The 2020-21 Budget: Taxation of E-Cigarettes

The 2020-21 Budget: Taxation of E-Cigarettes GABRIEL PETEK LEGISLATIVE ANALY ST FEBRUARY 24, 2020 analysis full gutter 2020-21 BUDGET LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET Executive Summary State Taxes Cigarettes and E-Cigarettes. The state levies a $2.87 per pack tax on cigarettes. The state currently taxes other tobacco products—including e-cigarettes—at 59 percent of the wholesale price. Governor’s Budget Proposal New Tax on E-Cigarettes. The Governor has proposed a new state tax on e-cigarettes at a rate of $1 for every 20 milligrams of nicotine in a product (in addition to the existing tax). The stated goal of this proposal is to reduce youth use of e-cigarettes. The proposal does not include an inflation adjustment. Revenue Would Go to New Special Fund. The Governor proposes that revenue from the proposed e-cigarette tax be deposited into a new special fund. The fund would be available for three purposes: administration and enforcement of the new tax, tobacco youth prevention programs, and health care programs. 2020-21 Spending Proposals. In 2020-21, the Governor proposes spending $9.9 million from the new fund on tax administration and $7 million on an enforcement tax force. LAO Comments Effects on Vaping and Smoking. Our review of available evidence suggests that the proposed tax likely would reduce both youth and adult e-cigarette use substantially. The tax also likely would increase adult cigarette smoking. The effects on youth cigarette smoking are unclear. Tax Structure. If the Legislature wishes to enact a new tax on e-cigarettes, the proposed nicotine-based tax structure is reasonable. If the Legislature agrees with the Governor’s focus on reducing youth e-cigarette use, we suggest it consider alternative nicotine-based taxes that place higher rates on products that tend to encourage or enable youth use. Governor’s Proposed Tax Rate. The administration estimates that its proposal would result in roughly the same state tax rate on nicotine intake, whether that intake comes from e-cigarettes or conventional cigarettes. The administration, however, has not presented a compelling argument for this rate. In particular, it has not made a case that e-cigarettes and cigarettes are equally harmful, nor that the current cigarette tax is set at the right rate. The administration’s comparison also does not account for federal taxes. Initial Tax Rate. As the Legislature considers what tax rate to set on e-cigarettes, it faces six key questions: • How harmful are e-cigarettes? • To what extent do vapers’ choices account for these harms? • How would the tax rate affect e-cigarette use? • How would the tax rate affect other outcomes, such as cigarette smoking? • How would the tax rate affect compliance with the tax? • How would the tax interact with other state and federal policies? www.lao.ca.gov 1 analysis full gutter 2020-21 BUDGET Future Tax Rates. We recommend that the Legislature index the tax rate to inflation to keep its economic value steady over time. We also recommend that the Legislature revisit the rate frequently in the coming years. Revenues. We estimate that the new tax would raise tens of millions of dollars annually. Revenue Allocation. We recommend that the Legislature take an approach to revenue allocation that prioritizes flexibility. Ideally, this would mean depositing the revenue into the General Fund. If, however, the Legislature prefers to deposit the revenue into a special fund, the Governor’s proposed approach is better than a restrictive, formulaic approach. Tax Stamps. The Governor proposes $8 million in 2020-21 and ongoing for a stamp contract. In the cigarette tax program, stamps help distinguish tax-paid cigarettes from others. Stamps could have similar enforcement benefits for e-cigarettes, but they would need to be more complex. The administration does not appear to have considered this complexity carefully enough to justify the requested appropriation. 