Targeting Tobacco: The Budgetary Effects of a Cigarette Tax Increase

CBO's latest report details the full effects on the federal budget of raising the federal excise tax on cigarettes. As they would when analyzing any tax policy, CBO estimates the revenue effect of this tax increase by looking both at how an increase in taxes would increase revenue, and how the subsequent reduction in cigarette purchases would reduce revenue. This report goes further, however, looking at the secondary microdynamic effects when accounting for changes in people's health. In reading through the report, one gets a thorough understanding of how many different factors interact with each other within the budget.

CBO analyzes the effect of a 50 cent increase in the cigarette tax, one which raises $38 billion of revenue through 2021 before accounting for health effects. To the extent that the tax causes cigarette consumption to decline, CBO finds that this will result in an improvement in people's health. The effects that this improvement has on the budget are numerous and include:

  • Effects of lower per capita health spending on outlays
  • Effects of increased longevity on both revenue and outlays
  • Effects of increased earnings on revenue
  • Effects of lower health insurance premiums on revenue

Through 2021, these effects reduce the deficit by an additional $4 billion through 2021. Most of this comes from increased earnings that lead to higher revenue, but also from lower outlays in health programs. Over the long term, the magnitude and even direction of the secondary effects change somewhat. 

Budgetary Effects of Cigarette Tax Increase (billions)
  Nominal Dollars Percent of GDP
  2013-2021 Savings 2025 Savings 2035 Savings 2085 Savings
Cigarette Tax Receipts $37.8 0.018% 0.017% 0.018%
Medicare Effects $0.3 *** -0.001% -0.007%
Other Health Program Effects $0.7 +0.001% +0.001% +0.001%
Social Security Effects $0.1 -0.001% -0.002% -0.005%
Other Outlay Effects  * *** -0.001% -0.002%
Secondary Revenue Effects $3.2 +0.005% +0.007% +0.009%
Total Savings $41.7 0.023% 0.023% 0.015%

Source: CBO
Note: Numbers may not add up due to rounding.
*Number is less than $100 million
***Number is smaller than 0.0005 percent of GDP and thus not presented by CBO

One would think that improvements in health would reduce spending in federal health care programs, and indeed this is true for Medicaid and the exchange subsidies. But importantly, better health actually has two offsetting effects – it reduces per-capita health care costs each year while at the same time increasing the number of years people live and therefore collect government benefits (including Medicare). This means that even as Medicaid and other non-Medicare health costs go down, Social Security costs go up. Medicare is more ambiguous, but CBO finds that over the long-term increased longevity pushes up costs for Medicare over the long term by more than improved health reduces them. In addition, increased longevity pushes up costs in Social Security, since the program would not "benefit" from reductions in per capita health spending.

At the same time, improved health and longevity increases the time that people are in the labor force and how much they earn when they are. CBO attributes some degree of higher earnings to not smoking or quitting and obviously the longer someone is in the labor force, the longer they are paying taxes. Also, improved health would marginally lower health insurance premiums overall, making the value of employer-sponsored health insurance go down and encouraging employees to take more compensation in the form of taxable income.

In terms of the comprehensive budgetary effects, the tax itself raises about 0.02 percent of GDP annually over the long term, but the secondary effects vary. The revenue enhancing aspects kick in faster than the outlays, so through sometime in the 2060s, the tax's overall deficit reduction is greater than the revenue brought in. By the 2060s, the outlay-increasing effects of longevity surpass the revenue effects, making the tax's overall deficit reduction less than the tax's revenue.

The graph below from CBO shows how these secondary effects change over time.

Source: CBO

Of course, increased longevity is great for the country, and only harms the budgetary bottom line if we allow it. One way to mitigate the effect of increased life expectancy on old-age programs is to index the Social Security and Medicare retirement ages for changes in life expectancy. Taking an approach that maintains the ratio of years in retirement to years worked, for example, would allow retirees and taxpayers to share in the gains of longevity; more aggressive indexing could still serve as a “win-win.” And increasing the retirement ages would have its own deficit-reducing secondary fiscal effects, which we detailed here.

If anything, the report is an interesting example of how policies can affect so many different parts of the budget, and how CBO's scoring can account for important microdynamic effects. It is certainly worth a read.