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Excise taxes

Originally published in the NTA Encyclopedia of Taxation and Tax Policy, Second Edition, edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle. The encyclopedia is available in paperback from the Urban Institute Press. Order online at www.uipress.org or call toll-free 1-877-847-7377

J. Fred Giertz
Institute of Government and Public Affairs, University of Illinois at Urbana-Champaign

Taxes levied on the manufacture, sale, or consumption of a single good or service or on a relatively narrow range of goods or services.


Excise taxes are an example of what have been traditionally called indirect taxes: taxes that are imposed on a transaction rather than directly on a person or corporation. Excise taxes are narrow-based taxes, as compared with broad-based taxes on consumption such as a general sales tax, a value-added tax, or an expenditure tax. Excise taxes can be collected at various stages, including the point of production, the wholesale level, or the retail level. They are also known as selective sales taxes or differential commodity taxes.

Excise taxes are levied on either a unit or ad valorem basis. For unit (also known as specific) excises, the tax is denominated in terms of money per physical unit produced or sold. Examples include the federal government taxes of 18.4 cents per gallon of gasoline, $13.50 per gallon of distilled spirits, and $3.10 per domestic flight segment for passenger airline travel. Ad valorem excises are based on a percentage of the value of the product or service sold. The 7.5 percent federal tax on the cost of domestic airline passenger tickets (in addition to the unit tax mentioned above) and the 3 percent tax on the cost of telephone services are examples of ad valorem taxes.

Rationale for excises

The use of excise taxes is explained or justified by a variety of rationales. Often more than one rationale will explain a particular tax. There are obviously alternative instruments, including other types of taxes, for achieving the same goals that excise taxes achieve.

Excises are sometimes employed simply to raise revenue because they are easy to administer. In the past (and continuing today in some less-developed countries), excise taxes were applied only to products produced in sectors of the economy with well-developed markets. Broader-based taxes, such as the income and general sales taxes, are difficult to administer when most of the economic activity takes place outside a structured market setting.

Excise taxes may also be employed to achieve particular redistributive results. Excise taxes are sometimes used as a means of implementing an ability-to-pay approach to taxation. So-called luxury taxes are an example of this approach. In the past, the United States levied excise taxes on so-called luxury items purchased by individuals-items such as expensive passenger vehicles, boats, aircraft, furs, and jewelry. By taxing items consumed disproportionately by higher-income individuals, excise taxes can be progressive. There are questions, however, concerning horizontal equity because not all people at the same income level have similar expenditure patterns for luxury items. Hotel occupancy taxes are another variant of this motive, where the intent is to shift the burden to nonresidents of a jurisdiction. Windfall profits taxes such as the excise on domestic oil in the 1970s also have a redistributive intent.

Excises are also levied on goods or services that are considered harmful or undesirable in an attempt to discourage consumption or punish the consumer. Taxes based on this rationale are labeled sumptuary excises. Examples include taxes on alcoholic beverages, tobacco products, and wagering. Because many goods and services taxed by sumptuary excises have relatively inelastic demands, these taxes may have only a limited impact on curtailing consumption. This presents an added benefit, however, for the government because it provides a relatively stable source of tax revenue. Sumptuary taxes are often popular politically because many citizens do not engage in the taxed activities, whereas purchasers of the taxed items do so voluntarily. Such taxes may have negative consequences from the standpoint of vertical equity because sumptuary excises are often highly regressive.

Excises may also be imposed as a technique for dealing with negative externalities. Taxes on "gas-guzzling" automobiles and gasoline can be explained as a kind of Pigouvian (corrective) tax to reduce the divergence of the private and social costs of pollution and congestion. Such taxes are usually an imperfect technique for internalizing externalities because an efficient Pigouvian tax should be related to the marginal damage caused by an activity, which is not necessarily proportional to the level of consumption.

While the goal of Pigouvian taxes is to correct for resource misallocation, liability taxes may also be levied on negative externalities to generate funds to mitigate the damages these activities create. The Superfund tax on pollution damage and leaking underground storage taxes are examples of liability taxes.

Excises may be used for border adjustment purposes if foreign firms are avoiding certain costs imposed on domestic firms. For example, if domestic producers are taxed to generate funds to deal with the negative consequences of the good they are producing, a border adjustment tax on the same good produced by foreign producers would "level the playing field." Excise taxes are also occasionally employed for regulatory purposes. An extreme example of this is an excise tax that some states have imposed on gambling devices that are, in fact, illegal.

Finally, excise taxes may be employed as a means of implementing a benefits-received approach to taxation. Gasoline taxes are an example. Gasoline usage is closely related to highway travel, thereby providing a link between taxes paid and benefits received from roadways. This link is further strengthened by earmarking where the revenues collected from an excise tax are designated for use in providing government services related to the activity. Examples include the earmarking of motor fuel taxes for highways and taxes on airline tickets for air traffic control and facilities expansion.