2 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET BACKGROUND What Are E-Cigarettes? Vaping products are from cigarettes. In addition to nicotine’s electronic devices that heat liquid to create an addictive properties, researchers have raised aerosol inhaled, or “vaped,” by the user. This report other concerns about its effects, particularly uses the term “e-cigarettes” to refer to devices with regard to youth brain development. that create aerosols containing nicotine—the • Other Aerosol Contents. E-cigarettes contain substance that makes tobacco products addictive. much smaller amounts of the known toxicants E-cigarettes come in a variety of forms, and the mix and carcinogens present in cigarettes. That of available products has changed rapidly in recent said, emerging research suggests that they years. Some e-cigarettes create aerosols that are may contain other substances of potential unflavored or tobacco-flavored, while others taste concern. More generally, many of the like fruit, candy, menthol, or mint. long-term health effects of e-cigarette use E-Cigarette Health Concerns. Researchers appear to be unknown at this time. and public officials have raised a variety of health concerns related to e-cigarettes and to vaping E-Cigarette Use more generally. We classify these concerns into Youth Use of E-Cigarettes Has Grown Rapidly. three categories: As shown in Figure 1, youth e-cigarette use has • 2019 E-Cigarette or Vaping Use-Associated grown rapidly in the U.S. over the last few years. Lung Injury (EVALI) Outbreak. In the summer Nationwide, the share of high school seniors who of 2019, public health officials in many states report using e-cigarettes at least once in the past reported a sharp increase in severe lung injuries Figure 1 associated with the use of vaping devices. This increase Nationwide, Youth Use of continued until September E-Cigarettes Has Grown Rapidly 2019, at which point the Share Using E-Cigarettes At Least Once in the Past 30 Days (Self-Reported) number of new EVALI cases began to decline. As 30% of February 4, 2020, the Centers for Disease Control 25 and Prevention (CDC) had received reports of 2,758 20 hospitalizations and 64 8th Grade 10th Grade deaths resulting from these 15 injuries. The CDC has identified a substance used 10 in certain illicit cannabis 12th Grade products as a key factor 5 contributing to EVALI, but investigations into the causes of these injuries are 2017 2018 2019 still ongoing. Source: Miech, Richard, Lloyd Johnston, Patrick O'Malley, Jerald Bachman, and Megan • Nicotine Concentrations. Patrick (2019). "Trends in Adolescent Vaping, 2017-2019." New England Journal of Medicine Many e-cigarettes enable 381:1490-1491. users to inhale more nicotine than smokers typically obtain www.lao.ca.gov 3 analysis full gutter 2020-21 BUDGET month rose from 11 percent in 2017 to 25 percent by purchasing cigarettes over the Internet in 2019. Despite California’s relatively low and from retailers in lower-tax states. A 2009 declining rates of cigarette smoking, the state also federal law known as the Prevent All Cigarette has experienced rapid growth in youth e-cigarette Trafficking (PACT) Act gives states some use. As shown in Figure 2, e-cigarettes were roughly five Figure 2 to six times as popular as Among California High School Students, conventional cigarettes among E-Cigarettes More Popular Than Cigarettes California high school students during the 2017-18 school year. High School Students' Reported Tobacco Use in 2017-18 California Student Tobacco Survey Daily E-Cigarette Users Disproportionately Young, but Combustible Cigarettes Most Are Adults. As shown in Figure 3, daily e-cigarette users Not Users are disproportionately young, but Users the majority are adults. One-fifth E-Cigarettes of daily users are under 18 and another fifth are 18 to 24 years Not Users Users old. The remaining three-fifths are 25 or older. Current Cigarette and 1 to 2 3 to 5 6 to 19 20 to 30 E-Cigarette Policies Days of Use in the Last 30 Days State Taxes Cigarettes. California levies a $2.87 per pack excise tax on cigarettes. Ballot measures have enacted $2.75 of this rate, while the Legislature has Figure 3 enacted the other $0.12. Two of Daily E-Cigarette Users Are the key tools used to enforce this Disproportionately Young, but Most Are Adults tax include: Share of Daily E-Cigarette Users Nationwide • Stamps. To pay the cigarette 25% tax, cigarette distributors purchase tax stamps from 20 the state-approved vendor, then affix them to packs of 15 cigarettes before they sell the cigarettes to wholesalers 10 or retailers. These stamps help tax administrators, businesses, and consumers 5 distinguish tax-paid cigarettes from others. 