacco tax revenue since the overall price will be highest here) with low uninsured populations may experience a real net loss.

Even if a state experiences no net loss of money, S. 525's mandates (such as the Sec. 2852's Maintenance of Effort requirements) will require it to experience a real spending increase. On the surface, the program may seem to give states an additional $20 billion to spend. However, this money is really only funneled through the states. States will in effect have to "build the funnel" by paying for a variety of new costs through matching requirements and new obligations.

Overall S. 526, the tax bill, will cost the states at least $6.5 billion in reduced revenues. When the new spending costs of S. 525 are added to this figure, the cost to the states will be much more. Combined, the two bills create a situation where states will be persuaded to assume new federal mandates, but will be placed at much greater financial risk for fulfilling their end of the bargain.

If the intention is to help uninsured children by having states help them, a better approach would be to abandon mandates and new taxes altogether. There are already sufficient federal mandates, federal taxes, and federal spending to allow for helping uninsured children. Reprioritizing within the $1.7 trillion annual federal budget would allow us to help uninsured children without hurting the states.