Economic impacts

The economic impacts of excise taxes are usually investigated using a partial equilibrium approach because excises apply to only one product or, at most, a narrow range of goods or services. An analysis of the incidence of an excise tax in a competitive industry is usually divided between its impacts in the short run and the long run. In the short run, an excise tax increases the price of the product, albeit by less than the full amount of the tax, and the price burden is shared by both the producers and the consumers. The exact effect depends on the elasticities of demand and supply for the product. The increase in price resulting from the tax will be greater as the elasticity of supply increases and the elasticity of demand falls. The impact on quantity will be greater as both the elasticity of demand and the elasticity of supply increase.

In regard to sharing the price burden, the more inelastic the demand is, the larger the share of the tax borne by consumers. The more inelastic the supply is, the larger the share borne by producers. In the limiting cases, consumers will bear the full price burden if demand is completely inelastic, whereas producers will bear the full price burden if supply is completely inelastic.

In the long run, the price will increase by more than it does in the short run because firms will exit the industry due to losses created by the tax. In constant cost competitive industries, the price will increase by the full amount of the tax; in increasing cost industries, by less than the amount of the tax; and in decreasing cost industries, by more than the amount of the tax. (A constant cost industry is one in which industry costs are unaffected by the exit or entry of firms. An increasing cost industry is one in which the costs of all firms in the industry increase with the entry of new firms. In a decreasing cost industry, the costs of all firms fall with the entry of new firms.)

In general, nothing can be said about the progressivity or regressivity of excise taxes because the answer depends on the consumption pattern by income class of each product that is taxed. As noted above, some excise taxes are highly regressive, such as those on tobacco and alcohol, while others, such as those targeting luxuries, may be progressive.

In regard to the welfare effects of excise taxes, excess burdens or deadweight losses generally result from the selective taxation of a small number of products. Such taxes distort consumer choices by driving a wedge between marginal cost and price. The more elastic the demand for a product, the greater will be the excess burden of an excise because such a tax will have a relatively large impact on the quantity consumed. In addition, the excess burden of an excise tax increases roughly with the square of the tax rate-doubling the tax rate quadruples the welfare loss. This result argues for the use of a broadbased tax on a wide range of commodities rather than a high tax rate on a small number of goods.

It also follows from this that tax optimality can be achieved with a general set of selective excise taxes (given the amount of revenue to be collected) by setting excise tax rates for various products inversely to their elasticity of demand. While such a plan may be efficient in the sense that it minimizes excess burdens, it may have negative equity (distributional) consequences by taxing goods with inelastic demands (such as necessities) very heavily.

From the standpoint of efficiency, a general tax on all consumption at a uniform rate will generally dominate a partial system of taxation using excises. Such a tax does not distort consumer choices at the margin as excise taxes do. However, the general tax on consumption needs to be truly broad-based, with all goods (including leisure) part of the tax base. Such a broad base is extremely difficult to achieve.

Use of excise taxes

Historically, excise taxes have played an important role in the tax systems of most governments. They have declined in relative importance, however, in the last hundred years because of the increased reliance on broad-based taxes such as income, general sales, and value-added taxes. Today, less-developed countries rely somewhat more heavily on excises than more highly developed countries.

In the United States, excise taxes are used by all levels of government, with states relying most heavily on this source of revenue. At the federal level in 2003, various excises (not including customs duties) amounted to $68 billion, or 3.7 percent of federal revenues. At the state level, excises accounted for $79 billion in revenues in 2001, or 10.6 percent of ownsource state revenues. Local governments collected $18 billion, or 3.1 percent of own-source revenues from excises.

Among the large number of federal government excises are taxes on various fuels, tires for highway use, truck trailers,"gas-guzzling" automobiles, air transportation, telecommunications services, wagering, alcohol, tobacco, and firearms. States generally apply excise taxes to a narrower range of items including motor fuels, alcohol, tobacco, and wagering. Excises on highway fuels constitute the single largest category in terms of revenue for both the federal and state and local governments.

Some local governments, especially municipalities, tax a similar range of activities, although usually at a lower rate than the state.

ADDITIONAL READINGS

  • Bowman, John H. "Excise Taxation." In Handbook on Taxation, edited by W. Bartley Hildreth and James A. Richardson (549-78). New York: Marcel Dekker, 1999.
  • Cnossen, Sijbren, ed. Theory and Practice of Excise Taxation. Oxford: Oxford University Press, 2005.
  • Davie, Bruce F. "Tax Expenditures in the Federal Excise Tax System." National Tax Journal 47, no. 1 (March 1994): 39-42.
  • Keeler, Theodore E., Teh-Wei Hu, Willard G. Manning, and Hai-Yen Sung. "State Tobacco Taxation, Education and Smoking: Controlling for the Effects of Omitted Variables." National Tax Journal 54, no. 1 (March 2001): 83-102.
  • Oldenski, Lindsay. "Searching for Structure in the Federal Excise Tax System." National Tax Journal 57, no. 3 (September 2004): 613-37.
  • Poterba, James. "Lifetime Incidence and the Distributional Burden of Excise Taxes." American Economic Review 79, no. 2 (May 1989): 325-30.
  • Young, Douglas J., and Agnieszka Bieli¢nska-Kwapisz. "Alcohol Taxes and Beverage Prices." National Tax Journal 55, no. 1 (March 2002): 57-73.