11-17 18-24 25-29 30-39 40-49 50-59 60+ • Federal Law on Purchases Age From Other States. Sometimes consumers try to Sources: 2018 National Youth Tobacco Survey, 2018 Behavioral Risk Factor Surveillance System, and 2018 American Community Survey. avoid state cigarette taxes 4 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET effective tools for preventing this type of tax (CDPH) to develop recommendations and take avoidance. actions related to e-cigarettes, including a vaping awareness campaign. State Taxes E-Cigarettes. California levies an • In November 2019, the Attorney General and excise tax on non-cigarette tobacco products. This local officials sued JUUL, a leading e-cigarette tax has applied to e-cigarettes since April 1, 2017. manufacturer, for allegedly marketing its The rate currently is 59 percent of the wholesale products to youth and failing to provide price. required health warnings. Required Adjustments Reduce Tax Rate Over Time. The California Department of Tax and The Legislature currently is considering further Fee Administration (CDTFA) must adjust the tax actions, including a bill that would ban flavored rate on non-cigarette tobacco products (including tobacco products (including flavored e-cigarettes) e-cigarettes) annually based on a formula originally and the tax proposal discussed in this report. established by Proposition 99 of 1988 and modified Federal Government Has Taken Actions. by subsequent ballot measures. Under this formula, Although the federal government levies excise the tax rate on e-cigarettes depends on the ratio of taxes on conventional cigarettes and most other the state cigarette tax rate to the average wholesale tobacco products, it does not levy such a tax on price of cigarettes. (In particular, the rate is equal e-cigarettes. However, the federal government has to this ratio multiplied by roughly 117 percent.) taken some steps towards regulating e-cigarettes. However, cigarette prices tend to grow over time, For example, in January 2020, the Food and Drug so the tax rate as a share of the overall price Administration (FDA) banned the sale of certain tends to decline over time. Correspondingly, the types of flavored e-cigarettes. The FDA additionally e-cigarette tax rate tends to decline over time as announced that e-cigarette manufacturers would well, as illustrated in Figure 4. need to submit applications for FDA approval by State Has Taken Other Actions. In addition May 2020. At this time, the scope and timing of to levying an excise tax, the state has undertaken further FDA actions are unclear, but the agency a variety of efforts related to e-cigarettes, with a particular Figure 4 focus on reducing youth use. Examples include: Required Adjustments Reduce California's Tax Rate on E-Cigarettes Over Time • Chapters 7 and 8, Statutes Tax Rate (Percentage of Wholesale Price) of 2016 (SB X2 5, Leno and SB X2 7, Hernandez) 70% raised the minimum age to 60 purchase e-cigarettes (and other tobacco products) 50 from 18 to 21. • Chapter 295, Statutes of 40 2019 (SB 39, Hill) imposed 30 stricter age verification requirements for e-cigarettes 20 (and other tobacco products) 10 sold online or by mail. • In September 2019, 2017-18 2018-19 2019-20 the Governor issued an executive order directing Fiscal Year CDTFA and the California Department of Public Health www.lao.ca.gov 5 analysis full gutter 2020-21 BUDGET appears to be taking a more active Figure 5 role in e-cigarette regulation than it Statewide E-Cigarette Taxes had in the past. Many States Tax E-Cigarettes. Year State Implemented Current Rate California is one of 18 states that currently levy statewide excise Taxes on Wholesale Price taxes on e-cigarettes. As shown in California 2017 59% Illinois 2019 15% Figure 5, these taxes come in four Maine 2020 43% forms: Minnesota 2012 95% • Percentage of Wholesale Nevada 2020 30% Pennsylvania 2016 40% Price. California is one of nine Vermont 2019 92% states that impose e-cigarette taxes as a percentage of the Tax on Retail Price New York 2019 20% wholesale price. The tax rates range from 10 percent to Taxes on Volume of E-Liquid 95 percent. Delaware 2018 $0.05/ml Kansas 2017 $0.05/ml • Percentage of Retail Price. Louisiana 2015 $0.05/ml New Jersey and New York tax North Carolina 2015 $0.05/ml retail sales of e-cigarettes at Ohio 2019 $0.10/ml 10 percent and 20 percent West Virginia 2016 $0.08/ml respectively. Taxes That Vary By Type of Product • Volume-Based. Nine states Connecticut 2019 10% of wholesale price levy e-cigarette taxes based or $0.40/ml on the volume of liquid, New Jersey 2018 10% of retail price or $0.10/ml with rates ranging from 5 to New Mexico 2019 13% of wholesale price 27 cents per milliliter. or $0.50 per cartridge • Cartridge-Based. New Washington 2019 $0.09/ml or $0.27/ml Mexico taxes cartridge-based e-cigarette products at $0.50 per cartridge. GOVERNOR’S PROPOSAL New Tax on E-Cigarettes. The Governor has exact amount of tax on each item would be proposed a new state tax on e-cigarettes with the determined in two steps: (1) rounding up the total stated goal of reducing youth use of e-cigarettes. amount of nicotine to the next-highest multiple (The new tax would be in addition to the existing of 20 milligrams, and (2) assessing a $1 tax per tax described above.) The proposed tax would go 20 milligrams, For example, the tax on an item into effect on January 1, 2021. The proposal also containing 92 milligrams of nicotine—roughly the includes a one-time tax on e-cigarette inventories amount in a four-pack of 3 percent nicotine JUUL to deter businesses from stockpiling untaxed pods—would be $5. products in advance of the tax increase. Governor’s Revenue Estimates. The 2020-21 Tax Rate. The rate of the new tax would be Governor’s Budget assumes that the proposed roughly $1 for every 20 milligrams of nicotine in e-cigarette tax would raise $34 million in 2020-21 a product (in addition to the existing tax). The and $55 million in 2021-22. That said, the 6 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET administration has emphasized that the amount of • Tax Administration. The Governor has revenue raised is highly uncertain at this time. proposed spending $9.9 million from the new Revenue Would Go to New Special Fund. The fund in 2020-21, $10.2 million in 2021-22, Governor proposes that revenue from the proposed and $10.4 million in 2022-23 for CDTFA to e-cigarette tax be deposited into a new special administer the tax. fund. The Legislature would appropriate the monies • Vaping-Related Enforcement. The Governor in this fund during the annual budget process. has proposed spending $7 million in 2020-21 The fund would be available for three purposes: and ongoing for the California Highway Patrol administration and enforcement of the new tax, (CHP) and the California Department of tobacco youth prevention programs, and health Justice (DOJ) to create a task force to enforce care programs. laws related to vaping devices generally 2020-21 Spending Proposals. The 2020-21 (not limited to e-cigarettes). We analyze this Governor’s Budget includes two specific proposals proposal along with other CHP proposals in for spending the revenue raised by the new tax. The 2020-21 Budget: Transportation. LAO COMMENTS In this section, we provide information and regarding youth cigarette smoking is more perspectives for the Legislature to consider as it ambiguous. weighs not just the Governor’s proposal, but also Tax Structure the design of e-cigarette taxes more broadly. Nicotine-Based Tax Reasonable. The amount Effects on Vaping and Smoking of nicotine contained in e-cigarette liquid can vary Tax Likely Would Reduce E-Cigarette Use widely, even for a given volume and price. For Substantially. Our review of available evidence example, retailers often sell ten-milliliter bottles of a suggests that the proposed tax likely would reduce given brand of liquid for the same price, regardless both youth and adult e-cigarette use substantially. of whether that liquid’s nicotine concentration That said, the size of these effects is uncertain. Key is high, low, or somewhere in between. Due to sources of uncertainty include recent changes in this variation, the Governor’s proposal to tax the e-cigarette market, potential major state and e-cigarettes based on nicotine content would federal policy changes besides the proposed tax, raise the cost of nicotine more directly and and the novelty of the proposed tax structure. consistently than a price-based, volume-based, or Likely Increase in Adult Smoking; Effects on cartridge-based tax. This would make the proposed Youth Smoking Unclear. In principle, the new tax tax structure more effective at discouraging nicotine could lead to higher or lower conventional cigarette consumption than the alternative tax structures. smoking. On one hand, to the extent that the This focus on nicotine—rather than some other tax reduces the number of people who become measure of the chemical composition of e-cigarette addicted to nicotine, it could reduce cigarette liquid—is reasonable for two reasons: (1) many smoking. On the other hand, to the extent that the e-cigarette health concerns are nicotine-related; tax reduces the number of smokers who switch and (2) information about e-cigarettes’ nicotine from cigarettes to e-cigarettes, it could increase content generally is readily available. cigarette smoking. In our view, the best available Alternative Nicotine-Based Structures Worth evidence suggests that the proposed tax likely Considering. If the Legislature agrees with the would increase cigarette smoking among adults, Governor’s focus on reducing youth e-cigarette use, at least over the first few years. The evidence we suggest it consider alternative nicotine-based tax structures that could target youth use more www.lao.ca.gov 7 analysis full gutter 2020-21 BUDGET effectively. In particular, the state could levy a the comparison should include federal taxes, since relatively high tax rate on products that tend to they also affect consumers’ behavior. encourage or enable youth use, and a relatively Setting the Tax Rate low tax rate on other products. For example, the Legislature could levy a higher tax rate on types of Consider Wide Range of Rates. The e-cigarettes that are smaller or easier to use, and a administration has not presented a compelling lower tax rate on other types. argument in favor of its proposed tax rate. More generally, the evidence we reviewed does not Assessing Governor’s Proposed Tax indicate any “sweet spot” that would make one Rate specific tax rate preferable to others. Consequently, Administration Aims to Tax Vaped we suggest that the Legislature consider a wide and Smoked Nicotine at Same Rate. The range of possible rates. As it considers what tax administration has indicated that it intends to rate to set, the Legislature faces six key questions: tax nicotine intake at the same rate, regardless • How Harmful Are E-Cigarettes? The choice of whether the nicotine is vaped or smoked. of an e-cigarette tax rate depends crucially The administration estimates that the proposed upon a full assessment of the harmful e-cigarette tax rate of $1 per 20 milligrams of effects of e-cigarettes, which requires close nicotine, combined with the existing tax rate of consultation with scientific experts. All else 59 percent of the wholesale price, would bring the equal, the greater the harm, the higher the state’s overall tax rate on e-cigarettes roughly in appropriate tax rate. line with its tax rate on conventional cigarettes. • To What Extent Do Vapers’ Choices Are E-Cigarettes and Cigarettes Equally Account for These Harms? The choice of Harmful? Given potential substitution between a tax rate depends on the extent to which cigarettes and e-cigarettes, we suggest considering consumers’ choices—such as whether or the two tax rates in relation to each other. If the not to vape, and how much—account for Legislature views cigarettes and e-cigarettes as e-cigarettes’ harmful effects. All else equal, equally harmful, then taxing them at the same rate the greater the extent to which vapers’ could make sense. The administration, however, choices account for these harms, the lower has not presented an argument that they should be the appropriate tax rate. The answer to considered equally harmful. this question likely differs between youth Is the Cigarette Tax Currently Set at the and adults, both of whom represent large Right Rate? Even if the Legislature shares the shares of the overall population of frequent administration’s intent of taxing e-cigarettes e-cigarette users. and cigarettes at the same rate, a key question • How Would the Tax Rate Affect E-Cigarette remains: what should that rate be? As long as Use? In general, we would expect higher the Legislature is considering changes to the tax rates to reduce actual e-cigarette e-cigarette tax rate, we see no reason to rule consumption more effectively than lower tax out changes to the cigarette tax rate as well. rates. Whether the current rate appropriately balances the • How Would the Tax Rate Affect Other trade-offs discussed above is unclear. (As noted Outcomes, Such as Cigarette Smoking? In in the “Background” section, ballot measures have general, we would expect higher e-cigarette enacted cigarette taxes totaling $2.75 per pack.) tax rates to increase adult smoking more than Why Not Consider Federal Taxes? The federal lower rates. (As noted above, the effects on government currently taxes cigarettes at $1.01 per youth smoking are unclear.) As noted above, pack but does not levy a tax on e-cigarettes. If the however, the Legislature could consider Legislature would like to set the e-cigarette tax rate changing not just the tax rate on e-cigarettes, based on a comparison to the cigarette tax rate, 8 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET but also the tax rate on conventional to this inflation, the real economic value of any cigarettes. fixed amount of money—such as one dollar per • How Would the Tax Rate Affect Compliance 20 milligrams of nicotine—diminishes over time. With the Tax? In general, we would expect As shown in Figure 6, for example, tax rates set higher tax rates to reduce tax compliance in fixed dollar terms—such as the state’s taxes more than lower rates. For example, a on cigarettes and distilled spirits—do not remain higher tax rate would give consumers fixed in economic terms. Instead, absent policy a stronger incentive to avoid the tax by changes, they tend to decline over time. To address purchasing e-cigarettes from out-of-state over the Figure 6 Internet. The PACT Act does Inflation Can Reduce Real Tax Rates Over Time not apply to e-cigarettes, so the state’s ability to deter Real Tax Rate on Distilled Spirits this type of tax avoidance is 2019 Dollars per Ounce somewhat limited. $0.14 • How Would the Tax Legislative Increase 1967 Interact With Other State 0.12 and Federal Policies? In 0.10 general, the greater the extent of other state or 0.08 federal policy actions to 0.06 Legislative Increase 1991 reduce youth e-cigarette 0.04 use, the lower the tax rate needed to achieve this 0.02 policy goal. For example, if the state bans flavored 1959 1969 1979 1989 1999 2009 2019 e-cigarettes, the tax rate need to achieve a given reduction in youth vaping Real Tax Rate on Cigarettes likely would be lower than if 2019 Dollars per Pack the state does not enact a $3.50 flavor ban. Proposition 56 3.00 2016 Recommend Revisiting Rate Frequently. Currently available 2.50 answers to these questions likely do not provide clear guidance 2.00 on the tax rate. Accordingly, we Proposition 10 recommend that the Legislature 1998 1.50 revisit the e-cigarette tax rate at least once every two years to 1.00 Legislative Proposition 99 Increase 1967 1988 assess the need for changes. 0.50 Adjusting Rate for Inflation 1959 1969 1979 1989 1999 2009 2019 Inflation Can Reduce Real Tax Rates Over Time. Prices tend to rise over time. Due www.lao.ca.gov 9 analysis full gutter 2020-21 BUDGET this issue, some of the state’s tax policies—such on e-cigarettes—could have large effects on as fuel tax rates, cannabis cultivation tax rates, e-cigarette sales in California. and income thresholds used to calculate income • Consumer Response to Tax. The extent to taxes-include statutory language directing the which consumers would respond to the tax by administration to adjust these policies annually to reducing e-cigarette use or avoiding the tax account for inflation. through other means is uncertain. Governor’s Proposal Does Not Include Useful Data Could Be Available Soon. Inflation Adjustments. The Governor’s e-cigarette Until recently, the state did not require tobacco tax proposal does not include annual inflation taxpayers to distinguish e-cigarettes from other adjustments. The administration argues that types of tobacco products (such as cigars or adjusting the new tax for inflation would not be chewing tobacco) on their tax returns. As a result, consistent with its goal of aligning the state’s tax on the state did not collect any administrative data on e-cigarettes with its tax on cigarettes, which is not e-cigarette sales. The Governor’s recent executive subject to an inflation adjustment. order directed CDTFA to require taxpayers to list Recommend Inflation Adjustments. If the e-cigarette sales separately from other tobacco Legislature chooses to enact a nicotine-based sales starting in January 2020. This administrative e-cigarette tax, we recommend that it direct the change could yield data that could help us refine administration to adjust the tax rate for inflation. our revenue estimates in the coming months. Even If the Legislature wants to maintain a consistent in the best-case scenario, however, many of the relationship between tax rates on cigarettes and uncertainties described above will remain. e-cigarettes, we recommend that it adjust both tax rates for inflation, rather than neither. The Revenue Allocation Legislature could create a cigarette tax inflation Options Range from Very Flexible to Very adjustment without amending any ballot measures. Restrictive. If the Legislature chooses to enact a For example, in addition to the existing cigarette new tax on e-cigarettes, it has a range of options tax, the Legislature could create a new cigarette tax for allocating the resulting revenue. At one end of that starts at zero dollars per pack and increases the spectrum, the Legislature could take a very annually by the amount required for the combined flexible approach, depositing the revenue into rate to keep pace with inflation. the General Fund and appropriating it through Revenues the annual budget process along with other General Fund revenue. (For example, this is the Tax Likely Would Raise Tens of Millions of current method for allocating alcoholic beverage Dollars Annually. The amount of revenue raised tax revenues.) At the other end, the Legislature by the proposed tax is highly uncertain at this time. could take a very restrictive approach, depositing Our current best estimate is that the tax initially the revenue into a special fund and directing would raise tens of millions of dollars annually. the administration to appropriate it continuously The estimates included in the 2020-21 Governor’s to specific departments or programs based Budget are reasonable, but actual revenue could on a detailed formula. (For example, this is the be much higher or lower than those estimates. Key current approach for allocating most tobacco tax sources of uncertainty include: revenues.) • Data Limitations. We have not found any The Governor’s proposal falls somewhere in precise, credible estimates of the current size between these two approaches. On one hand, the of the proposed tax base—the total amount of proposal would place some restrictions on the use nicotine sold in e-cigarettes in California. of the new revenue by depositing it into a special • Changing Policy Landscape. Potential fund set aside for designated purposes. On the state and federal policy changes—such as other hand, the Legislature would appropriate the a state flavor ban or further FDA restrictions funds during the annual budget process, and a 10 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET wide range of programs would be eligible to receive above, the revenues raised by the new tax are the funds. highly uncertain. Accordingly, if the Legislature Recommend Very Flexible Approach. We chooses to deposit the new e-cigarette tax recommend that the Legislature take an approach revenue into a special fund, appropriating less than to revenue allocation that prioritizes flexibility. $24 million from this fund in 2020-21 would be Ideally, this would mean depositing the revenue prudent. Alternatively, the Legislature may want to into the General Fund. If, however, the Legislature consider how it will fund the planned expenditures prefers to deposit the revenue into a special fund, if revenues fall below $24 million. As discussed in we view the Governor’s relatively flexible approach The 2020-21 Budget: Transportation, for example, much more favorably than a restrictive, formulaic the Legislature could consider a variety of options approach. for funding the proposed enforcement task force, rather than relying exclusively on the new We discuss in detail a number of advantages e-cigarette fund. of flexibility in our 2018 report, Taxation of Sugary Drinks. Flexibility allows budgeting to focus on General Fund Could Help Address Revenue key issues like the costs and benefits of different Uncertainty. Although the revenue raised by the proposals. The resulting budget discussions proposed tax is highly uncertain, the range of revolve around questions like, “How cost-effectively possible revenues would be small in the context does this proposal advance our policy goals?” of the General Fund. Consequently, depositing or “Would these resources be better spent in a the revenues into the General Fund would allow different program?” In contrast, when the state the Legislature to provide some insurance against uses formulas or special funds to commit excise tax this revenue uncertainty by pooling the risk across revenues to specific purposes, budget discussions many areas of the budget. often revolve around questions like, “How much Tax Administration revenue will this tax raise this year?” Connection Between Proposed Language Additional Cost to Add Tax to Information and Enforcement Proposal Unclear. The Technology (IT) System. The cost of implementing Governor’s proposed trailer bill language the proposed e-cigarette tax includes some items designates the monies in the new fund for that are not included in the Governor’s January youth tobacco prevention programs, health care budget proposals. Most notably, the January programs, and administration and enforcement of proposals do not include the cost of adding the tax the new e-cigarette tax. The proposed CHP-led to CDTFA’s new IT system. We anticipate a budget enforcement task force, however, would not focus proposal to cover this one-time cost—likely in the on e-cigarettes specifically. Instead, it would range of $6 million to $8 million—later this spring. conduct enforcement activities related to the illicit Stamps Could Aid Enforcement, But Cost and vaping market broadly, including devices that Feasibility Unclear. $8 million of the Governor’s deliver nicotine, tetrahydrocannabinol (THC), and $10 million tax administration proposal would be other substances. Accordingly, if the Legislature for a stamp contract. The intent of this proposal is decides to appropriate money from the new to create a system of tax stamps analogous to the e-cigarette fund to this proposal, we recommend ones used in the state’s cigarette tax program. The that it modify the trailer bill language to authorize feasibility and effectiveness of cigarette tax stamps this use of the fund. is due, in part, to the high degree of consistency in Consider How Funding Shortfalls Would Be the size, shape, and amount of tax due on a pack Handled. The Governor’s official January proposals of cigarettes. Packs typically contain 20 cigarettes include $17 million of expenditures from the new and thus require a $2.87 tax stamp. A second, fund. Including the additional administrative costs less common type of pack contains 25 cigarettes described below, we expect the administration’s and requires a $3.59 tax stamp. As a result, the overall 2020-21 expenditure plan for e-cigarette vendor needs to produce just two denominations of tax revenues to total roughly $24 million. As noted www.lao.ca.gov 11 analysis full gutter 2020-21 BUDGET stamps, and taxpayers can comply with the tax by would require taxpayers to affix multiple stamps per affixing just one stamp to each pack. item. Furthermore, the vendor would need to offer In contrast to cigarettes, the size, shape, and stamps that could fit on all manner of e-cigarette amount of tax due on e-cigarettes would vary packages. In principle, careful implementation widely under the Governor’s proposal. As a result, could overcome these challenges. The information the proposed e-cigarette tax either would require provided to date, however, does not suggest that the vendor to produce stamps in a much wider the administration has considered them carefully variety of denominations than cigarette stamps, or enough to justify the requested appropriation. CONCLUSION In this report, we have discussed many issues If the Legislature chooses to enact a new tax for the Legislature to consider as it decides on e-cigarettes, we recommend that it take an whether to change the state’s approach to taxing approach to revenue allocation that prioritizes e-cigarettes. We find that a tax based on nicotine flexibility. Ideally, this would mean depositing the content has some advantages. We also suggest revenue into the General Fund. If, however, the that the Legislature consider a wide range of Legislature prefers to deposit the revenue into a possible tax rates. Once the Legislature has chosen special fund, we view the Governor’s proposed a rate, we recommend indexing the rate to inflation approach much more favorably than a restrictive, and revisiting it frequently to assess whether further formulaic approach. adjustments are warranted. 12 LEGISLATIVE ANALYST’S OFFICE analysis full gutter 2020-21 BUDGET SELECTED REFERENCES Cantrell, Jennifer, Jidong Huang, Marisa S. Greenberg, Haijuan Xiao, Elizabeth C. Hair, and Donna Vallone (2019). “Impact of E-Cigarette and Cigarette Prices on Youth and Young Adult E-Cigarette and Cigarette Behaviour: Evidence From a National Longitudinal Cohort.” Tobacco Control. Cotti, Chad, Erik Nesson, and Nathan Tefft (2018). “The Relationship Between Cigarettes and Electronic Cigarettes: Evidence From Household Panel Data.” Journal of Health Economics 61:205-219. Cotti, Chad, Charles Courtemanche, Johanna Catherine Maclean, Erik Nesson, Michael Pesko, and Nathan Tefft (2020). “The Effects of E-Cigarette Taxes on E-Cigarette Prices and Tobacco Product Sales: Evidence From Retail Panel Data.” National Bureau of Economic Research Working Paper 26724. Deng, Xueting and Yuqing Zheng (2019). “Estimating the Effects of Electronic Cigarette Excise Taxes on the Demand for Tobacco Products.” Mimeo, University of Kentucky. Pesko, Michael and Casey Warman (2019). “The Effect of Prices and Taxes on Youth Cigarette and E-Cigarette Use: Economic Substitutes or Complements?” Mimeo, Georgia State University. Pesko, Michael, Charles Courtemanche, and Johanna Catherine Maclean (2019). “The Effects of Traditional Cigarette and E-Cigarette Taxes on Adult Tobacco Product Use.” National Bureau of Economic Research Working Paper 26017. Saffer, Henry, Daniel Dench, Michael Grossman, and Dhaval Dave (2019). “E-Cigarettes and Adult Smoking: Evidence from Minnesota.” National Bureau of Economic Research Working Paper 26589. Zhao, Juliana (2019). “E-Cigarettes and Cigarettes: Complements or Substitutes?” Mimeo, University of California, Berkeley. www.lao.ca.gov 13 analysis full gutter 2020-21 BUDGET LAO PUBLICATIONS This report was prepared by Seth Kerstein, and reviewed by Brian Uhler and Carolyn Chu. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 14 LEGISLATIVE ANALYST’S OFFICE